Are Cultural Organizations Recession-Ready?

In the fall of 2019, SMU DataArts — in partnership with Theatre Communications Group (TCG) — released a paper examining the financial health of nonprofit theaters in the years leading up to, during, and following the Great Recession. With data pointing to an economic slowdown, the researchers explored the financial preparedness of US theaters to weather the coming period of uncertainty and turbulence.

The study’s findings¹ suggest that the sector is far from recession-ready. In fact, many theaters are worse off financially than they were in the years leading up to the last downturn. Why are theaters faring so poorly? What can their leaders do to prepare for the next economic decline?

First, let’s consider the data. SMU DataArts followed 75 theaters over the 2004–2017 period. They found:

• Theaters’ unrestricted surpluses declined 6%, on average, between 2004 and 2017, the most recent year for which data is available. More organizations reported deficits in 2016 and 2017 (44% and 53%, respectively) than in 2007 (24%), the year before the last recession.
• Bottom lines have deteriorated, despite growth in overall earned and contributed revenue. All categories of donations, other than corporate, have risen strongly over the period. While overall attendance and subscriptions are on a downward trajectory, total ticket revenue has increased, reflecting growth in single ticket sales and higher prices.
• Working capital — the liquid portion of unrestricted net assets — has been and remains negative for two-thirds of US theaters, meaning theaters are borrowing from the bank and from tomorrow’s revenue (including restricted grants and subscription income) to pay their bills on time. Between 2004 and 2017, working capital declined by 125% on average.

SMU DataArts’ research points to unsustainably rising costs as the primary cause of widespread financial weakness. Expense growth has outpaced revenue growth since 2004, and all categories of expense have risen faster than inflation. Administrative payroll was a primary driver of budget expansion, suggesting theaters are filling gaps in critical functions such as fundraising and finance. But because many donors are still unwilling to pay sufficiently for these “overhead” costs, we can safely bet that theaters were not able to identify funding to fully support their new hires. Production costs also rose substantially over the period examined — an indication that artistic visions are not fully supported by existing revenue models.

When business models are weak, balance sheets naturally suffer. But the severity of balance sheet weakness reported in the new study is surprising. A 6% decline, on average, in organizations’ bottom lines since 2004 should not yield a jaw-dropping 125% drop in working capital over the same period.

What gives? Theaters, it seems, have progressively moved their liquid resources into facilities and other fixed assets. In the meantime, their endowments have expanded along with the financial markets. Over the research period, fixed assets and board-designated endowments grew by 57% and 63% respectively, on average. In other words, many theaters have “locked up” their limited liquid capital, leaving leaders struggling to manage their organizations.

The sharp reduction of working capital will have consequences in the next recession. Theaters now have more assets concentrated in facilities, and less cash to invest in maintaining their fixed assets. Endowments do not generally generate sufficient income to turn bottom lines positive, nor do they provide easily accessible liquidity during economic downturns. Board-designated endowments are more flexible than traditional, donor restricted investment funds — but only if board members are prepared to draw them down.

The reasons for recent negative financial trends — both unfunded growth and unevenly allocated assets — are complex. Too many boards, managers, and donors continue to believe the myths that “scale” equals “success” and that fixed assets lend stability. The notion that cultural nonprofits should not save like every other kind of business remains pervasive, even as national organizations like TCG, SMU DataArts, and Grantmakers in the Arts work tirelessly to advocate for better management and grantmaking practices.

In this difficult environment, I offer four recommendations to help cultural organizations prepare for, and navigate, the next recession. This advice is relevant not only for theaters, but for every nonprofit. I encourage grantmakers to be aware of these reminders as they engage with grantees and make investment choices.

Pause growth plans, unless flexible capital and full-cost funding can be secured.

As cultural organizations grow to serve more audiences, deliver more programs, and attract more staff, their new costs typically exceed growth in earned and contributed revenue. Often, nonprofit leaders pursue activities without full funding in place to satisfy an artistic or donor aspiration. Their existing supporters may furthermore exit after a year or two, leaving organizations carrying substantial new costs before they’ve identified replacement revenue. Deficits, as the data show, inevitably ensue.

Arts groups will continue to increase their losses unless management and funder behaviors change. First, organizations must commit to communicating the true, full costs of all expansionary efforts, and the donor community should signal a willingness to listen. Encouragingly, five major foundations have shown leadership by committing publicly to address the chronic underfunding of overhead costs.² Field-wide change will not happen unless many others follow suit.

Second, organizations should not pursue material budget expansion unless they can secure change capital upfront, or have reserves available for this purpose. Change capital is multi-year, flexible cash that can be invested in strategies to finance and sustain new (or different) programs and operating activities. Like for-profit equity, change capital is meant to help organizations figure out how to reliably cover their new costs over time. Grantmakers in some areas, such as Pittsburgh, are making this kind of substantial investment to bridge grantees’ temporary losses en route to financially stronger futures.

When full-cost funding and change capital are not forthcoming, nonprofit executives need to become more comfortable saying “no.” During recessionary periods, organizations can stem their losses by being creative with the artistic and human capital they already have.

Don’t take limited cash out of the drawer and stick it in the ground…or the market.

Since 2014, I have partnered with Grantmakers in the Arts to educate nonprofits and their supporters nationwide about the importance of building liquid resources to support artistic freedom for the long term. Our core message: organizations need to capitalize in the right order, and working capital should always come first. Most organizations benefit from having at least a few months of flexible operating cash on hand to pay for predictable costs ahead of reimbursement revenue from grants or fees. After everyday cash is in place, leaders can then set their sights on creating board-earmarked reserves for rainy days, such as the temporary losses nonprofits can expect from a recession.

Organizations should not consider fixed asset expansion and endowments (restricted or otherwise) until their balance sheets are otherwise healthy.

Get the board on board.

Board members are often unaware of the cultural sector’s liquidity crisis. With good intentions, many encourage the edifice and endowment complexes at the root of so much nonprofit financial instability. Trustees all too frequently require zero-based budgets, even though they would never run for-profit businesses with the same scarcity mentality. Grantmakers can support board educational efforts.

In the meantime, finance committees should develop surplus-generating budgets with annual working capital and reserve targets. When results are off-target, board members can help senior management develop new scenarios and consider tough decisions that align costs with revenue realities. Trustees should signal trust in their nonprofit executives by not locking up every penny of flexible cash in endowment-like structures.

Build a “tough times” toolkit.

When the economy goes south, theaters and other nonprofits cannot afford to manage by instinct. No one knows how hard the pocketbooks of audiences and donors will be hit, whether arts funding will again shift to front-line human services, or how markets will perform. Financial trends shift quickly, and organizations will need to stay on top of their data. Arts managers should create financial toolkits that include:

• Cash flow forecasting and analysis: This tool shows predicted and actual cash receipts vs. expenditures on a rolling, 12-month basis. When cash is tight, a monthly cash flow becomes essential for monitoring timely revenue collection and bill payment. This analysis helps leaders know when they may need to tap a credit line or draw on working capital.
• Budget analysis and re-forecast: Nonprofits often create thoughtful strategies and budgets, but fail to build in monitoring protocols that could inform timely course corrections. Leaders should formally and regularly assess their progress against plan, and re-forecast year-end financial targets as soon as they find themselves materially off track.
• Scenario planning: In other words, what will an organization do if…? We encourage cultural leaders to develop a “Plan B” that asks: Where are the primary risks to revenue in their budget? What will they do differently if one or more of these risks materialize? By when will they need to act to make a difference?

The economic outlook is uncertain. The financial state of the sector is sobering. Change will take courage and creativity. Luckily, arts leaders have both.

Rebecca Thomas, principal of Rebecca Thomas & Associates (RTA), advises cultural organizations and their supporters on how to balance artistic aspirations with business realities. She helps grantmakers deepen their impact by aligning capital to organizational needs. She assists nonprofits as they plan for, navigate, and learn from change. Within the field, she enjoys sharing her perspective on what it takes to build resilient institutions in the service of mission. Thomas serves on the national advisory board of SMU DataArts.

Notes

1. Voss, Zannie et al. “Theatres at the Crossroads: Overcoming Downtrends & Protecting Your Organization Through Future Downturns.” SMU DataArts, September 2019. Web. https://culturaldata.org/pages/theatres-at-the-crossroads
2. Di Mento, Maria. “Five CEOs of Wealthy Foundations Pledge to do More to Help Charities Pay Overhead.” Chronicle of Philanthropy, September 2019. Web. https://www.philanthropy.com/article/5-CEOs-of-Big-Foundations/247063