Perspectives on
Cooperative Finance
Cooperative Strategy,
Structure and Finance
Farmer Cooperatives Conference
November 19, 2008
St. Paul, Minnesota
2
Session Agenda: Three Panels
8:00 a.m.
Cooperative Finance:
Principals versus Practice
David Barton
Chris Peterson
9:00 a.m.
Equity and Capital
Management Strategies
Doug Derscheid
Tom Houser
10:00 a.m. Break
10:15 a.m. Legal Challenges and Solutions
Three Attorneys
11:00 a.m. Closing Session
3
Principles versus Practice:
David Barton
• Principles of cooperative finance: what
(most) experts agree on
• Practices of cooperative businesses: the
good, the bad and the ugly
• Point and counter-point: experts and
practitioners will disagree
• Your questions
4
Five General Recommendations:
A Preview
1. Co-ops must be competitive
2. Co-ops should make as much profit as
possible
3. Co-ops should use balance sheet
management
4. Serving core customers comes first
5. Finance, strategy and risk
management should be integrated
5
Five Specific Recommendations:
A Logical Process
1. Make profitable asset investments
2. Finance assets with sufficient equity
3. Choose equity structure, equity investments and
income distribution strategies most beneficial to
patron-owners
— Equity structure: source, ownership rights,
permanency, classes
— Purchased versus earned equity
— Allocated versus unallocated
— Qualified versus nonqualified
4. Calculate a redemption budget using balance
sheet management
5. Divide redemption budget among owners using
preferred redemption methods (programs)
6
Principles of Cooperative Finance:
What (Most) Experts Agree On
• Co-op business model
• Finance decision framework
• Income distribution
– Strategic choices
– Model and process
• Equity management
– Strategic choices
– Model balance sheet management
process
7
Cooperative Business Model: Focus on
Benefits and Responsibilities
A cooperative is a business operated
primarily to provide benefits to members
through marketing transactions and
through a distribution of patronage
earnings from these transactions; in return,
members have a responsibility to provide
ownership capital and exercise member
control (governance).
8
Four Unique Roles
Roles
1. Customer
2. Patron
Function
Marketing or
Profit Generation
Profit Distribution
Action
Buy/Sell
Transactions
Patronage Refunds
Per Unit Retains
3. Owner
Ownership
Investment &
Redemption
4. Member
Control
Vote
Which role is predominant in members’ minds?
Most say the customer role is predominant. Serving
customers is the end and the roles of patron, owner and
member are means to the end.
Challenge: Inherent conflict of interest between customer,
patron and owner roles.
9
Finance Decision Framework
Finance involves making three critically
important and interrelated decisions:
• Investment decision
– Assets needed to support business strategy
– Expected income and risk
• Financing decision
– Debt and equity to finance assets
– Expected income, cost and risk
• Income decision
– Distribution of income to patrons and owners as
cash or increased ownership
– Expected investment and financing needs
10
Finance Decisions and Interrelationships
1. Investment
• Assets
2. Financing
Balance
Sheet
• Liabilities or debt
• Equity
– Investment
– Redemption
3. Income
• Generation
• Distribution
Income Statement
Challenge: Access to equity capital - most co-ops get almost
all equity investment by retaining some of the income
generated by operations.
11
Balance Sheet Issues
1. Asset Investment
• Total assets, intended growth rate
• Asset type, profitability and risk
– Regional Investment
– Joint venture investment
– “Local” current and fixed assets
2. Debt and Equity Financing
• Liquidity: Working capital
• Solvency: Equity to assets & debt to equity
• Equity Structure
– Allocated: three basic types (redemption expectation)
• Permanent: NGC Stock or Preferred Stock
• Semi-permanent: Common Stock
• Revolving: Retained patronage refunds
– Unallocated: permanent retained earnings
• Non-permanent co-op equity is like debt! Owners
expect redemption.
Philosophy: (1) Use proactive Balance Sheet Management
(2) Protect the co-op, then redeem excess equity
12
Income Statement Issues
1. Income Generation
• Revenues – Expenses = Total Income
2. Income Distribution
• Non-patronage income (“non-member”)
–
–
–
Dividends on stock
Retained earnings (unallocated)
Income taxes
• Patronage income (“member”)
– Qualified
• Cash patronage refunds
• Retained patronage refunds
• Per unit retains
– Nonqualified
• Dividends on Stock
• Retained earnings (P)
• Retained patronage
refunds (NQ)
• Per unit retains (NQ)
• Income taxes
Philosophy and Challenge :
(1) Be competitive, make as much profit as possible
(2) Choose income distribution alternatives that maximize
benefits to patron-owners
13
Model Co-op: Case 1 (S1) 2007
Income Statement (“annual flow”)
Income Generation:
Sales
- Cost of Sales
= Gross Margins
+ Other Operating Income
= Gross Income
- Operating Expenses
= Net Operating Income
+ Regional Income
+ Other Investment Income
= Total Income (Before Taxes)
- Income Taxes
= Net Income (After Taxes)
$40,000,000
$36,000,000
$4,000,000
$1,000,000
$5,000,000
$4,700,000
$300,000
$300,000
$0
$600,000
$13,600
$586,400
Income Distribution:
Patronage Refunds
+ Per Unit Retains
+ Dividends on Equity
+ Retained Earnings
+ Income Taxes
= Total Income (Before Taxes)
$540,000
$0
$0
$46,400
$13,600
$600,000
Patronage Refund Distribution:
Cash Patronage Refunds (40%)
+ Retained Patronage Refunds
= Patronage Refunds
$216,000
$324,000
$540,000
14
Income Distribution:
Four Selected Strategic Choices
1. Patronage income allocation goal: high
customer-patron ownership (high
allocated) versus high retained earnings
(high unallocated or low allocated).
2. Patronage income distribution by source:
allocated versus unallocated
a. “Local” operating income
b. Regional (other) cooperative income
c. Other income (investment, etc.)
3.
Patronage refund taxability to co-op:
qualified versus nonqualified.
4. Qualified cash patronage refund rate
15
Barton Co-op Income Distribution Model: Model Co-op Case 1 (S1): High Allocation and Moderate Cash Patronage
Source
Allocation
Tax Deductability
Cash Patronage Refunds (P-Q)
$216,000
40%
Patronage Income Sources:
Operating
$300,000
Regional
$300,000
Other
$0
Total
$600,000
Distribution as:
Qualified
“Pure Co-op”
Allocated Patronage
100%Refunds
$540,000
100%
$540,000
Nonqualified
0%
$0
Retained Patronage Refunds (P-Q)
$324,000
60%
Net Retained Patronage Refunds (P-NQ)
$0
60%
Income Taxes (P-NQ)
$0
40%
Patronage
90%
$540,000
0%
Unallocated
0%
$0
Not Qualified
$0
Dividends (P-NQ)
$0
Net Retained Earnings (P-NQ)
$0
60%
Income Taxes (P-NQ)
$0
40%
Total Income
Cash Patronage Refunds (NP-NQ)
$0
60%
100%
$600,000
Allocated Patronage
0%Refunds
$0
Not Qualified
$0
Retained Patronage Refunds (NP-NQ)
$0
0%
40%
Income Taxes (NP-NQ)
$0
0%
Dividends (NP-NQ)
$0
Nonpatronage
10%
$60,000
Unallocated
100%
$60,000
Not Qualified
$60,000
Net Retained Earnings (NP-NQ)
$46,400
77%
23%
Income Taxes (NP-NQ)
$13,600
Model Co-op Case 1 (S1): 2007 Balance Sheet After Income Distribution
16
Assets
Current Assets
Cash
Receivables
Inventories
%
34%
15%
5%
14%
$
$3,586,400
$1,586,400
$500,000
$1,500,000
Investments
Regional Stock
Other Stock
19%
19%
0%
$2,000,000
$2,000,000
$0
Net Fixed Assets
Land
Buildings
Equipment
47%
14%
14%
19%
$5,000,000
$1,500,000
$1,500,000
$2,000,000
Total
$10,586,400
Liabilities and Members Equity
Current Liabilities
Accounts Payable
Loans Payable
Patronage Refunds Payable
Equity Redemptions Payable
%
21%
9%
9%
2%
0%
$
$2,216,000
$1,000,000
$1,000,000
$216,000
$0
Long-Term Liabilities
Bank Loans Payable
Contracts Payable
19%
17%
2%
$2,000,000
$1,750,000
$250,000
Members Equity
Allocated
Common Stock
Preferred Stock
Retains (RPR & PUR)
Unallocated
Retained Earnings
60%
$6,370,400
9%
0%
41%
$1,000,000
$0
$4,324,000
10%
$1,046,400
Total
$10,586,400
Financial Structure
Liquidity
Working Capital (CA-CL)
Current Ratio (CA/CL)
$1,370,400
1.62
Note: New equity totals $370,400.
Solvency
Equity to Assets (ME/A)
Debt to Equity (LTL/ME)
Equity to Adjusted Assets (ME/(TA-CL))
60.18%
30.14%
76.10%
21
Equity Management:
Six Selected Strategic Choices
1. Asset growth trend: high, low, none or
negative
2. Liquidity target and resulting trend:
high, moderate or low
3. Solvency target and resulting trend:
high, moderate or low
4. Equity structure:
a. High allocated versus high unallocated
b. Many allocated equity classes versus few
(especially applies to mergers)
22
Equity Management:
Six Selected Strategic Choices
5. Redemption budget: First manage the balance
sheet, then determine budget and redeem
“surplus” equity versus first manage patron
accounts with set targets like AP/O age or RF
length to determine budget
6. Redemption program and methods:
a. High proportionality of investment (AP/P,
RF, BC) versus other goals (AP/O, PP)
b. Simple program versus complex program for
each equity class
c. Same program for all equity classes versus
unique program for each class
23
Model Co-op Case 1 (S1): 2007 Balance Sheet After Paying Cash Patronage
Assets
Current Assets
Cash
Receivables
Inventories
%
33%
13%
5%
14%
$
$3,370,400
$1,370,400
$500,000
$1,500,000
Investments
Regional Stock
Other Stock
19%
19%
0%
$2,000,000
$2,000,000
$0
Net Fixed Assets
Land
Buildings
Equipment
48%
14%
14%
19%
$5,000,000
$1,500,000
$1,500,000
$2,000,000
Total
$10,370,400
Liabilities and Members Equity
Current Liabilities
Accounts Payable
Loans Payable
Patronage Refunds Payable
Equity Redemptions Payable
%
19%
10%
10%
0%
0%
$
$2,000,000
$1,000,000
$1,000,000
$0
$0
Long-Term Liabilities
Bank Loans Payable
Contracts Payable
19%
17%
2%
$2,000,000
$1,750,000
$250,000
Members Equity
Allocated
Common Stock
Preferred Stock
Retains (RPR & PUR)
Unallocated
Retained Earnings
61%
$6,370,400
10%
0%
42%
$1,000,000
$0
$4,324,000
10%
$1,046,400
Total
$10,370,400
Financial Structure
Liquidity
Working Capital (CA-CL)
Current Ratio (CA/CL)
$1,370,400
1.69
Solvency
Equity to Assets (ME/A)
Debt to Equity (LTL/ME)
Equity to Adjusted Assets (ME/(TA-CL))
Issue: What is best equity capitalization?
61.43%
31.40%
76.10%
24
Equity Capitalization Classes
• Allocated: Permanent or Semi-Permanent
– Common Stock
– Preferred Stock
• Allocated: Revolving
– Retained Patronage Refunds/Per Unit
Retains
• Qualified
• Nonqualified
– Allocated co-op equity is like debt! It should
be serviced through the redemption
program.
• Unallocated: Permanent
– Retained Earnings
25
Equity Capitalization Alternatives
Source
Ownership Rights
Permanency
Generic Equity Class
Revolving
Retains (RPR & PUR)
Semi-Permanent
Common Stock (P)
Unallocated
Permanent
Retained Earnings (P)
Unallocated
Permanent
Retained Earnings (NP)
Allocated
Patronage
Income
Total
Equity
Nonpatronage
Income
Common Stock
Purchased
Allocated
Permanent
Preferred Stock
Balance sheet management assumes all equity is permanent until
authorized for redemption.
26
Capital Structure Factors:
Debt versus Equity
Factor
1. Least cost financing
- equity costs more than debt
2. Risk
- ag co-ops have high risk
3. Profitability
- ag co-ops have low profitability
Amount of
Equity
Higher cost,
lower equity
Higher risk,
higher equity
Higher profit,
lower equity
Conclusion: Minimize equity, given risk and
profitability because of opportunity cost of equity
Capital Structure Choice Matrix
Risk
Low
Profitability
27
High
Moderate Solvency High Solvency
ETA: 60-75%
Low ETA: 50-60%
Low Solvency
High ETA: 35-50%
Moderate
Solvency ETA:
50-60%
If agricultural local co-op
Conclusion: Risk has increased, implying need for higher
working capital (liquidity) and equity (solvency), even though
profitability has also increased.
28
Equity Management Process:
Balance Sheet Management
Equity management involves making five critically
important and interrelated decisions:
1. Determine income generation and income distribution
2. Determine desired assets
3. Determine desired financial structure
–
–
Liquidity: Cash, Working capital, Current ratio
Solvency: Equity to assets, Debt to equity
4. Determine desired equity investment and structure
5. Determine desired equity redemption
–
–
–
First, manage balance sheet: Total redemption budget is
“surplus” equity
Second, manage patron accounts: Redemption program
distributes budget.
Don’t let the tail wag the dog!
Philosophy: Protect the company; owners get what’s left over.
Challenge: Implement balance sheet management philosophy.
29
Model Co-op Case 1 (S1): 2007 Balance Sheet After Paying Cash Patronage
Assets
Current Assets
Cash
Receivables
Inventories
%
33%
13%
5%
14%
$
$3,370,400
$1,370,400
$500,000
$1,500,000
Investments
Regional Stock
Other Stock
19%
19%
0%
$2,000,000
$2,000,000
$0
Net Fixed Assets
Land
Buildings
Equipment
48%
14%
14%
19%
$5,000,000
$1,500,000
$1,500,000
$2,000,000
Total
$10,370,400
Liabilities and Members Equity
Current Liabilities
Accounts Payable
Loans Payable
Patronage Refunds Payable
Equity Redemptions Payable
%
19%
10%
10%
0%
0%
$
$2,000,000
$1,000,000
$1,000,000
$0
$0
Long-Term Liabilities
Bank Loans Payable
Contracts Payable
19%
17%
2%
$2,000,000
$1,750,000
$250,000
Members Equity
Allocated
Common Stock
Preferred Stock
Retains (RPR & PUR)
Unallocated
Retained Earnings
61%
$6,370,400
10%
0%
42%
$1,000,000
$0
$4,324,000
10%
$1,046,400
Total
$10,370,400
Financial Structure
Liquidity
Working Capital (CA-CL)
Current Ratio (CA/CL)
$1,370,400
1.69
Solvency
Equity to Assets (ME/A)
Debt to Equity (LTL/ME)
Equity to Adjusted Assets (ME/(TA-CL))
Issue: How much equity should we redeem?
61.43%
31.40%
76.10%
30
Redemption Budget Calculation
+
+
+
=
Beginning Assets
Change in Cash (current assets)
Change in Investments
Change in Fixed Assets
Ending Assets
$10,000,000
$0
$0
$0
$10,000,000
Beginning equity to assets
Ending equity to assets desired
+
+
+
+
=
=
Beginning Equity Balance
New Retained Equity (Allocated)
New Retained Earnings (Unallocated)
New Common Stock Sales
New Preferred Stock Sales
Maximum Equity Available
Ending Equity Desired
Redemption Budget
60%
60%
$6,000,000
$324,000
$46,400
$0
$0
$6,370,400
$6,000,000
$370,400
Note: New equity allows co-op to redeem old
equity, increase solvency or finance growth.
31
Model Co-op Case 1 (S1): 2007 Balance Sheet with Equity Redemption Payable
Assets
Current Assets
Cash
Receivables
Inventories
%
33%
13%
5%
14%
$
$3,370,400
$1,370,400
$500,000
$1,500,000
Investments
Regional Stock
Other Stock
19%
19%
0%
$2,000,000
$2,000,000
$0
Net Fixed Assets
Land
Buildings
Equipment
48%
14%
14%
19%
$5,000,000
$1,500,000
$1,500,000
$2,000,000
Total
$10,370,400
Liabilities and Members Equity
Current Liabilities
Accounts Payable
Loans Payable
Patronage Refunds Payable
Equity Redemptions Payable
%
23%
10%
10%
0%
4%
$
$2,370,400
$1,000,000
$1,000,000
$0
$370,400
Long-Term Liabilities
Bank Loans Payable
Contracts Payable
19%
17%
2%
$2,000,000
$1,750,000
$250,000
Members Equity
Allocated
Common Stock
Preferred Stock
Retains (RPR & PUR)
Unallocated
Retained Earnings
58%
$6,000,000
10%
0%
38%
$1,000,000
$0
$3,953,600
10%
$1,046,400
Total
$10,370,400
Financial Structure
Liquidity
Working Capital (CA-CL)
Current Ratio (CA/CL)
$1,000,000
1.42
Solvency
Equity to Assets (ME/A)
Debt to Equity (LTL/ME)
Equity to Adjusted Assets (ME/(TA-CL))
57.86%
33.33%
75.00%
Model Co-op: Case 1 (S1) 2007 Ending Balance Sheet ("snapshot")
32
Assets
Current Assets
Cash
Receivables
Inventories
%
30%
10%
5%
15%
$
$3,000,000
$1,000,000
$500,000
$1,500,000
Investments
Regional Stock
Other Stock
20%
20%
0%
$2,000,000
$2,000,000
$0
Net Fixed Assets
Land
Buildings
Equipment
50%
15%
15%
20%
$5,000,000
$1,500,000
$1,500,000
$2,000,000
Total
$10,000,000
Liabilities and Members Equity
Current Liabilities
Accounts Payable
Loans Payable
Patronage Refunds Payable
Equity Redemptions Payable
%
20%
10%
10%
0%
0%
$
$2,000,000
$1,000,000
$1,000,000
$0
$0
Long-Term Liabilities
Bank Loans Payable
Contracts Payable
20%
18%
3%
$2,000,000
$1,750,000
$250,000
Members Equity
Allocated
Common Stock
Preferred Stock
Retains (RPR & PUR)
Unallocated
Retained Earnings
60%
$6,000,000
10%
0%
40%
$1,000,000
$0
$3,953,600
10%
$1,046,400
Total
$10,000,000
Financial Structure
Liquidity
Working Capital (CA-CL)
Current Ratio (CA/CL)
$1,000,000
1.50
Solvency
Equity to Assets (ME/A)
Debt to Equity (LTL/ME)
Equity to Adjusted Assets (ME/(TA-CL))
60.00%
33.33%
76.10%
Note: Ending balance sheet liquidity and solvency same as beginning balance sheet
except equity structure has changed with lower allocated, higher unallocated.
33
Equity Redemption Methods
• SP: Special (estate settlements, etc.)
• AP/O: Age of patron - oldest first
• AP/P: Age of patron - prorate
• PP: Percentage pool
• RF: Revolving fund
• BC: Base capital
Challenge: Select the combination of redemption methods for
each equity class that provide the right balance between (1)
simplicity, (2) highest proportionality of investment and (3)
highest cash flow to patron-owners.
34
Implications of Model Co-op Analysis
1. Biggest driver of equity management
performance is profitability.
2. Cash flow to patron-owners varies
little with alternative patronage
income allocation strategies.
3. High, medium and low patronage
income allocation strategies are all
sustainable if growth rate is linked to
profitability and cash flow. You can’t
enjoy a champagne diet on a beer
budget.
35
Four Cornerstones of Financial Success
1. Be a profitable business
– Manage income generation
2. Return profits to patrons
– Manage income distribution
3. Provide sufficient equity financing
– Manage balance sheet
4. Require patron equity investment
proportional to use
– Manage patron equity accounts
39
Practices of Cooperative Businesses:
the Good, the Bad and the Ugly
• Top three good innovative
practices
• Top four bad innovative practices
• Top three ugly traditional
practices
40
Top Three Good Innovative Practices
Less than one percent of co-ops do any of these.
Maybe 1 in 1,000 do all three.
1. Drop traditional qualified patronage refund
distributions and replace with nonqualified
distributions.
2. Practice strict balance sheet management on the
finance side by (a) setting liquidity solvency targets to
derive a total redemption budget first; (b) then
choose a redemption program to divide up the budget
of the individual patron-owner equity accounts.
3. Divide up the equity redemption budget among
patron-owner accounts by using a base capital
redemption program.
41
Top Four Bad Innovative Ideas
1. Distribute regional patronage refund income to a
separate nonqualified “regional” equity class and
classify it not eligible for redemptions except upon
company dissolution.
2. Distribute regional patronage refund income to a
separate qualified “regional” equity class and tie
redemption to redemption of regional investment.
3. Distribute all patronage income to unallocated
retained earnings except for a small 100% cash
patronage refund; tied to patron-owners having
only one share of common stock (e.g., $100)
4. Sell large volume product transactions to patrons
on a non-patronage basis and use volume discount
pricing at lower net margins than patronage sales.
42
Top Three Ugly Traditional Practices
1. Pursuing a high growth, low
profit, low solvency, high risk
strategy.
2. Redeeming equity using the age of
patron, oldest first method.
3. Redeeming equity using the
percentage pool method especially
to natural persons.
43
“Destiny is no matter
of chance…
it is a matter of choice.”
-William Jennings Bryan
44
Questions
and
Discussion