SOCIAL ENTERPRISE: INNOVATION OR MISSION DISTRACTION ...

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I am particularly grateful to Professor Dr. Marco Meneguzzo, Dean Dr. Brian Nickerson, and Professor Alex Murdock for their guidance and advice on this work; the participants and discussants of the ProDoc session of the 2009 Swiss Public Administration Network conference for their useful feedback; Monica Bommarito for her support during my time at the University of Lugano; Wilson Center graduate student aid Anna-Kay Sinclair for her research assistance; and Keywan Rasekhschaffe for his useful insights, keen intuition, and invaluable support. All errors are my own. SOCIAL ENTERPRISE: INNOVATION OR MISSION DISTRACTION? REBECCA TEKULA, PH.D. Pace University Helene and Grant Wilson Center for Social Entrepreneurship 163 William Street, 21 st Floor New York, NY 10038 Tel: (212) 346-1028 Fax: (914) 989-8038

Transcript of SOCIAL ENTERPRISE: INNOVATION OR MISSION DISTRACTION ...

I am particularly grateful to Professor Dr. Marco Meneguzzo, Dean Dr. Brian Nickerson, and Professor

Alex Murdock for their guidance and advice on this work; the participants and discussants of the ProDoc session of

the 2009 Swiss Public Administration Network conference for their useful feedback; Monica Bommarito for her

support during my time at the University of Lugano; Wilson Center graduate student aid Anna-Kay Sinclair for her

research assistance; and Keywan Rasekhschaffe for his useful insights, keen intuition, and invaluable support. All

errors are my own.

SOCIAL ENTERPRISE:

INNOVATION OR MISSION DISTRACTION?

REBECCA TEKULA, PH.D.

Pace University

Helene and Grant Wilson Center for Social Entrepreneurship

163 William Street, 21st Floor

New York, NY 10038

Tel: (212) 346-1028

Fax: (914) 989-8038

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ABSTRACT

This study examines the relationship between unrelated business income (UBI) and

program-related expenditure of human service nonprofit organizations based in New York

County. The results of my analysis do not indicate a positive relationship between unrelated

business income and programmatic expenditure. These findings are in accordance with cross-

subsidy theories of diversification in which internal budgeting allocates funds to divisions with

few investment opportunities (ailing enterprises of nonprofits) while failing to channel funds to

those with ample investment opportunities (effective, efficient programs that attract public and

private funding).

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INTRODUCTION

“Increased resources bring added outputs, but at the cost of the distraction of the

nonprofit from its declared mission.” Burton Weisbrod, 1988

In 1988, when Burton Weisbrod hypothesized that as nonprofits branch out from their

central mission the quality of their principal tax-exempt activities would decline, the terms

“social entrepreneurship” and “social enterprise” were not part of the popular discourse. Since

then, the work of Bill Drayton (2002), Charles Leadbeater (1997), David Bornstein (2004), and

Gregory Dees (1998) have further shaped the way academics and practitioners think about social

entrepreneurship, social enterprise and sustainable income in nonprofit organizations. The

central argument of many of their theories is that charitable or socially beneficial activities will

be longer lasting and have a more penetrating effect when these activities are either married with

or fully integrated into a model generating earned income.

The Drayton-Leadbeater-Bornstein-Dees paradigm has significant impact in a growing

sector of the global economy. The nonprofit sector plays an increasingly important role in the

provision of vital services in fields such as healthcare, social service, and education. The size of

the U.S. nonprofit sector has increased rapidly from approximately 12,000 registered

organizations in 1940 to over 1.5 million today, and the aggregate book value of assets, as

reported by nonprofit organizations which filed IRS information returns for tax year 2008, was

over $4 trillion, or 8.9% of U.S. GDP (Urban Institute, 2009).

Background of Enterprising Behaviors of Nonprofits

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Researchers have noted that by the mid-1970s, data on the revenue sources of nonprofits

clearly indicated a substantial dependence on non-donated revenues, that is, income from either

membership dues or some form of sales. Burton Weisbrod (1991) notes that as early as 1908,

the Metropolitan Museum of Art operated a sales shop. In 1982 the Girl Scouts sold 125 million

boxes of cookies for gross revenue of over $200 million (Weisbrod, 1991).

Through the 1980s researches noted that this earned income behavior was increasing

sharply. There is general agreement amongst theoreticians that we can trace this growing

engagement in profit-generating activities to cutbacks in federal funding in the 1980s both in the

U.S. and across Europe (Adams & Perlmutter, 1991). As early as 1983, sector analysts were

reporting the growth of nonprofit enterprise. According to a text published that year, “sixty-nine

percent of the organizations we surveyed have given birth to new [profit-oriented] enterprise

within the past twelve years” (Crimmins and Keil, 1983).

Mission Distraction

Just five years after Crimmins and Keil noted the proliferation of profit-oriented

enterprises, in 1988 Burton Weisbrod hypothesized that unrelated business activities might divert

nonprofits from their charitable purpose (Weisbrod, 1988). This most important dilemma, that

business activities may distract charities from their mission, may be due to the pressure to

perform profitably in the competitive marketplace, which can divert resources and energy from

the organization’s principal social purpose even while total resources are being expanded. This

behavior can be likened to the inefficient cross-subsidies theory of corporate diversification.

Diversification discounts have been calculated by various researchers in the field of corporate

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finance. Findings estimate that the subsidization of poorly performing segments contributes to

value losses between 13 percent and 15 percent (Berger & Ofek, 1995).

Human Service Nonprofits

Amongst all public charities, human service organizations can be considered the closest

to the traditional definition of charity, in that they provide essential services, especially for those

who are least able to help themselves (USDHHS, 2009). Human service is an area considered

inappropriate for profit making (Groenbjerg, 2001; Guo, 2006). Yet following with overall

trends in the nonprofit sector in recent decades, human service nonprofit organizations have

notably increased their earned income behaviors, tripling this type of income in the years 1995 to

2005 (IRS BMF, 2007)

Nonprofit charitable organizations are generally exempt from paying state and local taxes

on property used “primarily” for the organization’s exempt purpose; and nonprofits are exempt

from federal and state corporate income taxes on income from activities that, even if commercial,

are deemed to be substantially related to the organization’s primary exempt purpose (Cordes &

Weisbrod, 1998). However, in addition to this exempt income, a growing number of tax-exempt

organizations have begun to earn an increasing amount of “unrelated business income” (UBI)

from commercial and other activities that are not substantially related to their tax-exempt

missions and is thus subject to Federal taxation. Income is defined as UBI if it is produced from

an activity that is conducted on a regular basis and is not directly related to an organization’s tax-

exempt mission: the fact that the income may be used for furthering an organization’s exempt

purposes does not alter the definition and therefore any profits from these activities are taxed at

regular corporate or trust income tax rates (Riley, 2002). Current theoreticians of social

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enterprise and social entrepreneurship would term this type of revenue generation by a nonprofit

an “external” model of social enterprise (Alter, 2007).

Until now the possible consequences of social enterprise on programmatic activities has

remained speculative; hard evidence from large sample empirical studies does not exist. Previous

authors have conjectured that an increase in financial dependence on market sales relative to

donations will diminish the contribution of some nonprofits to social welfare (Weisbrod, 1988).

Still, myriad philanthropists and private foundations, as well as government agencies, purport the

benefits of “sustainable” earned income for nonprofit organizations without the benefit of an in-

depth analysis of the effects of earned income on programmatic output. Closer study of the

impact of enterprising activities on program activities is necessary and long-overdue.

Unanswered questions which I hope to address with the present study include: What is the

relationship between unrelated business income (external social enterprise) and program

expenditure? What is the relationship between financial distress factors of organizations and

their enterprising behavior? In other words, do financially weak organizations become more

enterprising, and vice versa? I also attempt to address the issue of causality by relating future

changes in enterprising behavior and program expenditure to lagged explanatory factors.

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LITERATURE REVIEW

Globally, there is growing attention placed on the enterprising activities of nonprofit

organizations, much of which is theoretical analysis of this activity. Kim Alter (2007) offers a

spectrum-like typology of social enterprise the motivation for which she describes with the

following:

The growing practice of social enterprise is fueled by nonprofit organizations’

quest for sustainability, particularly in current times when support from

traditional, philanthropic, and government sources is declining and competition

for available funds is increasing. Social enterprise enables nonprofits to expand

vital services to their constituents while moving the organization toward self-

sufficiency. Nonprofit organization leaders understand that only by establishing

an independent means of financing can they become a going concern.

Alter’s typology ranges from a fully “integrated” model of social enterprise, in which the

income-generating activity is in fact part of the mission of the organization to an “external”

model in which the enterprise in unrelated to the mission.

Many researchers and theoreticians look to enterprising behavior as a beacon of light for

a nonprofit sector rife with struggling organizations. Lasprogata and Cotton (2003) offer an

analysis of the business and legal challenges of social entrepreneurship and conclude that

“Traditional revenue sources are rapidly dwindling…Social service nonprofit organizations that

adopt an entrepreneurial approach to sustaining social mission may have the solution” (p. 110).

Stefan Toepler (2006) reviews the underpinnings of the current commercialization debate

in the nonprofit sector with an analysis of the Metropolitan Museum of Art and finds that current

conceptual frameworks of this phenomenon are adequate in explaining the motivations behind

the Museum’s commercial activities. However, Toepler argues that the changing rationale and

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the economic fortunes of these enterprising activities highlights the need for a better

understanding of the effects and consequences of commercial activity by nonprofit organizations

which is increased by the push for growth of enterprising behavior by these organizations.

Foster and Bradach (2005) argue that the enthusiasm for business which reached a height

during the 1990’s has had a profound impact on nonprofits. Yet they hypothesize that launching

and running enterprising ventures consumes scarce management resources and dilutes an

organization’s focus on its social programs and caution that executives of nonprofit organizations

should not be encouraged to “search for a holy grail of earned income in the marketplace” for

fear of harming “society itself, which depends for its well-being on a vibrant and mission-driven

nonprofit sector (p. 100).

J. Gregory Dees (2004) cautions that we must not consider nonprofit business ventures as

a panacea: “Nonprofit leaders should not jump on this bandwagon without understanding and

addressing the challenges, costs, and risks of taking the ride…In some cases, the financial

benefits will not be worth the hidden costs to the organization” (p. 4).

Several studies have endeavored to uncover the impact of such behavior on the mission-

related output of nonprofit organizations. For example, in the face of commercialism, blood

transfusion services deteriorated (Titmuss, 1971), and nonprofit organizations that were

successful in their enterprising activities shifted their emphasis toward a more affluent client

base (Adams & Perlmutter, 1991; Weisbrod, 2004). Salamon (1995) examined the impact of

income source on client focus and found that revenue from fees are negatively correlated with

poverty focus.

More recently, Baorong Guo (2006) conducted an analysis of self-reported survey data of

67 nonprofits which considered themselves to be “venturing” (from a larger sample of 519).

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Guo found that as commercial revenue increases in human service nonprofits, donative revenues

decrease. More relevant to my analysis, Guo finds that commercial revenues “do not make a

significant contribution” on the organizations mission and service delivery.

Pierre-Emmanuel LY (2006) analyzed data on 74 UK-based international NGOs to

determine if NGOs treat donated and earned income as perfect substitutes. LY found that while

donated and earned income have a positive and significant effect on charitable expenditure, the

effect of earned income is significantly less than that of donations.

Outside of the literature on social enterprising behavior and nonprofit earned income, we

can also look to the finance literature for information on the allocations of resources between

divisions of a diversified firm. In fact, Rajan, Servaes and Zingales (2000) were able to find

evidence consistent with their hypothesis that when diversity in resources and opportunities

increases in a firm, resources can flow toward the most inefficient division, leading to more

inefficient investment and less valuable firms.

Overall, there have been very mixed reviews and theories of the impact of enterprising

behaviors on the programmatic output of nonprofit organizations. While early work to explore

the impact of enterprising behavior on nonprofits did uncover evidence of a mission shift to less

necessary services, a large focus in the literature has been on touting the strengths of earned

income as a sustainability strategy for nonprofit organizations. Still, many researchers have

concluded that there is a distinct and growing need for a better understanding of the effects and

consequences of commercial activity by nonprofits organizations. But until now, empirical

analysis with a large random sample of nonprofit organizations does not exist in the literature.

Learning from the work of Rajan, et. al., the current analysis endeavors to uncover possible

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similar inefficient investment or cross-subsidy in the allocations of resources in nonprofit

organizations.

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METHODOLOGY

My analysis focuses on addressing the following questions:

(1) What is the relationship between unrelated business income (external

social enterprise) and program expenditure?

(2) What is the relationship between financial distress factors of

organizations and their enterprising behavior?

Specification 1:

My main regression is Specification 1. This regression directly relates the variable

programmatic expenditure as a proportion of total expenditure (PE) to the unrelated business

income as a proportion of total income (UBI_RATIO) and organization size as proxied by total

revenue. The motivation for this model is to explore the relationship between unrelated business

activities, as a percentage of total income, to the contemporaneous and future programmatic

focus. The program expenditure to total expenditure ratio is a commonly used indication of the

potential return on investment for a funder. This ratio represents the amount of a dollar invested

(donated) that will be spent on the programmatic mission of the organization. Total revenue is

introduced in this specification as a control variable.

TRRATIOUBIPE 21 _

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Specification 2

Specification 2 introduces the dependent variable of change in the ratio of program expenditure

to total expenditure and size as proxied by total revenue. While it is often difficult to relate or

predict changes in a variable (here, change in programmatic spending as a proportion of total

spending), with this specification I attempt to draw out the relationship between changes in

unrelated business activity and the change in program focus.

Specification 3

Specification 3 introduces contemporaneous proportion of unrelated business income as the

dependent variable, as related to the value of liabilities-to-assets ratio (LIAB_RATIO) for the

previous organizational year. The motivation for this specification is to uncover the relationship

between organizational distress (LIAB_RATIO) and unrelated business income. Total revenue is

again introduced as a control variable.

Sample and Data

I consider unrelated business income as the sum of Lines 104b and 104d of the IRS Form

990. The lines represent, respectively, taxable unrelated business income and income tax-

excluded by sections 512, 513, and 514 of the tax code. This data, as with the data for each of

my variables, is collected from the IRS Business Master Files and the IRS Statistics of Income

and assumed to be an accurate proxy for the unrelated business activities of the given

TRRATIOUBIPE 21 _

TRRATIOLIABRATIOUBI 21 __

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organizations. I further consider the programmatic expenditure of these organizations to be an

accurate proxy for the relative level of their programmatic activity. Of course we cannot look at

market value of nonprofits, but the output of social goods can be proxied by the expenditure on

social goods (program expenditure).

I test my hypothesis empirically using a sample of nonprofit human service organizations

operating within New York County, which has the same boundaries as the Borough of

Manhattan and is reported in the IRS Business Masters Files as those organizations with the five-

digit Federal Information Processing Standard (FIPS) code 36061. In order to ensure a high level

of homogeneity, I focus on a relatively specific yet large population of organization: human

service nonprofits operating in Manhattan. In addition to offering a homogeneous sample,

human service organizations are often considered the most closely related to the idea of charity,

and are addressing the most visceral needs of the neediest groups of people.

My data are from IRS Form 990 samples drawn by the Statistics of Income (SOI)

Division of the United States Internal Revenue Service, for the six years 2000 to 2005, inclusive.

The Form 990 includes detailed data on each registered nonprofit organization’s revenue,

expenses, assets and liabilities. The SOI samples include all nonprofits that are exempt from

taxation under section 510 ( c ) (3) of the Internal Revenue Code (donations to these

organizations are tax-deductible on personal income tax returns) and that have assets of at least

$10 million, as well as a smaller sample of small organizations. While the number of registered

nonprofits organizations in the U.S with assets of over $10 million represents only 5% of all

nonprofit organizations filing form 990 US Tax Returns (including 990EZ and 990PF), this

group represents 81.5% of total reported revenues and 89.5% of total reported assets for the

sector. From these samples, I drew upon only those in the Human Services division of the

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industry: those classified as within the National Taxonomy of Exempt Organizations (NTEE)

classification system Major Group code “HU”. The final sample represents 700 organizational

years, and covers 2000 to 2005, inclusive.

Characteristics of Sample Nonprofits

Table 1 displays distributions for the characteristics of the sample, including all

explanatory variables used in the regression analysis. The values listed are means of values for

each organization, computed using sums for all years that the organization appears in the sample.

Total expenses values are derived from the value listed as such on the tax return for each

organizational year, for each organization. Program service expenses are also listed as such on

the tax return. Program spending ratio is the proportion of program service expenses to total

expenses. Total revenue includes direct and indirect contributions, government support, revenue

from program services, membership dues, investment revenue, and both related and unrelated

business income. Unrelated business income the sum of Lines 104b and 104d of the IRS Form

990. The lines represent, respectively, taxable unrelated business income and income tax-

excluded by sections 512, 513, and 514 of the tax code. Total assets include cash, savings,

receivables (accounts, pledges, grants, loans, and notes), inventories, prepaid expenses, deferred

charges, investments, land, buildings and equipment. Total liabilities include accounts payable,

accrued expenses, grants payable, deferred revenue, loans, tax-exempt bond liabilities,

mortgages and notes payable.

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The average expenses for these organizations is $19,176,503. Program services make up

an average of 82.2% of total expenses, at an average $16,647,579. Mean total revenue is

$20,306,188, with an average of $1,325,121 in unrelated business income. The assets of these

organizations are substantial, averaging $42,402,251, with mean liabilities of $19,342,615.

Pearson Correlation Coefficients

Table 2 reports mean cross-sectional correlations for the period 2000 through 2005

(inclusive). Reported correlations are average correlation coefficients across the six years in the

sample. Pearson correlations are presented in the table with corresponding p-values in italics

below.

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Not surprisingly, the proxy for size (total revenue) is positively correlated with program

spending ratio. Clearly economies of scale would contribute to this finding. Also noteworthy is

the result that total revenue and unrelated business income ratio are strongly correlated, which

indicates that larger organizations are more likely to earn a high proportion of unrelated income.

Regression Analysis

I follow the methodology first proposed by Fama and Macbeth (1973), which continues

to be considered an appropriate and fairly simple approach to analyzing panel data. For each

year, and for each specification of my three models, I conduct cross-sectional regressions and

record the slopes (coefficients). The final coefficients are the time series averages for each of the

cross-sectional slopes. The t-statistic is computed using the time series standard deviation.

Intuitively, it is natural to judge the accuracy of a coefficient by its variation. This approach very

directly uses the time series variation to assess the significance of coefficients. The method was

devised for asset pricing tests, but in this case we face a similar problem of correlated errors in

the cross-sectional dimension.

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RESULTS

Regression Analysis

The next few tables report the results of estimating each of my three specifications for the

six cross-sectional regressions for the years 2000 to 2005, inclusive. Mean coefficients are

means of the six estimates. The t-statistics are computed in the manner of Fama and Macbeth

(1973). The indicated “t-statistic” value in each of the following tables represents the results

from the test on whether or not the coefficients are statistically different from zero. Generally, a

coefficient with a t-stat of ≥1.96 or ≤-1.96 (95% confidence level) indicates that the coefficient is

significantly different from zero. In other words, at ±1.96, there is a 5% chance that the

coefficient is not different from zero.

Table 3 presents the main result of my analysis, Specification 1. In this table, PE

represents the program expenditure to total expenditure ratio. UBI_Ratio is the unrelated

business income as a proportion of total income. TR is Total Revenue.

Specification 1:

TRRATIOUBIPE 21 _

The proportion of unrelated business income (“external” enterprising behavior) is significantly

negatively related to program expenditure ratio. As hypothesized, the internal capital markets of

Table 3: Specification 1

1 2 adjr2

coefficient -0.173 0.064 0.047

tstat (-7.24) (5.68)

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nonprofit firms seem to follow that of for-profit firms in that diversification leads to value loss as

proxied by programmatic expenditure. What can be inferred from my findings is that this

particular type of external enterprising behavior is associated with less value in the programmatic

output of human service nonprofits.

Table 4 presents my next model, Specification 2. ∆PE represents a ratio of the current PE

to the previous period’s PE. UBI is the unrelated business income as a proportion of total

income. ∆UBI_RATIO is the logarithmic change in the proportion of current UBI to the previous

period’s proportion of UBI. TR is total revenue.

Specification 2:

TRRATIOUBIPE 21 _

Here, when considering change in program spending ratio, unrelated business income

remains negatively, but insignificantly associated.

Table 5 details my third and final model, in which UBI _RATIO is the unrelated business

income as a proportion of total income. LIAB_RATIO is the ratio of liabilities to assets. TR is

the total revenue.

Table 4: Specification 2

1 2 adjr2

coefficient -0.13 0.485 0.0065

tstat (-1.19) (0.823)

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Specification 3:

TRRATIOLIABRATIOUBI 21 __

Results from this model suggest that UBI is significantly and negatively related to

organizational distress as proxied by liability-to-asset ratio. This serves as evidence that

nonprofit organizations follow for-profit firms in their diversification behaviors in that

financially stronger (weaker) nonprofits are more likely to have a higher (lower) proportion of

unrelated earned income. In other words, it appears that larger firms are more likely to source

diversified revenues in the form of unrelated business income.

Table 5: Specification 3

1 2 adjr2

coefficient -0.146 -0.001 0.11

tstat (-23.08) (-6.30)

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CONCLUSION

Until now the possible consequences of social enterprise on the programmatic activities

of nonprofit organizations has remained speculative; hard evidence from large sample empirical

studies did not exist. Previous authors have conjectured that an increase in financial dependence

on market sales will diminish the contribution of some nonprofits to social welfare (Weisbrod,

1998). Still, myriad philanthropists, associations and now federal and local governments are

supporting the social enterprise movement with growing fervor, and without the benefit of an in-

depth analysis on the relationship between earned income and programmatic output: closer

study of the impact of enterprising activities on program activities has been necessary and long-

overdue.

My findings are in accordance with cross-subsidy theories of diversification in which

internal budgeting allocates funds to divisions with few investment opportunities (ailing

enterprises of nonprofits) while failing to channel funds to those with ample investment

opportunities (effective, efficient programs). While this research is a first step toward

identifying the factors associated with earned income behavior in nonprofit organizations, there

is much work to be done in this area. My analysis focused clearly on unrelated business income,

which social enterprise scholars and practitioners would consider an “external” funding model in

which the source of funds is not related to the exempt mission of the organization. A large-

sample empirical analysis of the relationship between proportion of programmatic expenditure

and related or “internal” earned income would also be beneficial to the current body of literature.

It also would be useful to identify failures of unrelated business ventures in order to identify

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potential risk factors and begin to understand potential indicators of future success (failure) of

these activities.

Furthermore, in order to create a clear distinction between “charitable” and “business”

activities, I identified human service organizations as the target of my analysis. Much work

could be done in areas of the arts, healthcare, and education which have also experienced growth

in the area of earned income.

Clearly more thought and research must be invested in this area and caution must be

given in popularizing and glorifying the unproven benefits of unrelated or external enterprising

activities on the very organizations that have become important service providers for society’s

neediest individuals.

From a broad perspective, this works has an overarching motivation: myriad

philanthropists, associations and now federal and local governments support with a growing

fervor the social enterprise movement and the use of business practices and measures in the

nonprofit sector, but without the benefit of much analysis on the appropriateness or the success

of these practices and the programmatic output of these vital public service providers.

Continuing exploration and critique of the applicability of business practices in the nonprofit

sector is unarguably important not only for health of the nonprofit sector, but for the well-being

of the general public which has come to rely so heavily on these organizations for human and

social services.

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Tekula: Page 29

BIOGRAPHICAL SKETCH

Rebecca Tekula, PhD, MPA, MBA

Rebecca Tekula, PhD, is the Executive Director of the Helene and Grant Wilson Center for Social

Entrepreneurship, an institute of Pace University aiming to serve students and nonprofit

organizations towards the goal of more effective and efficient nonprofit management practices.

Dr. Tekula completed her PhD in Economics at the University of Lugano, Switzerland. She earned

her BA at Vassar College, her MPA from Pace University, and her MBA from the University of

Oxford. She has an extensive background in New York City philanthropy and across the nonprofit

sector.