Financial due diligence: What grantmakers look for and what you should know about it
Grantmakers are by necessity becoming more selective in how they allocate their resources. Many are looking for data to help inform increasingly difficult funding decisions. Across the sector, we are seeing a genuine desire among grantmakers to better understand how to effectively use financial information as part of the due diligence process. The challenge is that interpreting financial data can be time consuming and complex, running the risk of creating additional burdens on grantmakers and grantseekers and at times drawing incorrect conclusions.
Due diligence, as defined by Merriam-Webster Dictionary, is “thoughtful research and analysis of an organization prior to a business transaction.” For grantmakers, the due diligence process is a multifaceted one, combining subjective insights and judgments about organizational capacity, governance and leadership with objective data analysis such as financial review. This financial dimension should begin with the examination of audited financial statements and/or IRS Form 990, the current agency budget and some details as to the stability of revenue sources. This information should, in theory at least, help to answer some very basic questions, such as: Did the organization operate at a surplus or a deficit? Does the organization have sufficient cash-on-hand? Is there a healthy reserve base? But it is not always that simple.
Take for example the fact that the total change in net assets (read: surplus or deficit) may include revenues restricted for future use. In other words, what appears to be a surplus may in fact be—on an unrestricted basis—a deficit when you extract those restricted or “spoken for” dollars. Conversely, what looks like a deficit may be an unrestricted surplus if the organization released more restricted revenues than it brought in for the fiscal year. The available cash-on-hand may also have restrictions, rendering it technically illiquid. Or, the unrestricted net asset base may be comprised entirely of property, plant and equipment. Welcome to nonprofit accounting!
The point is it is not an easy task to open up an audit or a Form 990 and interpret an organization’s financial statements. Many of us—nonprofit executives and grantmakers alike—have not had formal nonprofit finance training. In this topsy-turvy world of nonprofit numbers, meaning-making can become overwhelming to the point where the desire is to run for the hills. Yet, there is valuable information to be gleaned from analyzing the numbers. And, for those who take the time to learn how to read and interpret nonprofit financial data, we will have at our disposal a language through which
we can communicate. It is not rocket science, but like any language, it takes time to learn and will likely involve a certain degree of trial and error before getting it right.
When it comes to financial due diligence, there are really only a couple of things to know. First, financial due diligence should provide some insight into whether an organization is at risk of going out of
business. Common indicators of risk include an audit with a qualified or adverse opinion, negative net assets and/or payroll tax liabilities. If you are a grantmaker, these are the kinds of red flags that should give you pause and require follow-up. If you are a nonprofit executive, you should have a well-articulated plan in place to address these issues, and this plan should be communicated proactively to your funders.
Second, and perhaps more importantly, financial due diligence should result in an increased understanding of an organization’s operating model, structure and financial position. It should also result in more successful grant structuring. The documents to review might include one or more years of the following: audited financial statements and management letters, IRS form 990, year-to-date internal financial information, current organization-wide budget, documents describing the status of revenue sources (received, committed, pending) and fundraising plans. If you are a grantmaker, the financial analysis you conduct should lead to insightful questions to ask your potential grantee. If you are a nonprofit executive, you should be prepared to actively engage in this dialogue and impress upon your funder a deep understanding of the financial dimensions of your nonprofit business.
Financial due diligence plays a key role in helping a funder to gauge their level of confidence in “investing” in a nonprofit. But due diligence is not merely a tool for managing risk—it can also be a powerful relationship-building opportunity. As described in Due Diligence Done Well, a guide by Grantmakers for Effective Organizations and La Piana Consulting, the due diligence process can help funders develop a better understanding of the day-to-day realities of their nonprofit partners, and nonprofits gain insight into funders’ philanthropic goals and strategic priorities. When put to its best use, financial due diligence will help to build and sustain a lasting trust between these two interdependent parties. This, in turn, can translate into generating more sustainable sources of revenue for nonprofits at a time when nonprofits desperately need it.
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