| University of
Wisconsin Center for Cooperatives
UWCC Occasional Paper No. 12
Equity Redemption Practices:
A Study of Wisconsin Cooperatives
Dr. Robert Cropp
Dr. David Trechter
Dr. John
Cottingham
Dr. Patrick Berends
UWCC Occasional Paper No. 12 September 1998
Robert Cropp is Director, Center for Cooperatives; Professor,
Department of Agricultural and Applied Economics; and Extension Dairy
Marketing and Policy Specialist; all at the University of
Wisconsin-Madison
David Trechter is Professor, Department of Agricultural Economics
Rural Development Institute, University of Wisconsin-River Falls
John Cottingham is Professor, School of Agriculture and Extension
Marketing Specialist, University of Wisconsin-Platteville
Patrick Berends is Assistant Professor, School of Agriculture,
University of Wisconsin-Platteville
Introduction
Equity capital is the investment by owners in a business. For
cooperatives, like other businesses, equity is a portion of the capital
needed to acquire the assets used by the business. Equity is also the amount
of investment that owners of cooperatives have at risk—the amount members of
the cooperative could lose if the business fails. For cooperatives, equity
management is one the most challenging responsibilities for the board of
directors.
Unlike other forms of business, cooperatives are owned by the people who
use them. User-ownership is, in fact, one of the three fundamental
principles of the cooperative form of business.' The User-ownership
principle makes equity management one of the most significant challenges
faced by the board of directors of a cooperative. The board must manage the
cooperative's equity to ensure that the business has an adequate supply of
capital and that the business is truly owned by the people using it. Thus,
equity management entails not only the acquisition of capital from members
but its return, or redemption, to members who are no longer active in the
cooperative. This publication describes the means by which cooperatives
manage the flow of equity through the cooperative. It will discuss why
equity is so important, how cooperatives generate equity capital, and
alternative equity redemption practices. The equity management practices of
Wisconsin's agricultural cooperatives are described and discussed.
Why Equity Capital Is So Important
One reason equity capital is so important is because, as note above, it
fulfills that basic cooperative principle of user ownership. User ownership
in a well-managed cooperative means that equity capital is provided by
members in close proportion to the amount they use the cooperative. Those
who use the cooperative more should contribute more equity because they
receive more of the benefits from the cooperative (in form of the goods and
services provided) than do those who use the cooperative less.
Secondly, equity capital opens the door to the other source of capital
for a business, debt capital. Debt is borrowed capital, and in contrast to
equity capital, has a definite repayment period with an enforceable interest
cost. Unless a cooperative has adequate equity capital, lenders will be
unwilling to provide debt capital to the business. In simple terms, a lender
will say, "If the owners of this cooperative are unwilling to place their
own money at risk in this cooperative, why should I risk mine?" A general
rule of thumb is that equity in the cooperative should be at least 50
percent of the value of total assets, which implies that the owner-members
of the cooperative have provided at least as much of the capital for the
business as have lenders. Based on the latest survey by USDA’s Rural
Business Cooperative Service (RBCS), the average equity level for all
agricultural cooperatives was only 43 percent.2
Finally, equity capital is important because it forms the foundation for
membership involvement in the cooperative. Member involvement in a
cooperative is critical to the success of the cooperative at a number of
levels. First, the business they do with the cooperative creates the
economic rationale for the existence of the cooperative. Second, by
approving bylaws and electing the board of directors they exercise their
control over the business. If the membership does not view the cooperative
as their business and as vital to the success of their farming operations,
the diligence with which they exercise control over the cooperative is
lacking. Equity investment in the cooperative is one means of ensuring their
diligence.
A farmer thinking about patronizing a cooperative has to answer two
questions. The first question is whether or not the mix of products,
services and prices meets the needs of the farmer. The second question is
whether or not to join the cooperative and agree to provide equity capital
to the business. The answer to this second question turns on the following:
Is the cooperative 's price plus returns on equity greater than or equal to
the price offered by competitors plus a return on alternative investments?
Measuring returns on cooperative equity is not easy. Returns on
cooperative equity include the following:
- Dividends paid on equity investments
. Most state laws limit
dividends paid by cooperatives to 8 percent or less. Further, few
cooperatives actually pay dividends on equity.
- Cash patronage refunds
. When a cooperative generates net savings
(profits), members share this net income according to how much they used
the cooperative. This is referred to as patronage refunds. Cooperatives
are required by the Internal Revenue Service to pay out at least 20
percent of patronage refunds allocated to members as cash.
- Present value of retained patronage
. Most cooperatives do not
pay out all of their profits as cash patronage refunds. Rather most
cooperatives retain a portion of these profits as retained patronage to
capitalize the cooperative. Cooperatives can, by law, keep up to 80
percent of a patronage refund as retained patronage. The goal is to
"redeem" these retained patronage refunds to the members at some future
date. Retained patronage does not appreciate in value during the time it
is held by the cooperative. Therefore, the present value of patronage
redeemed in the futures must be discounted to account for inflation and
the loss of use of that money (a dollar to be paid to me a year from now
is worth less than a dollar available to me today).
- Service and product differences from alternative sources
. How do
the products and services offered by the cooperative differ from those
available from alternative sources? This is, in most respects, a
subjective factor but one on which members and prospective members may
have strong opinions.
- Existence value of the cooperative.
Many cooperatives were
organized because of market failure. That is, markets were not meeting
farmer needs (prices of inputs were artificially high, prices of
commodities being marketed were artificially low, services were not
being supplied, etc.). Once the cooperative was organized and provided
competition, the markets functioned more efficiently and satisfactory.
The initial organizers of the cooperative saw first-hand the benefits of
the cooperative but the next generation often fails to see the benefits
since the markets are again working efficiently. The question, which is
difficult to evaluate, is " How would the market respond if the
cooperative were to go out of business and competition diminished?"
- Value of risk reduction
. A cooperative can reduce risk in a
number of ways (providing an assured market, vertical integration,
diversification, etc.). Placing a value on the reduction in risk
provided by a cooperative may be difficult.
The sum of the above divided by the equity investment in the
cooperative is the member's return on equity. While coming up with a
dollar value for each of the above factors is not easily done, an attempt
to do so is important. As indicated, members of a cooperative have an
obligation to help finance the cooperative. So, when farmers do business
with the cooperative, they are obligated to provide financing for the
cooperative. In most cases this is handled through retained patronage
refunds.
In an investment oriented firm, doing business with and investing are
separate issues. A farmer can do business with the firm (buy its products
or services, or sell commodities produced) but not be required to invest
in the firm (purchase stock). Or a farmer may choose to invest in the firm
but not do business with it. These separate decisions are based on the
competitiveness of prices and services and on the return on investment
(dividends on stock, and expected appreciation value of stock).
Therefore, it is critical that cooperatives illustrate potential
returns on equity to members and prospective members. Farmers may be able
to purchase goods and services from or market their commodities through an
alternative to the cooperative and at competitive prices and not invest a
dollar in that alternative business. As a consequence, cooperatives and
their members both have major capital requirements. Cooperatives need to
demonstrate favorable returns on equity investment as well as timely
redemption of that equity. If cooperatives do not, members and prospective
members are not going to be willing investors in the cooperative.
Sources of Equity Capital
The common ways a cooperative obtains equity are the following:
- Direct investment
. Normally this is a rather small sum, but
many cooperatives have a membership fee or a requirement to purchase
one share of common stock called membership stock or voting stock.
Membership fees or common stock are normally $100 or less. However,
some of the new value added cooperatives being organized require
substantial up-front investments by members in proportion to the
amount they will use the cooperative.
- Retained patronage
. This is the most common means of obtaining
equity capital. As described above, a portion of the net savings
(profit) from member patronage is retained at the end of the year and
a portion is paid out to members in cash.
- Per-unit capital retains
. This method works best for marketing
cooperatives where a small reduction (percentage or absolute sum) in
the pay price is made per unit of product marketed through the
cooperative. For example, 5 cents per bushel of corn marketed might be
deducted.
- Net profits from non-member business
. Cooperatives may do
business with non-members and retain the profits generated for equity
capital.
- Sale of preferred stock to members and/or non-members
. Since
preferred stock does not have a specific repayment period or an
enforceable interest or dividend payment, it is equity and not debt
capital. Few cooperatives, however, sell preferred stock.
Types of Equity Capital
Another way of categorizing equity is as allocated or unallocated.
Allocated equity is capital that has been allocated to an individual
member and is recorded in their name. Allocated equity includes the
initial investment. Most allocated equity, however, is generated from
retained patronage or from per-unit capita retains. The member pays income
tax on allocated equity that comes from retained patronage refunds.
Unallocated equity is capital not assigned to a specific member
account. Net income that is derived from non-member business or
non-patronage business are sources of unallocated equity. The boar' of
directors may also decide to retain a portion of member patronage net
income as unallocated equity. Unallocated equity may serve as a shock
absorber for the business. In an event of a loss, for example, unallocated
equities may be drawn upon. Unallocated equities are not paid back to
members unless the cooperative dissolves.
Allocated equity is the focus of this publication. There is an
obligation of the cooperative to redeem allocated equity at some future
date. This is critical if the cooperative principle of ownership in the
hands of users is to be upheld. Without timely redemption of allocated
equity a disproportionate share of the equity may be held by former users
of the cooperative, that is retired farmers. It is extremely important
that the board of directors establish policies for a good equity program.
Defining an Effective Equity Program
As part of the financial planning process, the board of directors needs
to establish policies for an effective equity program. The equity program
should define the amount of equity capital needed, the means of raising
this capital, the means of redeeming equity, and the timing of equity
redemption. A good equity program will:
- Generate adequate amounts of equity.
- Ensure that a relatively small portion of equity is held by past
users.
- Treat members equitably by maintaining member investments in close
proportion to their use of the cooperative.
- Provide sufficient cash returns to enable members to pay taxes on
allocated patronage.
- Generate adequate returns on equity.
Alternative Equity Redemption Programs
Equity redemption plans may be classified as systematic or
unsystematic (often referred to as special programs). With
systematic programs equity is redeemed annually using consistent criteria.
Unsystematic programs only redeem equity when certain defined events
occur.
Systematic plans:
There are three systematic redemption plans used by cooperatives. Each
are discussed here.
1) Revolving Fund Plan:
The revolving fund plan is the most common systematic equity redemption
plan used by cooperatives. In a revolving fund plan, allocated patronage
refunds are held by the cooperative for a fixed number of years. For
example, a patron receiving allocated patronage refunds in 1998 would
receive these funds in 2008 if the cooperative had a 10 year revolving
fund program. With a revolving fund plan, equity is redeemed on a
first-in, first-out basis. The ability of the board to stick to the
defined revolvement period is dictated by the profitability of the
cooperative. If inadequate profits cause the board to postpone some or all
of scheduled equity redemption, it may revolve more than one year of
equity when profit levels are more favorable.
Some advantages to a revolving fund plan are:
- It is easily understood by members
- It is fairly easy to administer
- It keeps investment proportional to use when revolving period is
short
- It requires no cash outlay by members
- Revolvement period may be extended, if more equity is needed or weak
financial performance is experienced.
Some disadvantages to a revolving fund plan are:
- Investment levels are not proportional to use if revolvement period
is long.
- Members perceive redemption as certain regardless of the
cooperative's financial condition
- It is easily manipulated because revolvement period can be easily
extended.
2) Base Capital Plan:
A base capital plan is a method of getting more equity investment
up-front from members and keeping the investment proportional to use. The
cooperative determines the amount of capital needed and what proportion
should be equity capital provided by members. The cooperative then
determines each member's equity obligation based on what share of the
cooperative's total business is contributed by each member. For example,
if a member accounts for S percent of the cooperative's business, he/she
would be obligated to provide 5 percent of the needed equity capital.
Another approach, used by marketing cooperatives, is to express the equity
obligation in terms of dollars per unit of product to be marketed, for
example, $2.50 of equity per hundredweight of milk. If a member markets
1,000,000 pounds of milk annually through the cooperative, hislher equity
obligation would be $25,000. Some cooperatives use an average of 3 or 5
years of business done with cooperative in determining the equity
obligation of a member.
In a pure capital base plan, since members invest their equity
up-front, they receive 100 percent of their patronage refund in cash. The
cooperative does not need to retain a portion to build equity capital.
Further, when a member ceases doing business with the cooperative his/her
equity investment is paid out (redeemed). But most cooperatives do not use
a pure capital base plan as their only equity plan. Rather, equity targets
are established for each member based on use. Those members who have not
reached their target are referred to as under-invested, and those who have
exceeded their target are over-invested (usually someone who has reduced
their business done with the cooperative or has retired from farming).
Those who are under-invested receive the minimum cash patronage refund (20
percent) with the remainder retained and applied to their equity target.
Those who are fully invested may receive all of the patronage refund in
cash. Those who over-invested receive all of the patronage refund in cash
plus the amount of investment in excess of that required of them.
Prior to the new generation cooperative movement, few cooperatives used
the base capital plan. New generation cooperatives share the basic
principles of all cooperatives (user-ownership, user-control, benefits
distributed according to use) but have a number of unique features: large
up-front investments, two-way contractual obligations, focus on
value-added activities, limited membership, ownership shares that
fluctuate in value and are tradable under rules established by the
cooperative. The new generation cooperatives that have been organized
require equity investment that is proportional to the use of the
cooperative. These are shares or marketing rights that obligate the member
to market a specific quantity through the cooperative. For example, one
share may be 1,000 bushels of corn. The cost of this share may be $2.00
per bushel or $2,000. These shares or marketing rights are dissimilar to a
base capital plan in that the shares/rights are allowed to appreciate and
are transferable with, perhaps, approval of the board.
Advantages of the capital base plan are:
- Equity investment is always in proportion to use
- Equity requirements can be rather easily altered
- A good framework exists to require under-invested members to
contribute their share of equity capital.
Disadvantages of the capital base plan are:
- Under-invested members may be the least able to contribute more
equity capital
- It is a rather complex plan to explain and administer
3) Percentage of All Equities Plan:
Under this plan the cooperative redeems a percentage of all outstanding
equities regardless of issue date. For example, if the board of directors
determine that the cooperative could redeem 10 percent of the equity held,
all members would receive of 10 percent of their equity investment
regardless of the current use of the cooperative or how long the equity
had been invested in the cooperative. If one member had $10,000 invested
for 20 years, they would receive back $1,000. Another member who had
$5,000 invested for 2 years would receive back $500. Very few cooperatives
use this plan.
Advantages of the percentage of all equities plan are:
- New members receive some immediate reward.
- It is easy to explain to members.
- It can be readily adjusted to different operating results.
Disadvantages to the percentage of all equities plan are:
- It does little to keep levels of equity investments proportional to
use.
Unsystematic plans:
The most common of all redemption plans is the special situation plan.
The special situation plan is "unsystematic" in the sense that there is no
rule that would guide the annual redemption of equity. Rather, equity
redemption in a special situation plan is triggered by the occurrence of
one or more events. The most common events that trigger equity redemption
under a special situation plan are:
- When a member dies, equity is redeemed to his/her estate
- When a member reaches a specified age (e.g. 70) his/her equity is
redeemed
- When a member retires from farming
- When a member moves away from the cooperative's trade area
- When a member is facing special hardships (bankruptcy, ill health,
etc.)
Many cooperatives use the special situation plan in conjunction with
one of the systematic plans described above. Settling estates and the age
limit are the most common form of triggers used by cooperatives in a
special situation plan.
The advantages of a special situation plan are:
- It is easy for members to understand
- It is easy to administer
- It is flexible and allows the board to address unusual problems
facing their members
The special situation plan is faulted because:
- The most common triggers are not under the control of the
cooperative
- Redemption is generally triggered by adverse events
- Equity is often held after a patron is an active user of the
cooperative.
Equity Redemption Programs In Wisconsin
Cooperatives
A recent study of equity redemption practices in Wisconsin cooperatives
was undertaken to: 1) describe the current status of equity redemption
practices in Wisconsin cooperatives, 2) examine the differences in equity
redemption practices across types of cooperatives, and 3) analyze
relationships between cooperative characteristics and equity redemption
practices3. All Wisconsin cooperatives that were borrowers from the Saint
Paul Bank for Cooperatives were surveyed in 1997. Of 78 cooperatives
surveyed there were 50 useable surveys returned. The results of this
survey are presented below.
Description of the study sample:
Major business activity: Each cooperative was asked to indicate
their major business activities. Fifty percent were primarily farm supply
cooperatives and accounted for 81 percent of the total business volume of
the cooperatives surveyed, 19 percent were primarily marketing with 7
percent of the business volume, and 31 percent were service type
cooperatives with 12 percent ofthe business volume.
Structural changes: Within the past 5 years 30 percent of the
cooperatives had undergone some type of structural change. There were 16
percent that had entered into some joint venture business arrangement, 10
percent had merged with another cooperative(s), and 4 percent were
involved in a consolidation.
Equity redemption practices:
Types of redemption programs used: There were 4 percent of
Wisconsin agricultural cooperatives that had no equity plan (Table 1).
Forty-nine percent had a combination of plans, 43 percent had special
situations only and 4 percent had a revolving fund plan only. There were
no percentage of all equities plans or pure base capital plans. These
results compared to the U.S. show Wisconsin cooperatives were more likely
to have some sort of redemption program than cooperatives in the U.S. as a
whole. On the other hand, Wisconsin cooperatives were more likely to rely
on a special situation plan and substantially less likely to use a
revolving fund plan alone than were U.S. cooperatives.
Table 1. Equity Redemption Programs of Wisconsin Cooperatives as
Compared to U.S. Cooperatives