Are you about starting a nonprofit and want to know how they cover their expenses? If YES, here are 11 ways nonprofits are funded and how they make money.
Nonprofit organizations are formed with the aim of pursuing a charitable, scientific, educational, or literary cause. They are registered as 501(c) organizations with the Internal Revenue Service (IRS), and by extension, they are exempted from paying tax on any income they earn from any source, as long as the funds go into the support of the organization.
Even if a 501(c) organization brings in more income than it spends, they are not required to pay tax on the excess revenue, which must be ploughed back into the nonprofit in order to support and strengthen its mission. In other words, the excess proceeds are not distributed among shareholders or owners like a conventional business.
Even though a nonprofit organization itself cannot earn a taxable profit, the staff who run it can receive a taxable salary. Nonprofit organizations, just like a regular organization incur administrative costs, which include not only expenses like paying rent and utilities, but also compensating the staff that runs the organization. Directors and officers of the nonprofit cannot be paid, but people who hold a position within the company can be.
When you start a nonprofit organization, you can put yourself in any position you want within the company, with a salary you set. However, you should bear in mind that you can’t just give yourself a unlimited paycheck. The IRS expects that you’ll pay yourself reasonable compensation for the services you provide—and it judges reasonableness on the basis of comparable salaries for comparable organizations. If you fail to comply with this guideline, you could risk losing your tax exempt status.
Charitable organizations survive primarily from the donations they receive from organizations and individuals. For most charities, raising donations during the holiday season is easy. But in the eleven other months of the year, they must get creative about finding ways to make money, aside from simply relying on the generosity of others. Here are some of the ways that nonprofit organizations are funded and how they make their money.
11 Ways Nonprofits are Funded and How They Make Money
1. Gifts and donations: nonprofits usually get gifts and donations from individuals (e.g. from a fundraising appeal or given as a legacy), from companies, or from charitable trusts and foundations. Unless the donation was received in response to a particular appeal, the nonprofit is free to use the donation to further the cause of the organization in any way they deem fit.
Gifts and donations are a particularly important sources of income for charities and can attract tax relief. Raising funds however can be time-consuming and costly – and you could even lose money. Members of the charity or non-profit board have to consider the following;
- Is your fundraising effective and economic? Have you set cost/income ratios for your fundraising (bearing in mind that some fund raising efforts are more costly than others) and are you achieving them?
- Are you claiming back tax (eg. through Gift Aid)?
- Is your fundraising legal? The rules about fundraising can be detailed and complex and you may need to seek advice. There are for example rules on data protection, the use of professional fundraisers, and for house-to-house collections and lotteries.
- Is your fundraising ethical? Do you comply with the Institute of Fundraising’s Codes of Fundraising Practice? Have you signed up to the self-regulatory scheme for fundraising?
- Are your fundraising activities likely to damage your reputation in any way? Do you have policies for example on corporate donations?
- Have you made clear what the appeal is for, and what you will do if you raise more or less than target? Have you ensured that the money will be spent on the purpose for which it was given?
2. Gala Events: A lot of nonprofit organizations hold a yearly gala in order to raise funds that they will use to carry out their mission. Gala events can be quite costly to plan and organize, but when done correctly, they can bring in some of the largest revenue of the year.
Some organizations can bring in more than $1 million from a fundraising gala through a mix of wealthy donors, corporations that sponsor the event or individual tables, as well as numerous other individuals interested in the cause.
3. Grant funding: Grants are typically made by the public sector or by charitable trusts and foundations. The money that is given in form of a grant does not have to be repaid to the donor and is usually free from tax. A lot of grant funders will only fund organizations with charitable status.
Some grant makers prefer not to fund organizations that have built up significant reserves or generate cash surpluses. This can be a disadvantage to those with a business-like approach to running a sustainable social enterprise. You should also note that grants almost always come with conditions, for instance;
- particular outputs or outcomes
- achieving agreed milestones
- unspent monies are returned to the funder
- Reporting requirements on the progress of the project or use of the money.
Before a nonprofit organization tries to get a grant, the board should consider the following;
- Is this an activity consistent with the organizations aims and strategy – or will this grant result in a deviation from the core mission.
- Can they meet the grant conditions?
- Will the cost of seeking grant monies outweigh the benefits?
- How will the activity be maintained or wound up after grant funding ends?
4. Contracts: A contract can be seen as a form of trading where there is a formal agreement between two parties. What this implies is that each party has agreed to meet an obligation and should any of the party fail to meet their end of the bargain, the other party will be covered both by the terms of the contract and by contract law.
It is good to note that a contract is a commercial agreement and as such the income from it may be liable for tax and VAT. An increasing number of non-profits are contracting with the public sector to deliver specific services. However, it is not without pitfalls.
If care is not taken, delivering public services can distract a nonprofit organization from its core objective or even undermine its independence.
There is also a danger that contracts are underfunded so that the organization can only provide a substandard service or has to use its own resources. Achieving Full Cost Recovery is essential to long term sustainability. And for charity trustees it is against the law to use charitable resources to subsidize public services.
Members of the charity or non-profit board should consider the following.
- Does the contracted service fit the organization’s aims?
- Can they fulfill all the terms of the contract, and provide evidence that they have done so?
- What would be the consequence of not fulfilling the contract?
- Does the contract price cover all your costs?
- Have the risks been appraised and steps agreed to manage them?
5. Volunteerism: even though this does not directly put money into the pockets of nonprofits, but in a way it does. Donations from different sources bring in revenues into nonprofits and charities, but in order to make sure that these donations last long, nonprofits can rely on the generous time and skill of unpaid volunteers. There are even nonprofit organizations that exist to help other charities maximize their army of volunteers. The majority of charities rely mainly on volunteers to help them run, and people can volunteer in many great ways.
6. Trading: a lot of nonprofit organizations make money by selling goods and offering services to members, service users, the general public, or other organizations. Some nonprofit organizations even depend solely on this means to get all their funding. You have flexibility about how to spend your earned income.
For example, the annual sale of Girl Scout cookies and Boy Scout popcorn are two of the highest profile product examples, bringing in hundreds of millions of dollars each year, much more than its fees from annual membership. The cookie sales have been a lucrative revenue stream for the Girl Scouts since the early 1900s, when the first cookies were said to have been sold.
Other Examples of trading by non-profits include:
- Events and Performances: Organizations in the performing arts can organize concerts, dance performances and music recitals to help support the arts. Other events can include telethons, such as those that public radio and television organizations hold to secure operating funds.
- selling publications or products
- hiring out a venue
- Selling in-house expertise to interested parties e.g. publishing, training, consultancy.
Charities can trade. However, there are charity and tax law implications and you should seek specialist advice. You may need to set up a separate trading arm. It goes without saying that performing trading will pose some peculiar challenges for charities. Nonprofits should consider the following;
- Does the governing document allow you to create and invest in a trading subsidiary?
- Will the proposed trading involve significant risk to a charity’s assets?
- Will investment in a trading subsidiary be in line with the charity’s current investment policy?
7. Publicity: the truth still remains that in order to make money, you will need to spend money. Your nonprofit is more likely to get more donations when more people know about you. Advertising and publicity can increase a charity’s reach and awareness among potential donors. As with volunteerism, advertising doesn’t directly generate revenues, but it can lead to giving and related revenue, such as gala attendance or product sales. A celebrity endorsement can have a huge impact as well.
8. Loan financing and equity capital: in the for profit sector, it is not uncommon to use Debt and equity finance. However, this option is not so popular in the nonprofit sector.
Debt finance is essentially loans and overdrafts, which have to be paid back. Equity finance on the other hand does not have to be repaid. Instead, the investor takes a stake in the organization, entitling them to a share in the rewards (and risks) of the organization.
Loan financing: basically is an amount of money that has been borrowed from another and which has to be paid back after a stipulated length of time in addition to the accruing interest. Loan finance is potentially useful for a range of nonprofits. The pros of getting a loan is that it is flexible and can be gotten a lot quicker as opposed to grant funding. However they have to be repaid and may require assets to be offered as security.
Loans are usually secured against an asset like a property but sometimes they may be unsecured. Lenders usually look for a successful track record of operations and income generation. Consequently a small charity or startup social enterprise may find it difficult to get a loan. Before sourcing for a loan, members of the charity or non-profit board should consider:
- If loan finance is the best option
- If the governing document gives them the power to borrow and, potentially, to pledge assets as security
- If they have the appropriate skills and systems to manage the loan and its repayment
- If they have appraised the risks and agreed steps to manage those risks
Equity capital: Equity capital is provided by external investors in return for a (permanent) stake in the organization and if the organization is successful, the investors share in the rewards. Equity capitals do not have to be repaid unlike loans and they do not require the nonprofit to provide any form of security.
An equity investor tends to take a long-term view of the organization and may also want to contribute expertise. If the organization should fail, then they would have lost their money. Equity finance is most likely to be used by social enterprises. Members of the charity or nonprofit board should consider:
- If they have the power to raise equity finance
- If their potential investors shares their objectives
- If they wish to distribute profit to external investors
9. Federal, State, and Local Governments: Many nonprofits benefit from all levels of government. Good examples of this include public education, higher education, and the public media. Federal, state, and local government grants fund many programs provided by nonprofits, especially for human service and healthcare.
10. Federated Funds: Community-based efforts such as United Way, United Arts, and community funds can be reliable sources of relatively large amounts of money. Federated funds have been known to thrive because they supported employee giving at companies. Today, they have become less popular as new ways of employee giving have been established and as younger donors, such as millennials, seek to be more involved with the charities to which they give.
Identifying and Cultivating Major Donors
In most cases, nonprofits know that 88 percent of total funding comes from just 12 percent of donors, so it is very important to focus on the major donors. Even though your major donors will not give donations as frequently as smaller donors, their donations will have more monetary significance; therefore, nonprofits should have a strategy in place to continually cultivate major donors.
The amount that is considered as “major” will differ from organization to organization. Take a look at your organization’s history of giving and identify the largest gifts to determine what would be considered a major gift. Large nonprofit organizations might consider major gifts to be six-figure gifts and above, while small organizations might consider a gift of a few thousand dollars to be a major gift.
Major gift prospects need to be connected to your organization’s mission, and they need to have both the inclination and the capacity to give large gifts. Starting with your largest donors, most frequent donors and board members is a great way to start cultivating major gift donors.
After you’ve identified your top major gift prospects, building relationships and soliciting gifts from major donors takes considerable time and effort.
You might take a number of steps while cultivating them, including meeting them face-to-face in a one-on-one setting; inviting them to tour your facilities; having them meet your Executive Director; inviting them to events; asking them to volunteer for your organization; and providing them with regular updates and thanks.
Then, of course, they need to be asked for a gift — either to support a specific program or an unrestricted donation to support the organization.
In conclusion, there are a lot of ways that nonprofit organizations can make money for running their organization. In addition, with volunteers helping them out for free of charge, margins are even better for these non-profits.