A Development Officer friend of mine called me with a strange request. Could I please help an nonprofit Executive Director decide what to do with a six-figure donation? It’s not often nonprofit leaders don’t know what to do with a large gift. But this gift had a unique restriction. The money must be allocated to an account reserved for emergencies or unplanned incidents, whatever they may be; an unrestricted, restricted gift you could say.
In 2020, nonprofit organizations had to maintain operations during a healthcare crisis, an economic recession and environmental disasters simultaneously. If at any other time, it has shown nonprofit leaders and boards the importance of strong financial resilience policies to ensure that the organization can meet expected and unexpected cash obligations at a reasonable cost.
Nonprofits operate on very thin margins, which is to say that most of the money that comes in as revenue goes right out as expenses. As a result, there’s very little wiggle room for a nonprofit to pivot quickly after an unplanned incident like an external event or even a major error. That is why cash gifts that are formally structured as an Emergency Operating Reserve provide a true lifeline for nonprofits, allowing them to be financially resilient in the face of adversity.
To be clear, this is not just a large unrestricted gift. It is a gift that should be governed by an Operating Reserve and Liquidity Policy, ratified by the board so it has its maximum effect.
Operating Reserve and Liquidity Policy
The Operating Reserve and Liquidity Policy is intended to provide guidelines to fund
sudden increase in expenses,
a onetime, unbudgeted expenses,
an unanticipated loss in funding,
a long-term capacity-building initiative, or
investment in infrastructure.
The policy would not allow funds to replace a permanent loss of funds or eliminate an ongoing budget gap. Additionally, the policy would stipulate that any funds used would be replenished within a reasonably short period of time.
In addition to stipulating the appropriate uses of reserve funds, the Operating Reserve and Liquidity Policy specifies the approval process to use operating reserves. In other words, how the Executive Director can gain approval from the Finance Committee or full Board of Directors to use the reserves.
Now let’s discuss where to hold emergency funds. The strategy to invest and manage accumulated reserves is based upon several factors that are inherent to the targeted use of the funds. We will focus on three important ones here.
Liquidity is the ease at which an asset can converted to cash. Savings accounts, money market accounts and short-term Treasury securities are examples of very liquid securities. Illiquid assets are those that cannot be quickly converted to cash. Examples include real estate, equipment, or collectibles.
Volatility describes the amount of change a price experiences over time, typically measured by standard deviation. An asset whose prices swings widely, rising and falling over a sustained period, is said to be volatile. Low volatility assets exhibit more stable and steady price changes over time.
The time interval from when funds are invested to when the funds are used for their intended purpose is referred to as Time Horizon. Funds to be used within two years is typically said to be short-term. Medium term is considered between two years and ten years and long-term is a period of over ten years.
Funds intended to restore the organization after an unexpected emergency should be invested in liquid, relatively stable and short-term investment vehicles, particularly for incidents that are very likely to occur within a 12-month cycle. Appropriate investments for income smoothing could be a savings or checking account, a money market or maybe a short-term CD, if the exact timing of the expense need is known.
Some emergencies, on the other hand, might be projected to occur every other year or maybe once every five years. If possible, organizations should have funds available for these less frequent incidents as well and could invested them in less liquid and/or more volatile assets that are more likely to grow in value than ultra-liquid, ultra-stable assets. A short-term bond fund might give the organization sufficient liquidity as well as some value growth to keep up with inflation.
In this time of extraordinary uncertainty, where nonprofit survival may be only one expense away, donors should consider giving the gift of a financial lifeline in the form of an Emergency Operating Reserve.
Talk to the financial experts at Fairlight Advisors to learn more about managing your nonprofit’s investments. Schedule a free consultation today!