Journal Entry (Reflection)

ARE 132: COOPERATIVE BUSINESS ENTERPRISES

Prof. Kiesel

From last week: Membership Issues (cont.)

 Open versus Closed Membership Open membership as tradition Reasons to restrict membership: Expansion would push co-ops beyond efficient

capacity (in short run) Sales outlets are limited (in short run) New members might be of lower quality Limit production flow to market

Non-member Business

 Restricted to be less than 50% of business  Affords co-op flexibility

 E.g. in low supply years, can take nonmember business to utilize plant capacity, meet commitments, etc.

 Caution: Make membership the preferred alternative

1. Offer no guarantees from year to year to accept nonmembers

2. Pay patronage only to members 3. Offer additional benefits to members

Optimal Vertical Integration

 Farmers observe effects of market failure at farm gate (e.g. variability of prices received)

 Market at any point in production chain will be transmitted throughout the chain and adversely affect farmers  Upstream: Fertilizer example (e.g. Retailer or Manufacturer

market power)  Downstream: Concentrated Retail (e.g. Bundling

wholesale or Consumer co-op)

 A successful cooperative must integrate to the stage or stages in production flow where market failure is occurring

Mutuals as Special Case of Co-ops

 has its roots in a desire to prevent something bad from happening; meeting a need for common resource  In many cases, these companies provide property and

casualty insurance and life insurance.

They invest in or provide a common resource to prevent communities from collectively suffering

Summary of Challenges in Decision Making

 Coops face several challenges related to property rights and collective action  Free Rider Problem: Untradeable, insecure, and unassigned benefits of

entrepreneurial spirit. Non-members might benefit as well; New members might join; Dilution of benefits overall

 Horizon Problem: Disincentive to invest in long-term assets and maximize current member interests; Asset might outlive the member’s physical life.

 Portfolio Problem: Diverse interests to address when deciding on goods and services provided; Equity is not liquid; Members may experience more risk rather than less

 Control (Principal-Agent) Problem: Boards are principals and managers are agents. Boards, managers and members might lack information and have different incentives.

 Influence Costs Problem: Diverse objectives in a co-op and costs of decision making overall can be high

Financing Cooperatives

 How does investment in Cooperatives compare to other investments? Underinvestment in cooperatives

 What are the sources of capital and how are the managed? Primarily through equity

 How are cooperative organizational structures affecting financial statements? Cooperative principles embedded in these statements

 How are cooperatives taxed?

Underinvestment in Cooperatives

Cooperative principles and organization tend to make it difficult to generate necessary capital: 1. Pool of potential equity contributors is limited to

potential membership. Outside investors will not find cooperatives attractive.

2. Even among potential members, individuals might have tendency to underinvest.

Finance Topics

 Sources of Capital  Grants

 Debt Capital

 Equity Capital

 Patronage Refunds & Pooling  How much income should be distributed

 How much of patronage return to pay out in cash vs. retain?

 Financial statements

 Taxation

Sources of Financing

Debt financing Equity Traditional sources of equity Equity redemption programs

Debt/equity mix

Characteristics of Debt

 Debt is money borrowed from a lender with a promise to repay principal & interest on a set schedule

 3 types of major debt from creditors operating loans intermediate & long-term debt

Sources of Co-op Debt

Cooperative banks CoBank National Cooperative Bank (NCB) Rabobank Co-op Finance Corp (CFC)

 NCB, Rabobank & CFC go to capital markets for the funds that they then loan to their customers/members

 Commercial banks Have difficulties understanding temporary nature of

member equity

Sources of Co-op Debt (Cont.)  Bonds and notes

Bonds must be registered with Securities and Exchange Commission (SEC)

Some co-ops issue voluntary member notes for short- & medium-term loans convenient to co-op & member can increase member risk

 Short term debt from suppliers, members (usually backed by liquid assets)

 Leasing tied to use of a specific asset

Equity Capital Programs  Investment made by members in assets of

cooperative  Equity is basis of all investment capacity &

borrowing flexibility  Board determines equity program with

management input  Key financial responsibility is to provide equity in

proportion to benefits received

Characteristics of Equity Capital

 Equity is risk capital Potential returns to equity are unlimited Potential losses to members limited to

their equity investment  Cooperative equity is generally not publicly

traded, but it is sometimes sold to other members (or prospective members)

 Cooperatives have fewer sources of risk capital than other corporations

Sources of Co-op Equity

 Common stock, preferred stock and membership certificates

 Retained patronage refunds and per unit retains

 Direct Investments

Common Stock and Membership Certificates

 Cooperatives can be financed either as stock or non- stock cooperatives; difference fairly trivial

 Almost all agricultural cooperatives are organized as stock cooperatives Typically one stock is required for membership

Common (“A”) stock has voting rights; cannot be traded and must be sold back at original price

Preferred (“B”) stock does not have voting rights; fixed dividends but might be delayed

 Non-stock cooperatives offer membership certificates received when members pay membership fee

Common Stock

 Common stocks cannot be traded Must be sold back to Cooperative At par value (purchase price) Only at dissolution, merger or bankruptcy is book value

of relevance

High- or Low-Priced Shares and Certificates?

 Low-priced shares and certificates make it possible to diffuse and extend membership to more people

 High-priced shares and certificates create membership commitment and stronger financial position

 With more initial equity, greater proportion of patronage refunds can be distributed as cash

Preferred Stock

 Can sell preferred or non-voting stocks Still somewhat uncommon Can be sold to members and non-members Receive pre-determined dividend (by board of

directors) Ranges from none to 8%

Allocated and Unallocated Equity

 Established cooperatives generate new capital from business profits as well as investments

 Patronage refunds can be paid out in cash or be deferred (form the basis of members allocative equity accounts)  Allocative equity is technically owned by individual

members, often issued as certificate of equity  Unallocated reserves are shock absorbers

 Unallocated reserves typically from non-patronage earnings such as non-member business and from sales of assets

Sources of Equity

Example of Allocation Choice for Annual Co-op Profits

Retained Patronage Refunds

Assessed on net earnings of co-op, after payment for members’ raw product based on commercial value

Advantages directly related to patronage in past year doesn’t require direct cash payment

Disadvantages dependent on net income members can perceive it as a “fee or

deduction” rather than as an investment

Per Unit Retains

Similar to retained patronage refund, but assessed per unit of member volume, such as per box, hundredweight, ton (per unit retain)

Assessed regardless of existence of patronage refund

Commonly used by marketing co-ops a source of equity capital

Usually repaid to members several years later.

Direct Investment (from Members)

Usually for new cooperatives Advantages increases member commitment assures proper level of equity

Disadvantages may be difficult for capital constrained

members

Equity Redemption Plans Equity redemption means that cooperative returns retained allocated equity in cash eventually  Three basic redemption plans:  Revolving fund  Base capital  No plan (unsystematic or ad-hoc)

Revolving Fund Plan

 Known as “first in, first out” equity redemption plan (new money replacing old money) Co-op continuously withholds money, pays

oldest equities in cash first  Usually try to maintain a specific revolving

period, such as 5 years Board’s discretion because other conditions

need to be considered

 Most common

FARMER CHAVEZ FRUIT FARMERS CO-OP REVOLVING FUND PLAN

5 YEAR REVOLVING PERIOD

YEAR BEGINNING BALANCE

NEW EQUITY TOTAL

AMOUNT REDEEMED

ENDING BALANCE

2008 0 500 500 0 500

2009 500 650 1150 0 1150

2010 1150 900 2050 0 2050

2011 2050 700 2750 0 2750

2012 2750 650 3300 0 3300

2013 3300 600 3900 500 3400

2014 3400 750 4150 650 3500

2015 3500 1000 4500 900 3600

Revolving Fund Plan (Cont.)

 Advantages:  Easily understood and most effective to

accumulate capital  Maintains equity in proportion to use when

revolving period are relatively short  Easily adjustable by lengthening or shortening

revolving period

 Disadvantages: Difficult to maintain established or fixed

revolving plan Length of revolving period can be easily

extended Disparities can occur if margins vary

substantially over time or long revolvement periods are needed

Members may expect fixed revolvement period

Revolving Fund Plan (Cont.)

Base Capital Plan

Base target of total co-op equity needed is determined as a whole or by each member (e.g. each member’s share is determined proportionate to their use of co-op over specified base time period)

Redeems all equity that exceeds base Members’ share requirements are reviewed annually

and equity is collected or refunded accordingly Equity is collected over specified time until

member is “fully invested”

Simple in principle but complex in practice

BASE CAPITAL PLAN

MEMBER

Share of Co-op;

Business (%) Beginning

equity

5 year total

patronage Over/ under

Equity retained

Equity redeemed

Adjusted equity

obligation A 11 $1,685 $120,208 -$350 $350 0 $2,035

B 19 3,345 207,631 -170 170 0 3,515

C 14 2,805 152,991 +215 0 215 2,590

D 30 5,515 327,839 -35 35 0 5,550

E 26 4,550 284,127 -260 260 0 4,810

Fa -

TOTAL 100 18,250 1,092,796 -250 565 18,500

-350 +350 - 350

815

-

a inactive member

• Start with $18,250 member equity • Board determined it needs an additional $250

 Advantages: Ties member investment to co-op’s total

equity requirements Promotes concept of member investment

directly tied to patronage Very flexible Allows orderly transfer of ownership from

past users to new members

Base Capital Plan (Cont.)

 Disadvantages: Doesn’t work well when large membership

turnover Plan is complex in practice New members may be unable to promptly

provide their equity requirements Higher burden on new members that might

need investment/returns more

Base Capital Plan (Cont.)

Specialized Plan/No Plan

 Special plans redeem equity only because of a specific condition, such as: death, retirement from farming, reaching

a specific age, resignation from co-op, hardship

 Fails to meet “financing according to use” test

 Complicates co-op’s financial planning

Other Equity Redemption Provisions

 Cooperatives can facilitate equity exchanges, where equity shares are transferred between members at a discount. Only works if co-op sets penalty for underfunded

members Addresses lenders’ criticism that members’ equity

shares in co-op are poor collateral

Sources of Net Income

 Cooperatives can operate on a business at cost basis

 Usually generate net income, which is also known as: Profits Net margins Net proceeds Net surplus

 Cooperatives could also be at a net loss

Distributing Net income: How and how much?

1. How much income should be distributed as: Dividends on equity? Patronage returns/pool payments? Unallocated equity?

2. How much of patronage should be returned: Returned to members in cash?  Invested in cooperative as retained patronage

(equity)? Decisions are made by co-op’s board—

directly related to user-benefit, user-control and user-financed principles

How Much Income Should be Distributed?

 Dividends on equity (stock) Return to ownership, rather than

patronage  Patronage returns/pool payments

Distribute proportionate to value or quantity of members’ patronage (deliveries or purchases)

 Unallocated equity Retained as permanent equity capital Usually from nonmember business

earnings

Dividends on Equity  Most co-ops, just like C-corporations, can’t deduct

equity dividend payments from co-op’s taxable income, so they usually don’t make equity dividend payments

 Dividends on stock represent less than 2% of income distribution by US ag co-ops

 Returns to co-op ownership investment have been downplayed historically

 Dividend payments reduce net earnings  Can be appropriate if paid out of co-op’s investment

activities rather than its patronage activities  May be appropriate if many members are overinvested  Dividend payments affect co-op’s cash flow

How Much of Patronage Return to Pay out in Cash vs. Retain?

 Members have cash flow needs  IRS requires that at least 20% of patronage

return must be paid in cash for ag co-ops  Issues:

Members are taxed on entire patronage income & return, not just the cash portion

Co-op has cash flow & equity capital needs, especially if it wants to grow

Example: Co-op Finances

2018-19 sales = $2,000,000 2018-19 net earnings = $150,000 Board decides to keep 33% retained

($50,000 in retains for its improvement fund), leaving $100,000 to be distributed to members as patronage refund

A member bought $4,000 from Co-op during 2018-19

His business = .2% of co-op’s total sales of $2,000,000

Member’s total patronage refund is .2% of $150,000 = $300

Member’s 2018-19 investment (retain) in Co-op is .2% of $50,000 = $100

 $100 retain is added to member’s investment account in Co-op and will be returned to him at some future date

Member is entitled to .2% of Co-op’s total cash patronage refund

.2% of $100,000 = $200

Example: Co-op Finances (cont.)

Alternatively, Co-op’s board decides on per unit retain $.025 per sales dollar

Member’s retain is $4,000 X $.025 = $100 This $100 is member’s equity investment

in Co-op Total per unit retains = $.025 X $2,000,000

= $50,000

Example: Co-op Finances (cont.)

Financial Statements

 Impacts of member ownership and received benefits traced through financial statements  Income Statement Balance Sheet

Balance Sheet

 Summarizes the book value of the assets of a corporation; its liabilities (debts that must be repaid); and the member or owners’ equity or net worth

 Accounting identity is that the assets must equal or be balanced by the sum of liabilities and owners’ equities

Income Statement

 Begins with gross receipts (sum of all products or services sold by the cooperative multiplied by their respective prices; or sum of all products bought from the members and sold at the competitive market price)

 Subtract costs of goods sold or costs of sales (variable costs) to get gross margin

 Subtract operating costs (fixed costs) to get operating income

 Add interest income, patrons finance charges, patronage refunds received to get patronage refunds

Additional Material

Allocation of Losses Like IOFs, cooperatives sometimes incur

operating losses Too many years of losses can force a co-op

to become bankrupt Ways to allocate losses

Charge against past allocated equity Charge against unallocated equity (most

common) Cash collection (send bills—very rare)

Co-op Member Payment Methods

Members of supply & retail cooperatives usually receive refund checks after fiscal year closing

Members of marketing cooperatives are also paid for delivering raw product to the cooperative, which processes and markets it Various ways that members of marketing

co-ops can be paid for their deliveries

Co-op Member Payment Method: $ on Delivery

 Many co-ops, especially grain & oilseed co- ops, pay cash for commodities on delivery

 Raw product is then processed & sold  Net income remaining after expenses is

refunded to members  Provides immediate cash payment to

members  Co-op takes title & assumes risk

Commercial Market Value (CMV)

Approximates price paid if commodity sold directly to Investor Owned Firm (IOF)

Relatively common for fruit & veg marketing co-ops

Some cooperatives will pay CMV upon delivery

CMV is reported as part of “cost of goods sold” and/or used to compare with co-op’s return

When crop is processed & gets sold out, net income determined & patronage return paid

Back to Economic Theory

Paid as if price taker and selling to IOF firm

 Usually maximizes member delivery payment  Usually minimizes co-op net income &

patronage returns--close to breakeven pricing  Requires co-op to have significant operating

capital  Puts co-op at risk for losses

Commercial Market Value (CMV) (Cont.)

Key Concepts: Marketing Margin

 Marketing margin will typically include the costs of the following:  Assembly of the raw products from the farm  Processing  Distribution  Retailing

 Alternatively, break margin down into costs for inputs (e.g. labor, capital, energy, materials, etc.) and mark up

𝑃𝑃𝑡𝑡∗ = (𝑃𝑃𝑟𝑟 -M)/K 𝑃𝑃𝑡𝑡∗ as maximum farm price

𝑃𝑃𝑟𝑟 as retail price

M as margin

K as conversion factor

1. Margin Reduction

 Two possible ways to lower margin: 1. Cooperative might face lower prices for some

inputs used in marketing 2. Cooperative might market the product more

efficiently than presently done  Three advantages of internalizing transactions

1. Internalization creates common incentive among parties

2. Disputes within organizations can be resolved quickly

3. Information flows more freely

2. Market Power Avoidance  Opportunistic behavior results in trading partners

attempting to exercise short-term market power over farms  Monopsony power  Monopoly power  Oligopoly power  Price discrimination

 Potential leverage exercised by bargaining associations (e.g. Cooperatives): 1. Play marketing firms off against each other, causing them

to bid up prices 2. Threaten to withhold product from private handler by

forming cooperative to directly process and sell product

3. Influence Consumer Prices

 Two possible avenues: 1. Cooperative might be able to restrict flow of farm

product to the market 2. Cooperative might be able to improve quality of the

finished product or offer value-added products

Oversupply(relative to demand) at heart of American agriculture’s financial dilemma in many markets

Marginalization

Double - Marginalization

Demand to Wholesaler

MR to Wholesaler

Double - Marginalization

Marketing Year

 Agricultural crops processed as inputs/ingredients for (food) products

 Value of crop not known at harvest but becomes known after product sold to consumer (before new harvest)

 12 month period (often begins Sept 1 and ends Aug 31) Advance payment at harvest Second payment as value becomes known

(4-6 month) Final payment at end of year

Pool Payments  Key elements of pooling:

Sharing of risks, expenses & revenues Payment of an average price Possible adjustments for product quality, and for

time & location of delivery

 Distributions of patronage refunds to specific pools for members’ deliveries

 Unique to ag marketing cooperatives  Used extensively by fruit, vegetable, nut, rice & dairy

cooperatives  Co-op can have single or multiple pools

Operating Procedures for Pooling

 Producers sign marketing contracts for their crops—often with an “exclusive” clause

 Contracts transfers all authority over marketing decisions from producer to co-op

 Initial advance payment to producer upon delivery of product

 When most or all product sold, close pool; Determine total value, including estimated value of remaining inventory

Operating Procedures for Pooling (Cont.)

 Operating, processing & administrative expenses are allocated & deducted

 Any excess over previous payments is then distributed to members

 Capital retain is withheld