Any extended conversation of nonprofit cultural enterprise will eventually wind its way to a certain business term: undercapitalization. The term and the challenge certainly came up often at the Getty Leadership Institute/National Arts Strategies roundtable I attended back in June. The general gist of the conversation is that the nonprofit arts lack sufficient capital to really do what they need to do, leading them down all sorts of dysfunctional paths as businesses that only get worse over time.

Capital is most simply described as 'wealth used or available for use in the production of more wealth.' It's the stuff (money, equipment, land, buildings) that an organization uses to do what it does. According to the About.com definition:

Capital is something owned which provides ongoing services. In the national accounts, or to firms, capital is made up of durable investment goods, normally summed in the units of money. Broadly: land plus physical structures plus equipment.

According to the GLI/NAS briefing for the conversation, the method of securing and building capital is a key difference between nonprofit and for-profit creative enterprise:

The inescapable difference, it could be argued, is that where you generate surpluses rather than deficits, you have the possibility of a level of capitalization that allows you to invest in your future. Where you do not, then securing the funds required for investment in people (including, not trivially, health benefits), in infrastructure, in marketing, in product development is significantly compromised. This simple difference informs not only the chosen legal structure but the culture of the organization.

Labeling any business as 'over,' 'under,' or 'adequately' capitalized is, of course, fairly subjective. Arts organizations, especially, could always use better facilities, more cash reserves, larger endowments, better office equipment, and the like. Yet so many continue to produce despite this lack of capital that it's easy to wonder why it's such a big deal.

For those managing, staffing, governing, or supporting a nonprofit cultural organization, it is a big deal, whether they recognize it or not.

Lack of adequate capital usually shows up as a series of symptoms, rather than an obvious disease: facilities become ragged and unrepaired, staff look increasingly burned out, training and professional development opportunities are ignored or discouraged, marketing budgets are cut, office equipment is crashing or straining with older software and not enough disk space. It can be like running a marathon without enough body fat to burn in the attempt -- eventually your body starts eating at the muscle itself for fuel.

For commercial firms, the profit margin on their sales will often feed capital savings or investment (so they can become more efficient at selling what they sell). For nonprofits, costs of production are almost always higher than earned income (which is why they're nonprofits), so there is no profit margin to siphon over to capital. One response is to build endowments -- a specialized form of capital available to nonprofits -- or to construct 'working capital reserves' (ie, restricted cash accounts that can be borrowed against and repaid). But more often than not, nonprofit arts groups just let their staff eat the difference, in more work, less training, less health insurance, and lower pay. Worse, they apply for more project grants to fill the hole, which often only support project costs rather than overhead, leading them to stretch themselves even thinner and dig the hole deeper.

There are good reasons that nonprofits don't or can't capitalize like for-profits do, and these will come in a future post. But in the meantime, just understanding and recognizing the structural problem can be an essential first step.

For some great resources to learn more about capital structure in nonprofits, take a look at Hidden in Plain Sight: Understanding Nonprofit Capital Structure from the Nonprofit Finance Fund, or Nonprofit Capital: A Review of Problems and Strategies from the Rockefeller Foundation and Fannie Mae Foundation.