April 29, 2020 · 7 min read
In a recent post I surveyed different types of funding models, including nonprofit models such as universities or private foundations, and for-profit models such as startups. Although we need both models, I believe that for-profit models are underrated today. In what follows I will explain some fundamental advantages of the for-profit model.
To understand these advantages and why they are essential, we have to understand the incentives and feedback loops that exist within the for-profit and nonprofit worlds. One framework I use to think about this is a concept I call organizational metabolism.
An organization, like a biological organism, has a metabolism: a core set of processes that keep it alive. These processes provide the resources it needs to act, to grow, and to sustain itself. For an organism, the basic resource is energy, whether from food, sunlight or chemicals. For an organization, the basic resource is money, for payroll and other expenses. Just as an animal must eat, an organization must collect revenue, or die.
Understanding an entity’s metabolism is fundamental to understanding its role within an ecosystem of competing entities and the selective pressures it is under. An entity with a successful metabolism survives and grows; one that fails in its metabolism is eliminated. Over time, through natural selection, an ecosystem becomes dominated by the entities with successful metabolism. Different entities can have different designs and make different choices, but the laws of nature decide which of them thrive.
Metabolism can be represented as a set of feedback loops. Here is the metabolism of a for-profit business:
The main loop is on the right: a business sells a product or service to its customers for a profit. To give birth to a business, investors can put in capital, which must produce a return; this is the loop on the left. Call the right-hand loop the “product loop” and the left-hand the “return loop”.
A business must be profitable over the long term to survive—but any business that makes a profit can survive. Similarly, a business must credibly promise a return to receive investment, and an investor must make a return over the long term to continue investing—but any promising investment can receive capital, and any successful investor can stay in business. And over time, resources accrue to the most scalable and profitable companies, and to the most successful investors.
In contrast, here is the metabolism of a nonprofit organization, such as a charity or foundation:
A nonprofit also typically provides a product to certain beneficiaries, whether clean water for poor rural areas, or a non-rival good such as research for the world at large. Note however that this product loop is not its core metabolic loop. As we will see, the nonprofit product loop is weak, and sometimes broken.
The loop that sustains a nonprofit is its return loop. Donors provide the organization with its revenue. What do they get in exchange? What does the organization have to provide to sustain or grow its revenue?
In theory, donors give because they support the organization’s mission: they want to sustain its product loop. In the best case, the product loop is closed with evidence of value delivered, from data and statistics to testimonials and case studies. This is provided to the donors to close the return loop: objective demonstration of success at the organization’s mission leads to more and larger donations.
Not all donors, however, are this discerning, thoughtful, or well-motivated. A charitable donation is often an emotional choice, fueled by moral sentiment. Donors may not demand, or even care for, evidence of success; they may be more persuaded by pictures and stories that tug at the heartstrings, or by the charisma of the executive director. Or they may be driven by motives less honorable than generosity, such as prestige, status, a public image. In short, donors may care less about doing good than about feeling good or looking good.
To the extent that donations are not driven by proof of effectiveness, the product loop is broken: it is no longer a loop, and it does not matter to the organization’s metabolism. The organization may still provide a valuable service, but if so, this is incidental to its survival, an epiphenomenon. The organization is now in a loop of providing a feeling or a social image to its donors, and as long as it can do that, it can survive indefinitely whether or not it does any good for the world.
It’s possible for a pathology like this to exist in a for-profit business—the nutritional supplements industry is probably an example—but it’s restricted to a subset of products for which it is difficult to make rational buying decisions. And even a supplements company would quickly go out of business if it failed to physically deliver its product into the hands of customers—yet this kind of failure is routine in the nonprofit world, where disaster-relief donations are often discarded and international aid ends up in the pockets of warlords.
Nonprofits can of course be effective and efficient, and some are more so than many businesses—but this happens more by the grace of an executive with courage and integrity, or the rare strategic donor, than by inherent selective pressures.
A second thing to note about these diagrams is that every part of a business’s loops can be measured. On the right, the business can measure costs, sales, and profit; on the left, capital, dividends, and return on investment. From fundamental measures such as these are derived a sophisticated system of financial metrics, and an entire discipline to manage them: accounting.
Financial metrics have a bad reputation; they are the implements of corporate “greed” and are blamed for everything from sweatshops to pollution to securities fraud. A myopic focus on financial metrics can indeed lead to long-term destructive behavior. But used properly, finance is a powerful tool to promote efficiency and effectiveness. It can identify waste, optimize portfolios, and justify long-term investment. Crucially, it can manage risk.
Precise, quantitative risk management is especially important in the allocation of resources to early-stage projects. Along the efficient frontier, risk is correlated with potential reward. A mechanism is needed to provide the investor with a higher rate of return in exchange for funding riskier projects. In debt, this is done with interest rates; in equity, by the mechanism of valuations: higher risk is reflected in lower stock prices. Particularly in the world of venture capital, this means there is a disproportionate reward for being right early—for being the first backer of a promising project at its inception, when risk is highest.
The result is that investors are actively incentivized to embrace contrarian theses: they win biggest when they bet on something that the rest of the world would not, once success is proven over time. I know of no such mechanism or incentive in the nonprofit world, where the incentive for donors is if anything the opposite: to seek out safe, consensus causes, especially to the extent that the donor’s motivation is prestige or social approval.
The weaknesses of the money metabolism come from two key requirements that the nonprofit metabolism does not have. First, you must capture part of the value you create. Second, you must generate a return within the time horizon of investors (about a decade in venture capital). As a result, there is often pressure to fund specific, visible goals rather than completely undirected exploration.
Conversely, the strength of the nonprofit model is its lack of these limitations. It is probably a better way to support, for example, basic research, which tends to explore uncharted territory to generate open, often unpatentable knowledge that leads to economic value only on the timescale of a generation or more. (There are also reasons to believe that nonprofits are better suited for a variety of areas from performing arts to nursing care.)
However, when it is possible, I see great advantages to the for-profit model:
Revenue is as scalable and reliable as demand itself. When your market grows, your revenue grows; as long as your unit economics work out, you can scale supply to meet demand. In a nonprofit, if your market grows, only your expenses grow. Your revenue is at best loosely tied to demand. A charity that donates clean water to poor rural Africans may or may not find enough rich Westerners to pay the bill, but a business that figures out how to sell water to them at a profit will serve as many customers as are willing and able to pay. Again, this is not to say that such a charity should not exist, but simply to point out that it has inherent limitations to scale.
For-profits have the incentives and the metrics to drive effectiveness and efficiency. A charitable donor may not think strategically about how many meals, mosquito nets, or doses of a vaccine can be delivered for their million-dollar donation. Indeed, to the extent they are motivated not by doing good but by feeling good or looking good, they are likely to measure themselves not on the results but on the amount of money they gave, or the portion of their wealth that represents—thus making the fundamental mistake of substituting metrics that measure input for those that measure output. In contrast, a business is constantly driven to serve more customers at lower cost, to expand into new markets and new product lines, to reduce waste, to cancel or overhaul failing programs. (Notable exceptions include many “effective altruist” organizations, such as Open Philanthropy—notable in part because the strategic thinking they evidence is so rare.)
For-profit investors are more likely to fund high-risk, high-reward experiments. The incentive for investors to seek contrarian theses at the individual level leads to a diversified global portfolio of bets at the ecosystem level. The mechanism of equity, in particular, allows investors to be rewarded proportional to risk, which allows each investor to build a successful portfolio even when many of their bets fail. Given how many crazy-looking, risky experiments turned into breakthrough innovations that transformed the world, a mechanism that funds them when they are overlooked by others is extremely valuable.
These advantages are so great that I submit a bold principle:
Anything that can be for-profit, should be.
Nonprofit organizations should be formed only as a last resort to fill in the gaps where for-profits cannot work.
If a given need cannot be served profitably, then finding ways to make profit possible in that area is even better than serving the need with nonprofit organizations.
Institutions and mechanisms that create opportunities for profit—such as property rights, including intellectual property rights—create enormous value for a society.
Conversely, when profit is prohibited in or drained from an industry, it represents an enormous destruction of value.
As an example, a challenging area of pharmaceutical development is repurposing drugs: discovering that a known drug (which may be off-patent) works for a disease it was not previously known to work for. Patents for this type of use can be difficult to obtain and enforce; better market protection for repurposed drugs would make it more profitable to discover these uses, and pharmaceutical investment would follow.
Conventional thinking says that money is a corrupting influence. We hear calls to get money out of politics, out of health care, out of everything. I believe the opposite.
Money illuminates what is murky. It aligns interests. It keeps people honest. Money is, in fact, one of the greatest forces for social good. Instead of getting money out, we should find ways to bring money and profit into as many areas as possible.
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