APPENDIX 9B
EVALUATING SOCIAL ENTERPRISES

In this appendix, we present a diagnostic tool to assist in evaluating social enterprises (some of which may be referred to as “earned income ventures”) from a liquidity perspective. We start with a brief argument for considering liquidity, follow with a numerical example, and then show how the graphical Financial Return & Financial Coverage Matrix (FRFCM) may be used in decision-making.¹

If the ALT (Approximate Liquidity Target) Theory is approximately correct,² and/or liquidity is of paramount importance (say, because the nonprofit is capital constrained and engaging in moderate or extreme capital rationing), then calculated Social Return on Investment (SROI, as presented by REDF and others) might be supplemented with or replaced by a form of Social Return on Financial Coverage Ratio (SROFCR). Regardless, the framework that follows should prove useful to nonprofits considering for-profit business ventures.

Hypothetical Organization XYZ has four possible business ventures to consider: A, B, C, and D. Which one(s) should it favor, and which ones avoid? As input into this, consider the table of relevant data for the ventures (Exhibit 9B.1).

Bubble Graph

Data Social Return, Financial Return, and Liquidity Analysis for New Nonprofit Business Ventures

Project	Social Return (5 year Projected)	Initial Investment*	Target Liquid Funds**	Financial Coverage Ratio: ABS(TLF/II)-1	Financial Return Present Value	Memo: NPV
A	300,000	$(100,000)	$35,000	−0.65	$30,000	$(70,000)
B	75,000	$(50,000)	$35,000	−0.30	$25,000	$(25,000)
C	45,000	$(25,000)	$35,000	0.40	$25,000	$
D	5,000	$(5,000)	$35,000	6.00	$10,000	$5,000

* Initial Investment probably best defined as all financial outlays to get venture up and running, including working capital outlays, less restricted funds designated (and restricted) for the venture and monies known with certainty to be forthcoming for the project within the next 6–12 months.

**

Exhibit 9B.1 Bubble Graph Data

These data plot as the bubble graph in Exhibit 9B.2, which is labeled the Financial Return and Financial Coverage Matrix (FRFCM).

Exhibit 9B.2 Financial Return and Financial Coverage Matrix

FRAMEWORK INTERPRETATION AND IMPLEMENTATION

The FRFCM Framework is diagnostic, not prescriptive. In general, managers should invest in projects to the right of the vertical axis, with further right and larger bubble size denoting more desirability. The vertical axis (at the origin) separates projects consuming more than (to the left) or less than (to the right) “organization available funds.” Projects to the left are major liquidity drains, while the further to the right a project plots, the more it adds to the organization's liquidity. Large bubbles represent projects with large (projected) social returns. Management and the board may well decide to go out and get funding for “large bubble” projects that plot left of vertical axis. Otherwise, the fact that these projects are to the left, and the further they are to the left, provides indication of need to delay the project until additional funding is in place.

In both the table and the graph, Project A is a significant liquidity drain but a large social return project. B drains less liquidity, but again would put the organization's liquidity into a negative, illiquid posture. C and D would not exhaust current liquidity, and B provides significant social returns. D is most easily funded from the current liquidity position, but provides lesser social returns. The officers and directors are faced with finding funding for A and/or B if they wish to achieve the projects' significant social benefits. It appears that C might be a more logical choice than B, given the fact that it drains the liquidity position less and yet provides almost equivalent social returns. At best, these are difficult decisions, and nonprofits often lack the managerial abilities as well as the financial resources to properly harness the business potential of these ventures.³

CAVEATS

There are several important reasons that this framework should be challenging for managers to implement:

1. Estimation error is inherent in the initial investment, present value of future returns, and social return estimations.
2. Incoming funds specific to the project may be sufficient to allow for investment in a certain project – if known this may be subtracted from initial investment to arrive at (modified) net initial investment.
3. Near-term deficits or other planned capital or financial outlays may dictate turning down even those projects that appear feasible.
4. There may be restricted funds for project(s) that must be used to reduce initial investment or override diagnosis.
5. No obvious accept/reject criteria are presented; merely guidance to board and officers.
6. No clear ranking criteria are provided from either table or graph, especially in light of the varying NPV prospects (see the rightmost memo column).
7. This shows projects' effect on the organization's insolvency risk, but there are other risk types and dimensions.
8. Managers should really supplement this analysis with payback period statistics.

New research currently being conducted should shed more light on the strains placed on organizations that are launching social enterprise ventures.

Notes

1. This framework is part of a larger paper that was presented in 2000 to two nonprofit conferences. References are as follows: John Zietlow, “Social Enterprise Financial and Nonfinancial Evaluation,” paper presented to the 29th Annual ARNOVA Conference (New Orleans, LA: November 16, 2000); and John T. Zietlow, “Social Enterprise Financial and Nonfinancial Evaluation,” presentation to the Alliance for Nonprofit Management (Cleveland, OH: April 21, 2001).

2. See Chapter 2 for our reasoning on why this appropriate liquidity target (here labeled target liquid funds) should serve as the primary financial objective of noncommercial nonprofits.

3. For more on the difficulties involved in these projects, see John T. Zietlow, “Social Entrepreneurship: Managerial, Finance and Marketing Aspects,” 2001 special issue of Journal of Nonprofit & Public Sector Marketing 9, no. 1–2 (2001): 19–43.