Capitalization

Here is a comment I posted earlier on Andrew Taylor's blog The Artful Manager on the subject of capitalization of not-for-profits. This topic is being discussed at the current Grantmakers in the Arts conference.

I'd like to propose an additional thought to this interesting and critical discussion: the traditional model of capitalization for traditional arts organizations is upside down from an incentive and operational point of view.

In commercial enterprises, one invests capital to stimulate future revenue, which one assumes (or maybe hopes) will far surpass the original capital invested. Often this investment takes, at least partially, the form of investment in research and development. Such businesses are used to, and have many means to maximize their capital. One mechanism is to increase it through leverage, which is mainly possible because of the expected potential return. As we have all recently seen, some businesses were able to leverage their capital by 100:1, even when not creating anything of tangible value.

Traditional arts organizations can be seen as businesses requiring tremendous research and development to accomplish their core mission. Every new production, dance, film, painting, sculpture, or piece of music is a research and development project that may or may not return any revenue at all.

And yet, the most popular capital that the organization can accumulate, usually in the form of an endowment, is not able to be leveraged. In fact, because the underlying premise is preservation of capital and not research and development, the organization has what I refer to as "negative leveraging," usually requiring $20 dollars of capital to be able to spend $1 (the prudent draw of 5% on endowment). I would argue that these strictures provide exactly the wrong incentive for these organizations that have high research and development needs and costs. Imagine a pharmaceutical company that has to have $20 in the bank for every dollar it spends on research and development!

Preservation of capital is about preserving the institution and not the mission (at least not directly). Leveraged investment in research and development is about building the future of the organization and directly supporting the mission activities.

I am not advocating we scrap the rules around endowments, but only that a real discussion of the purposes and uses of capital for such businesses, whose mission to create requires great research and development would be very helpful. Perhaps our organizations would be stronger and more importantly, more successful in their core mission to create, with another model to follow.