For-profit business practices are transforming charitable giving. Here's how
Bill and Melinda Gates do it. Bill Clinton does it. Bono does it. And thanks to the Internet, the Average Joe can do it. What is it, you ask? It's the new rage in philanthropy. And although it's called by many names — including engaged philanthropy, strategic philanthropy, philanthro-capitalism, social entrepreneurship and catalytic philanthropy, among others — we'll refer to it as “venture philanthropy.” Coined by John D. Rockefeller III in the 1960s and popularized by articles in the Harvard Business Review in the 1990s, the term refers to the application of the principles of business and, in particular, venture capitalism to philanthropy to increase its efficiency and impact.
Although it's been hailed as a new concept, Andrew Carnegie and the first John D. Rockefeller were practicing aspects of venture philanthropy over a century ago. Some commentators think it's controversial, letting those of extreme wealth (the so-called “plutocrats”) set the social, political and economic agenda for the future. Others believe that because of the availability of information and connectivity of the Internet, venture philanthropy represents a democratization of charitable giving.
Whatever one's point of view, venture philanthropy, in its various forms, is here to stay. It's gone from a few articles written in the 1990s to a major movement. Journals, websites, blogs and consultants of various varieties — many capitalized by the largest private and community foundations — have created an industry with a scale and growth trajectory that has the potential to transform philanthropy as we know it.
To give you a general understanding of the field, here's an overview of the theory and practice of venture philanthropy. And for those of you who want to dig deeper, we've provided references to additional sources and “must reads.”
There's no definitive definition of the term “venture philanthropy.” In fact, many experts think that venture philanthropy is a separate and distinct subset of “strategic philanthropy,” like social entrepreneurship and catalytic philanthropy. This classification, however, seems to be more of an issue of semantics than substance. All of these concepts share an emphasis on impact, strategy and the application of for-profit measurement and management tools to philanthropy.
Carnegie and Rockefeller, the wealthiest men in America at the turn of the last century, were the first people to apply concepts like social entrepreneurship and catalytic philanthropy. Carnegie and Rockefeller made their vast wealth as entrepreneurs during the scientific and industrial revolution that spread through America in the 19th century. It was a more optimistic time — when people commonly believed that science could solve all of the world's problems. Carnegie and Rockefeller formed the first major foundations in the early 1900s and through the application of both their entrepreneurial skill and belief in science, became the first venture philanthropists. They took on illiteracy, poverty and medical research, along with a host of other issues, and they found extraordinary success. Theirs was, as Rockefeller described, the “business of benevolence.” They applied the same passion and intensity to their philanthropy that brought them such success in business. Carnegie memorialized his views on philanthropy and wealth in his book, The Gospel of Wealth, which has become the key text for modern venture philanthropists like Bill Gates and Eli Broad.
Throughout the 20th century, most philanthropy wasn't as engaged or strategic as that of Carnegie and Rockefeller. For the most part, philanthropy involved choosing a nonprofit and determining how much to give. Individuals wrote checks and foundations made grants. Once the check was cut, there was little ongoing involvement by the donor. Individuals and foundations were satisfied to rely on the expertise of the recipient charity utilizing the gift. Without ongoing involvement and lacking measurement tools, it was difficult to determine the impact of any particular gift.
With the renaissance in entrepreneurship in the 1990s and, in particular, the technology revolution in the Silicon Valley subsidized by venture capitalists, academics began to ask whether philanthropists needed to apply the principles of venture capital to their philanthropy. A pair of articles published in the Harvard Business Review on that topic attracted wide interest. The first, “Virtuous Capital: What Foundations Can Learn From Venture Capitalists,”1 recommended that private foundations (PFs) adopt a venture capital model, rather than the traditional scattershot grantmaking model, when choosing recipients of their funds and helping those recipients implement their programs. The suggestion was that venture capitalists and grantmaking foundations face similar challenges in evaluating potential funding recipients and monitoring the results of their investments. But the authors found that PFs often made narrowly focused short-term grants, while venture capitalists have developed a comprehensive approach that involves close monitoring, clear performance objectives and building a sustainable organization. By adopting the venture capital model, the authors argue, foundations can directly participate in promoting the success of the programs they fund.
The second article, “Philanthropy's New Agenda: Creating Value,”2 was published in 1999. In it, authors Michael E. Porter and Mark R. Kramer (both national experts on business strategy) argue that most foundations act as passive middlemen or mere conduits between the donors to a foundation and the causes they support. They believe that foundations can promote social progress and, in fact, have an obligation to do so because of the tax breaks they receive. But foundations need to determine how they can create the greatest social value with their resources, and they must measure the results.
Porter and Kramer offer four ways foundations could create social benefits beyond the immediate effects of grants: Like business investors, they could (1) use their expertise to select the best recipients of their funds and then measure the effectiveness of these selections; (2) attract additional funding to these grantees by offering matching grants; (3) actively partner with recipients to measure their performance; and (4) conduct systematic studies of the long-term success of different types of projects and research new ways of addressing social problems.
The decade between 1999 and 2009 brought dozens of articles and books fleshing out the concepts of venture philanthropy, culminating in another seminal article by Mark R. Kramer, “Catalytic Philanthropy,”3 published in the Fall 2009 issue of the Stanford Social Innovation Review. Catalytic philanthropy combines the effectiveness concepts of venture philanthropy with an emphasis on solving the world's great social problems identified by Carnegie and Rockefeller. Kramer states that catalytic philanthropists are effective because they engage in four distinct practices: (1) They have the ambition to change the world and the courage to accept responsibility for achieving the results they seek; (2) they engage others in a compelling campaign, empowering stakeholders and creating the conditions for collaboration and innovation; (3) they use all of the tools that are available to create change, including unconventional ones from outside the non-profit sector; and (4) they create actionable knowledge to improve their own effectiveness and to influence the behavior of others.
Role of Technology
Putting the theory of venture philanthropy into practice is expensive. Historically, only the wealthiest donors and foundations have had the wherewithal to do the due diligence and follow-up necessary to engage in venture philanthropy. That's beginning to change, thanks to information networks like the Internet, text messaging and smartphones. According to “Disrupting Philanthropy: Technology and the Future of the Social Sector,”4 a whitepaper put out by the Center for Strategic Philanthropy and Civil Society at the Sanford School of Public Policy at Duke University, information networks are transforming philanthropy. Enormous databases and powerful new visualization tools can be accessed instantly by anyone, at any time. A decade of experimentation in online giving, social enterprise and collaboration has brought us to a place from which innovation around forms of enterprise, governance and finance will only accelerate. Ten years ago, individual donors and foundations gathered information about recipient nonprofits mainly through word of mouth. A few foundations had sufficient staffs to do the necessary due diligence, but for most foundations and individuals, there was no easy way to compare the financial health and resource allocation practices of recipient charities. Today, web-based rating services like Charity Navigator and Charity Guide assemble, analyze and make data available on tens of thousands of charitable organizations. Online philanthropy marketplaces, like Care2.org, Justgiving.com, Kiva.org and Donorschoose.org open the world of venture philanthropy to anyone who's interested.
Who Does It and How?
Traditionally, venture philanthropy was the domain of wealthy individuals, large PFs and community foundations. Over the past few years, improved information networks, online marketplaces, charity rating websites, community foundations and commercial donor-advised funds (DAFs) have made venture philanthropy much more widely available to average individuals and small family foundations. Even though venture philanthropy is now available to the masses via the Internet, the dominant players are still the large institutional PFs like the Gates Foundation and the Rockefeller Foundation, and community foundations like the Silicon Valley Community Foundation and the Cleveland Foundation. These organizations have the staffing and expertise necessary to engage in venture philanthropy on a large scale.
Because PFs are subject to a host of excise tax rules, they must be much more careful when engaging in venture philanthropy than community foundations, which are public charities and aren't subject to the excise tax rules. So what are the excise tax rules applicable to PFs that make venture philanthropy more difficult than for community foundations? Let's go back to the Tax Reform Act of 1969, which put in place the PF excise taxes of Chapter 42 of the Internal Revenue Code of 1986. These taxes were created to curb perceived abusive behavior by PFs. One of the most important excise taxes aimed at limiting a PF's speculative investments is the prohibition against “jeopardizing investments” set forth in IRC Section 4944. In this section, excise taxes are imposed not only on the PF, but also potentially against foundation managers. Tax penalties can be severe.
No category of investment by a PF is to be treated as a per se violation of IRC Section 4944. Rather, a jeopardizing investment is one for which a foundation manager has failed to exercise ordinary business care and prudence under the facts and circumstances prevailing when the investment was made. An investment in venture philanthropy typically doesn't meet the standard. Fortunately, under IRC Section 4944(c), there's an exemption to the jeopardizing investment excise tax rules for “program-related investments.”
A program-related investment is an investment by a PF that satisfies the following three tests:
- The Primary Purpose Test. The primary purpose is to accomplish one or more charitable purposes;
- The Production of Income Test. No significant purpose of the investment is to produce income or capital appreciation; and
- The Political Purpose Test. No purpose of the investment is to influence legislation or take part in political campaigns on behalf of candidates.
Program-related investments come in all shapes and sizes. Common examples include:
- loans to or investments in public charities supporting low-income housing projects;
- loans to or investments in businesses owned by economically disadvantaged groups in areas where commercial investment or reasonable rate loans aren't readily available; and
- international loans to, or investments in, not-for-profit and for-profit organizations working on solutions to world hunger.
Program-related investments can be structured through direct investments, generally in the form of low-cost loans or the use of financial intermediaries. Direct investments require the foundation to exercise significant due diligence and document extensively. Most smaller foundations don't have the expertise to structure a direct investment, and those that attempt it often request a private letter ruling.
Usually, smaller foundations will eschew direct investments and choose to invest through intermediaries, such as community foundations, community development institutions and other seed organizations, which receive grants and borrow funds from PFs, then make loans to smaller organizations to fund particular projects. Examples include the Tides Foundation, the Acumen Fund and Venture Philanthropy Partners. While many intermediaries are themselves not-for-profit organizations, some are commercial enterprises pursuing objectives that the Internal Revenue Service considers charitable, such as combating urban blight. The advantages offered by financial intermediaries include staff capacity to evaluate potential recipients and familiarity with the needs of particular regions of the United States and the world. Intermediaries also often develop deep technical expertise in certain programming areas, such as low-income housing.
Larger PFs have the capacity necessary to engage directly in program related investments. Prior to the late 1990s, however, only a tiny percentage of large foundations, such as The Ford Foundation and The John D. and Catherine T. MacArthur Foundation, engaged extensively in venture philanthropy through the use of program-related investments. For example, The Ford Foundation, through loans, gave Grameen Bank, a community development bank that started in Bangladesh, the necessary funding to demonstrate the viability of microcredit. It wasn't long before Grameen Bank showed a profit and for-profit investors jumped in with support. The Ford Foundation's willingness to loan Grameen Bank money when no one else would dramatically helped the incipient microfinance industry.
In recent years, many, if not most large institutional PFs have dipped their toes into direct program-related investments. The concept was given a big boost in late 2009 when the Bill and Melinda Gates Foundation announced that it would begin to make extensive use of program-related investments as a way to leverage the Gates Foundation's resources and to encourage broader financial support for its mission.
Community foundations are also major players in the field of venture philanthropy. Community foundations, which have been around for almost a century, are public charities that are funded by individuals and corporations and typically make grants within a specific community or region. There are more than 600 community foundations in the United States with a total of $31 billion (as well as approximately 200 Jewish federations nationwide). Community foundations, free from the PF excise tax rules, engage in venture philanthropy in a variety of ways. First, they act as intermediaries between individual donors and foundations and recipient non-profit organizations within the geographic area they serve. Second, through in-house technical expertise, they provide capacity building support for local charities to help them carry out their exempt purposes with greater impact and efficiency. Third, they run direct programs within the community, like the Chicago Community Trust's Chicago Redesign Initiative, the aim of which is to create quality education through small autonomous high schools throughout Chicago. Finally, several community foundations, like the Silicon Valley Community Foundation, run social venture capital funds in which donors invest in multi-year business plans that tackle persistent community problems.
Practicing venture philanthropy is hard. It requires much more expertise than traditional grantmaking. As such, it's important that venture philanthropists reach out and get advice to ensure the greatest impact of their venture philanthropy as well as compliance with various tax laws. In addition to traditional resources like tax lawyers, accountants, private bankers and organizations like community foundations, The Foundation Center and the Council on Foundations, a sizable number of outside experts have entered the field in the past decade. Among the best known are McKinsey, Arabella, Rockefeller Philanthropy Advisors, Bridgespan, the Monitor Group, FSC Social Impact Advisors and Foundation Source. The National Network of Consultants to Grantmakers provides an online directory of philanthropic consultants.
For those who like to do it themselves, the Internet hosts a number of excellent blogs on venture philanthropy, including Philanthropy 2173, Social Velocity, Tactical Philanthropy and Change.org's social entrepreneurship blog. The Harvard Business Review and the Stanford Social Innovation Review are also great sources for cutting-edge information on venture philanthropy. And three “must-reads” are Philanthrocapitalism: How the Rich Can Save the World,5 by Matthew Bishop and Michael Green; Money Well Spent: A Strategic Plan for Smart Philanthropy,6 by Paul Brest and Hal Harvey; and The Foundation: A Great American Secret,7 by Joel L. Fleishman.
A Glimpse Into the Future
Although venture philanthropy is still a very small portion of total philanthropy, it's growing at a rapid pace and should have a transformative effect on philanthropy in the next decade or so, as more and more donors and charities adopt its practices. The field has even spawned hybrid for-profit/not-for-profit entities like the L3C and B corporations, which have been blessed at the state law level but have yet to get final blessing from the IRS. Wherever venture philanthropy goes in the future, there's no going back. It will be an interesting ride.
- Christine W. Letts, William Ryan and Allen Grossman, “Virtuous Capital: What Foundations Can Learn From Venture Capitalists,” Harvard Business Review, March-April 1997.
- Michael E. Porter and Mark R. Kramer, “Philanthropy's New Agenda: Creating Value,” Harvard Business Review, November-December 1999.
- Mark R. Kramer, “Catalytic Philanthropy,” Stanford Social Innovation Review, Fall 2009.
- Lucy Bernholz, with Edward Skloot and Barry Varela, “Disrupting Philanthropy: Technology and the Future of the Social Sector,” whitepaper, Center for Strategic Philanthropy and Civil Society, Sanford School of Public Policy, Duke University, May 2010.
- Matthew Bishop and Michael Green, Philanthrocapitalism: How the Rich Can Save the World, Bloomsbury Press, 2008.
- Paul Brest and Hal Harvey, Money Well Spent: A Strategic Plan for Smart Philanthropy, Bloomberg Press, 2008.
- Joel L. Fleishman, The Foundation: A Great American Secret, Public Affairs, 2007.
David Thayne Leibell is a partner in the Stamford, Conn. and New York City offices of Wiggin and Dana LLP. Carolyn A. Chandler is a former managing editor of Trusts & Estates and is a New York-based attorney