Why funders engage with unrestricted funding and cost recovery (and why they don’t)

Flexible funding, as a key principle of trust-based philanthropy, entails long-term, unrestricted financial support for non-profit organisations, allowing them to allocate these funds at their discretion to best advance their mission.^[i] This approach stands in contrast to traditional funding models, which typically come with strict stipulations on how the funds should be used. Philea is aiming to bring this vital topic to various peer discussions. This piece explores some of the arguments brought to the table by funders who took part in a recent discussion about unrestricted funding and the cost recovery approach.

The COVID-19 as an inflection point

The COVID-19 pandemic catalysed a significant shift towards more flexible funding in philanthropy. Many funders relaxed or eliminated grant restrictions, enabling non- profits to faster respond to the crisis. The surge in flexible funding is evident in various initiatives, including the 800+ foundations who committed to reducing funding restrictions. Some argue that this shift underscores the need for flexible funding not just in times of crisis, but as a standard practice, to foster impactful and equitable partnerships between funders and non-profits.

The dawning of a new era for flexible funding?

MacKenzie Scott’s donations, totalling approximately $13 billion as of spring 2022, represent a significant departure from traditional philanthropic practices. Her approach is characterised by giving unrestricted grants without a rigorous application process, focusing on issues of equity, and supporting marginalised communities. This way of giving sent shockwaves across the sector  because, historically, the proportion of unrestricted grants has been low despite the limitations posed by restricted grants. Her method, challenging traditional norms, has generated significant interest and debate within philanthropic and non-profit circles.

The impact of large unrestricted gifts

The Center for Effective Philanthropy (CEP) recently undertook a study to examine the impact of the unrestricted funds granted by Scott. The unrestricted nature of Scott’s grants, which were often the largest ever received by the recipient organisations, has been described as transformational. They have enabled organisations to advance equity more effectively, serve marginalised communities, and focus less on constant fundraising. This shift in funding style empowered these organisations to pursue new opportunities and innovate, by reimagining their operations and future plans. Despite some initial concerns about the one-time nature of the funds, many leaders believe these grants have enabled long-term strategic planning and infrastructure investment. Will Scott’s giving have implications for how philanthropy evolves, with a potential shift towards more flexible, trust-based approaches? The field is indeed actively engaged in a debate, assessing both the advantages and disadvantages of unrestricted, flexible giving.

Why might unrestricted funding be a good idea?

Advocates of flexible funding emphasise its role in enabling non-profits to swiftly adapt to unforeseen changes. This approach is crucial in an era marked by multiple crises, allowing organisations to effectively navigate uncertainties, such as those brought on by climate change, demographic shifts, and health emergencies. Flexible funding also signifies trust in non- profit leaders’ expertise and judgment, which is essential for achieving transformational outcomes. It is based on a trust in frontline teams, who, with their hands-on experience in addressing challenges, possess a nuanced understanding of the most effective ways to allocate resources. Bridgespan’s research also advocates for changing the power imbalance between funders and grantees, especially for organisations led by people of colour.

Arguments against the use of unrestricted funding

There are also calls from the sector not to demonise project-based funding, acknowledging its potential benefits and the ways in which it can be structured to support non-profit health and address equity issues.  As discussed in a Council on Foundation’s article, the viewpoint favouring strategic philanthropy and the efficient use of funds in specific projects comes primarily from funders who emphasise the need for accountability and measurable impact. Funders who prefer restricted grants over general operational support would like to see their contributions directly fuel frontline activities rather than being diluted by organisational overheads like payroll or utilities.

This inclination is closely tied to a focus on efficiency and tangible impact, which is often gauged using the ratio of programme expenses to administrative costs. These funders are convinced that without targeted goals, unrestricted funding can lead to a lack of focus. For them, this is a way to ensure that the money is used for its intended purpose and every Euro granted is tied to a tangible result. This is crucial in satisfying stakeholders and boards who demand visible proof of how their investments are making a difference. The preference also stems from a desire to aggregate and report on the impact of their funding as it is easier for these funders to compile and communicate their successes.

Many funders, particularly corporate foundations, strongly believe in the efficacy of project-based funding as a critical tool for risk mitigation. This approach significantly diminishes both financial and reputational risks by allowing for ongoing assessment and adjustment of the projects they support. By directing resources to specific projects, foundations may align the funded initiatives more closely with their corporate goals and values, more accurately track the effectiveness of their funding, and have a course correction if needed.

Some funders strongly prefer project-based funding over unrestricted funding due to a belief that the latter may stifle innovation. In their view, the competitive, goal-oriented nature of project-based funding mirrors the dynamics of market-driven environments, where specific objectives and performance metrics are crucial for fostering creativity and problem-solving. They argue that unrestricted funding, lacking these clear targets and accountability, could lead to organisational complacency, diminishing the incentive for organisations to explore new ideas or refine existing methods.

Project-based funding is also preferred for levelling the playing field, particularly in a landscape where “funder darlings” – organisations frequently chosen for funding due to charismatic leadership, strong existing relationships, or a history of success – often dominate. Project-based funding is believed to shift the focus to the intrinsic merits of each project. It encourages participation from a variety of organisations, including those new to the scene, who are emboldened to apply, confident that their proposals will be judged on their conceptual strength and potential rather than on their history or network.

Non- profit starvation cycle

The “non-profit starvation cycle” is a critical concept in the philanthropic world, highlighting a detrimental pattern where non- profits consistently underfund their infrastructure and operational costs. This cycle, fuelled by funders’ unrealistic expectations about operating expenses, leads to organisations underinvesting in essential areas such as information technology, financial systems, and staff training. Non- profits find themselves compelled to conform to these expectations, often resulting in the underspending and underreporting of overhead costs in tax forms and fundraising materials. This not only perpetuates a misleading narrative about the true costs of running effective programmes, but also hampers the organisations’ capacity to fulfil their missions effectively.

The research conducted by Humentum on 81 national NGOs across Africa, Asia, Latin America, and Europe reveals a concerning trend of funders providing insufficient coverage for administrative costs, significantly impacting the financial health of these NGOs. The study found that a majority of funders fail to adequately fund crucial non-programme expenses like organisational management, finance, and office costs, leading to a situation where 50% of NGOs operate with less than three weeks of unrestricted reserves. This underfunding undermines organisations’ effectiveness and financial resilience.

Can the starvation cycle be broken?

Insufficient cost coverage means inadequate resources like non-functioning computers, lack of staff training, and outdated office infrastructure, all of which significantly limit a non-profit’s operational efficiency and its ability to deliver quality services. The cycle can be broken by addressing its starting point: the unrealistic expectations of funders. When funders shift their focus from costs to outcomes, and provide sufficient funding for indirect costs, non-profits feel empowered to invest adequately in their infrastructure.

To address this, the research recommends that funders should fully and fairly cover all associated administrative costs, directly support financial management capabilities, contribute to unrestricted funds, and regularly collect data on cost coverage. These measures are vital to break the cycle of financial starvation and bolster the resilience and sustainability of NGOs.

An inspiring example of cost recovery

The MacArthur Foundation is one of the leading funders in the field in adopting a 29% flat rate for indirect cost recovery which represents a significant shift in its approach to funding non-profit organisations. This change was informed by a comprehensive study commissioned by the foundation, which analysed IRS Form 990 data from over 130,000 U.S.-based non-profit organisations, sought to understand the real indirect cost rates that financially healthy non-profits were dealing with. The study revealed that these organisations typically had indirect costs amounting to at least 29% of their total expenses. By increasing the indirect cost rate from 15% to 29%, the MacArthur Foundation acknowledged the actual costs incurred by these organisations in carrying out their missions, thus aiming to foster a more realistic and supportive funding environment. This policy change represented a progressive step towards rectifying the non-profit starvation cycle and ensuring the long-term sustainability of grantees.

Arguments in favour of a nuanced approach

The stance of funders advocating for a more nuanced approach, as opposed to a 30% flat rate for cost recovery, is grounded in an understanding of the diverse financial needs of different organisations and projects. These funders argue that a one-size-fits-all rate fails to account for the unique financial dynamics inherent in various types of organisations. They argue that this blanket approach neglects the variability in indirect costs, which can differ significantly between organisations, and even between projects, within the same organisation. For instance, a think-tank engaged in policy research might have lower facility and equipment costs than an organisation with field operations.

They highlight that a flat rate can lead to inefficiencies like overlap and double charging, especially in organisations managing multiple projects. Shared indirect costs, for instance, would be repeatedly billed across projects under a flat rate system, leading to an overestimation of actual expenses. This methodology not only raises concerns about financial efficiency but also skews the equitable allocation of funds, disproportionately affecting smaller, often more innovative projects. Such projects might find a significant portion of their limited budget consumed by overhead costs, thereby limiting their scope and potential impact. These funders argue that the non-profit sector is expected to operate with minimal overhead. Critics worry that a blanket approach might lead to waste and reduced focus on tangible outcomes. To combat this, some suggest allowing non-profits to define their true overhead needs in grant applications and paying for them if justifiable​.

Join the debate!

In the ongoing debate about funding models for non-profits, the concepts of flexible funding and cost recovery stand out. Proponents of flexible funding argue that it allows organisations to respond quickly to changing needs and priorities, and empowers organisations. On the flip side, critics point out that such funding can lead to a lack of accountability and strategic focus. Cost recovery, meanwhile, is lauded for creating sustainability and reducing dependence on donors. However, detractors argue that a flat rate for cost recovery can overlook the diverse nature and specific needs of different programmes or services, potentially leading to underfunding in some areas while overfunding others.

These arguments present a complex picture, and we’re eager to understand diverse perspectives! What resonates with your experience? Do you advocate for or against unrestricted funding and cost recovery? Philea plans to continue highlighting and working around this topic, so your insights and opinions are valuable in this conversation as many funders are trying to find their way. Share your views to broaden the spectrum of ideas on this crucial subject!

[i] Flexible funding, while a part of trust-based philanthropy, is not its sole component. Trust-based philanthropy extends beyond just providing unrestricted funds. It encompasses relationship-building, mutual learning, transparency between funders and nonprofits, and a commitment to understanding and supporting the real needs of nonprofit leaders. This approach advocates for a partnership-based model, where funders support rather than control, and actively work to understand and address inherent biases and power imbalances​.