How nonprofits could access needed capital.

Who's giving, who's getting.
Nov. 13 2006 7:28 AM

Market Magic

Nonprofits could access needed capital by turning donors into investors.

Click here to read more from Slate's philanthropy series. 

Illustration by Rob Donnelly. Click image to expand.

Private-sector companies have ready access to a gargantuan capital market of tens of trillions of dollars globally. Nonprofit organizations, by contrast, are crippled by capital-raising efforts that are minuscule, inefficient, and badly organized. As a result, nonprofits that have developed solutions for critical and growing challenges—in fields like education, health care, housing, economic development, and environmental sustainability—often struggle to grow.

This is a problem with a solution that is entirely within the power of our legislatures. Like the private sector, nonprofits need investors who take risks in pursuit of financial return.

Yet only recently has the idea emerged that anyone might invest in a nonprofit, as opposed to just giving it money—and, to date, there aren't any nonprofit investment securities for investors to bet on. Lawmakers can unlock this magic of the capital market by passing legislation that permits investors to risk the size and timing of their charitable tax deductions.

We might call this approach "dynamic deductibility." Here's how it would work. Today, if you give $600 to the American Red Cross, you get a $600 tax deduction. If you're in the 25 percent federal tax bracket, this deduction is worth $150. The Red Cross gets $600, and giving it costs you only $450. The financial incentive created by the tax deduction is among the finest traditions in our law. Still, it treats you as a donor, not an investor.

The new legislation changes that. It permits the Red Cross to issue "dynamically deductible shares." Say the DD shares are offered at $10 each. You buy 60 of them, paying $600. You are not permitted to take a tax deduction, however, until you sell the shares. You choose to risk the size and timing of your deduction, based on your confidence that the price of Red Cross DD shares will go up.

Your bet pays off. Two years later, your 60 Red Cross DD shares are worth $16 each, or $960 total. You ask your broker to sell. That year, you get a federal charitable deduction of $960—worth $240 to you, assuming you're in the same tax bracket. You have done good by providing capital to the Red Cross. And you have done well by reaping a gain of $90 (the difference between the $150 savings on federal taxes you would have gotten for a donation versus the $240 savings from investing in the DD shares).

Of course, your investment might not have turned out favorably. You took a risk that the Red Cross would perform in ways that would attract other investors at a higher price. But the Red Cross might have run into problems, and you might have decided to pull the plug when the price of a DD share fell, say, to $8—leaving you with a $480 deduction worth $120 in tax savings and a loss of $30 compared with the $150 tax deduction for a charitable gift. (Though you'd still get to feel good about helping the Red Cross.)

This is how dynamic deductibility works for the investor. For the nonprofit, it provides an injection of capital every time DD shares change hands. You buy the 60 DD shares and the Red Cross gets $600. You sell the 60 DD shares two years later, and the Red Cross gets the proceeds as well—either the increased value, if the price has risen, or the decreased value, if it has dropped. This is different from private-sector capital markets. When companies issue stock, they receive the capital. After that, however, money changes hands strictly among investors who buy and sell the stock.

This difference is as it should be. When an investor buys your 60 Red Cross DD shares, he or she wants the capital to go to the Red Cross. Like you, the buyer is investing in the Red Cross because he or she believes in what the Red Cross does, and wants to take a financial risk based on the likelihood that the price of Red Cross DD shares will go up.

So, how does this market function? What makes the prices of nonprofit DD shares rise and fall, and would they really fluctuate? And how do investors get the information they need to buy and sell? The DD plan takes advantage of skills, relationships, firms, and networks that already exist. From Merrill Lynch to boutique investment advisors, from CNBC to Bloomberg, and from Arnold & Porter to small law offices, thousands of firms already provide the services needed by nonprofits offering DD shares and investors investing and trading in them.

Today, capital-market firms advise private-sector companies about when to issue stock and they advise investors on when to buy and sell. In return, the professionals are paid fees or commissions. They would stand to earn similar fees and commissions for applying their know-how to the new market for DD shares, and they'd learn the ropes because it would be a growth opportunity for them. Over time, the professionals would help investors evaluate nonprofits' current and future performance. Relevant factors include cash flow; balance-sheet strength; the size and growth of the market in which the nonprofit competes; the nonprofit's share of that market; what the nonprofit is really good at; the talent, skill, and even celebrity of top management; the nonprofit's strategic alliances; products, services, and distribution channels; brand strength; and use of technology. Different investors and advisors would draw various conclusions about a nonprofit's prospects based on these factors, just as they do with for-profit companies. These judgments would be based on information provided by the company (like annual reports) and analysis by professionals who follow the company (like an analyst's reports and recommendations).

The capital market for nonprofits will fluctuate for all the same reasons there are fluctuations in private-sector capital markets. Nonprofits with hot solutions to major challenges—for example, Habitat for Humanity's volunteer home building and repair—will see their DD shares bid up quickly. The DD shares of stodgy nonprofits that are slow to respond to market shifts will plateau and decline. Some nonprofits might overextend their reach by issuing too many DD shares and diluting value. Others might make the opposite mistake by issuing too few DD shares that remain too thinly traded to attract much interest. All the relevant choices, by nonprofits and by investors, would happen within the regulatory framework of information disclosure and fraud prevention that also already exists for other securities.

DD shares would be the latest in a string of capital-market innovations that allows investors to trade different instruments with various characteristics of risk and return. Investors can trade stocks that offer rights of ownership in companies, or they can trade options representing the right to buy or sell such stock. Investors can buy commercial paper—the rights to trade interest payments due from the borrowing corporations—or they can buy junk bonds, which blend interest payments and contingency ownership. DD shares, for their part, give investors the chance to trade in the right to the size and timing of charitable deductions rather than the rights of ownership in a nonprofit. Like other capital-market innovations, DD shares strengthen the economy—in this case, by establishing the missing link from high-performing nonprofits to the capital they need for growth.

Dynamic deductibility is a win for everyone. It is a win for nonprofits with the capabilities—but not the capital—to meet burgeoning needs. It is a win for the people and causes that increasingly depend on the nonprofit sector. It is a win for the capital-market firms and professionals whose business will increase. It is a win for legislators who believe in betting on markets to solve problems. And it is a win for investors: By taking smart risks on a better future, they'll be able to realize the elusive goal of doing good and doing well.

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