RBCDS Cooperative Information

November 1995

51
Contents

Highlights ..............................................iii

Background .............................................. .

What Is a Base Capital Plan? .................................2

Advantages and Disadvantages ......................... .4

Capital Program Considerations ..............................5

How a Base Capital Plan Operates .............................6

Accumulation Methods .................................6

Direct Investment ...............................6

Retention of Net Income ...........................7

Per-Unit Capital Retains ..........................7

Redemption Methods ...................................7

Constructing a Base Capital Program ...........................8

Establishing a Base Period ..............................8

Setting a Measurement Unit ............................lO

Determining Investment Levels ..........................I 1

Implementing a Base Capital Plan ............................I3

Modifying Corporate Documents .........................I 3

Determining Equity Capital Needs ....................... .I 3

Establishing Investment Levels ..........................13

i
Operating a Base Capital Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

Patronage Refunds vs. Per-unit Retains . . . . . . . . . . . . . . . . . . .I 5

Cash Patronage Levels . . . . . . . . . . . . . . . . . . . . . . . . . .I 6

Advance Capital Requirements . . . . . . . . . . . . . . . . . . . . . . . . . .I 7

Equity Redemption Considerations . . . . . . . . . . . . . . . . . . . . . . .I 8

Special Program Payments . . . . . . . . . . . . . . . . . . . . . . .19

Membership Terminations . . . . . . . . . . . . . . . . . . . . . . . .19

Equity Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

Combination Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

A Challenge to Cooperatives . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

Appendix A, Sample Bylaws . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Highlights

Management of equity capital is the most important financial activity in a

cooperative. Successful management of equity requires a responsive and

objective capitalization program. A base capital plan, because it is a complete equity management tool, meets that requirement.

A base capital plan fills this need because it (1) enables the cooperative to

“recapitalize” itself on a periodic basis; (2) maintains member investment

(financing) in proportion to use; and (3) keeps ownership and control in the

hands of current users.

Establishing a base capital plan requires careful study and analysis, but the

effort is rewarded with a responsive, equitable capitalization program.

Good financial planning is the key to the successful operation of the plan

because each year the cooperative establishes a required level of equity to

meet the capital needs of the coming year’s operation. Members are then

notified of their required level of investment for the new fiscal period and

the method to be used for collecting it.

Although base capital plans are used primarily by marketing cooperatives,

they can be readily adapted to supply and service cooperatives. In evaluating the use of a base capital plan, each cooperative should carefully weigh

how it will benefit its members through a better capitalized business.

This publication informs cooperative boards of directors, management, and

employees about the benefits of the base capital method of capitalization

and provides guidelines for implementing and operating such a plan.
Base Capital Financing of

Cooperatives

Robert C. Rathbone and Donald R. Davidson

Today’s agribusiness economy is changing rapidly. Production

agriculture has become very capital-intensive. Producers must determine

how the limited amount of capital available for their agricultural enterprise will be divided among competing needs.

It is not easy for a member to measure and compare the return on

capital invested in a cooperative. Boards of directors and management

face a difficult challenge in obtaining and keeping enough equity capital

in the cooperative to adequately capitalize it.

In this capital-competitive environment, member-investment programs must be flexible and equitable for two reasons: (1) they must permit a cooperative to meet rapidly changing capital requirements in a

timely and equitable way; and (2) they must allow the equity capital of

inactive or retired members to be redeemed in a more timely fashion.

This keeps ownership, control, and financing of the cooperative in the

hands of current users. The features, operation, and performance of base

capital plans meets these objectives.

Background

The idea of base capital equity financing was introduced by the

Farmer Cooperative Service [now part of USDA’s Rural Business and

Cooperative Development Service (RBCDS)] in the late 1950s [l].l It was

requested by a group of cooperatives with extended revolving fund periods and substantial inequities in the amount of member investment.

The resulting program was initially called the “Adjustable

Revolving Fund Capital Plan” and provided for annual adjustments to

bring equity investment in line with patronage, or use of the cooperative.

1 Numbers in brackets refer to publications cited in the references section.
Some of the first cooperatives to adopt the base capital plan concept were

centralized fruit and vegetable marketing associations on the West Coast

and in Florida in the early 1960s [2].

In the more than 30 years since the base capital plan concept was

introduced, it has, unfortunately, received only limited acceptance and

use. A 1974 survey conducted by the Farmer Cooperative Service showed

2 percent of marketing and supply cooperatives surveyed were using a

base capital plan [3]. More recently, USDA’s Rural Business and

Cooperative Development Service (RBCDS), using 1991 data, found that

less than 1 percent of all types of cooperatives were using base capital

programs. The percentage among marketing and supply cooperatives

was comparable to the 2-percent level found in the 1974 study [4].

Considering the many advantages the program offers, the limited

use is disappointing. One of the objectives of this report is to encourage

boards of directors and management to seriously consider the value of a

base capital program as an effective tool for managing their cooperative’s

capital needs.

What Is a Base Capital Plan?

Many cooperative equity capital programs have two parts that

operate completely separate from each other. The first part is the accumulating of equity, or ownership capital. The most common method used is

to retain a portion of the net income of the business as allocated patronage refunds.

Another method is the per-unit capital retain in which part of the

proceeds due patrons from the cooperative’s sale of their commodity is

retained as allocated equity. These funds are withheld based on either the

physical number of units handled or a percentage of the dollar value of

the product involved.

Direct investment by members is a third way cooperatives accumulate equity. This method is normally used for collecting membership fees

or as an assessment for a special capital need.

Net income derived from nonpatronage business is another source.

On a tax-paid basis, it is retained by cooperatives as a source of equity

capital in an unallocated capital reserve.

The second part of a cooperative’s capital program is the equity

redemption phase in which part of the retained allocated equity capital is

2
repaid to patrons. This is done through regular redemption programs

such as a revolving fund, a percent-of-all-equity program, a base capital

program, and/or through special programs.

With special programs, equity is paid as the result of an event that

happens to a patron-death, retirement from farming, attaining a certain

age, or a combination of these special programs. Equity redemption can

also consist of a combination of regular and special payment programs.

Too often, however, a cooperative’s method for acquiring and

redeeming equity capital is not directly related to its current capital

needs. Usually, the amount of new equity capital available results from

the organization’s profitability or is a function of the amount of product

handled (when per-unit capital retains are used). Likewise, any redemption is made only to dispose of leftover equity not needed for current capital requirements.

This residual approach to equity redemption does not involve

much financial management or planning. It also reduces a cooperative’s

ability to adjust its equity levels when faced with unforeseen capital

demands. This problem is caused by operating losses, low volume of

product which reduces capital retains, or demands arising from large

capital expenditures.

A base capital program, however, links equity accumulation directly to equity redemption. By doing so, it serves as a tool for handling all

aspects of the equity management function.

Base capital plans have many different names such as adjustable

capital, adjusted balances, permanent capital, or modified revolving

fund. Regardless of the name, the principal feature is the same. The plan

establishes a target amount of required equity that is periodically and

systematically adjusted to meet the current capital needs of the cooperative. In addition to meeting equity requirements, the goal is to keep the

patron’s equity contribution closely in line with use of the cooperative. In

this way, ownership is kept in the hands of current users in an equitable

manner and the fundamental cooperative operating principles of member-financed and member-controlled are fulfilled.

For example, if a member’s use of the cooperative represents 2 percent of total patronage, then the member’s equity investment should be

equal to 2 percent of the cooperative’s total allocated equity capital.

Base capital plans are used primarily by marketing cooperatives

such as those in fruit and vegetables, dairy, and grain. Some supply and

service cooperatives also use these plans successfully [4].
Advantages and Disadvantages

Base capital plans have their advantages and disadvantages, just

like other capital programs. A board of directors should weigh carefully

all aspects when considering the suitability of a base capital plan for their

cooperative.

Advantages

Links a member’s investment directly to use and provides a mechanism for maintaining that relationship.

Keeps ownership and control in the hands of current users and in proportion to use.

Permits the cooperative to systematically adjust capital requirements

up or down to meet changing needs. More capital can be obtained by

increasing the required amount of investment, or equity can be

redeemed if capital levels are met.

Encourages members to view their investment in a base capital plan as

a true investment compared with equity accumulated under other

programs that may or may not be redeemed in a timely fashion.

Requires the board and management to develop an annual budget and

financial plan. Even though smaller cooperatives may lack the expertise or resources to prepare a detailed financial plan, some planning is

necessary to determine capital needs and set investment levels for the

coming year.

Provides the board and management with a tool to manage the cooperative’s capital.

Allows a member, who is phasing out farming operations or withdrawing from membership, to have equity returned over a reasonable

period of time if the flow of funds into the cooperative from current

users permits.

May enhance member loyalty because of the plan’s equitable treatment and predictability.

Disadvantages

l Initial capital investment requirements can place a financial burden on

new members. This may act as a barrier to membership, but programs

can be designed to help new members achieve required investment

levels on an installment basis over a multiple-year period. This could

cause the further disadvantage of slowing the redemption of equity of

over-invested members.

4
The plan does not work well if there is a constant and large membership turnover. This situation puts a strain on remaining members to

provide the additional capital needed that is no longer being supplied

by exiting members.

A plan is difficult to manage if their are widely fluctuating capital

flows.

A base capital plan is more difficult to understand than traditional

capital programs such as the revolving fund method. This should not

be considered an obstacle to adopting such a plan, because these difficulties can be overcome with effective, ongoing education and communication programs.

Capital Program Considerations

The board of directors, before deciding to adopt a base capital plan

or any other type of capital program, should address a number of considerations about the financial needs, capabilities, and objectives of its cooperative [5].

l What is the annronriate level of equitv capital for the organization?

What isA the iequired level ofworking capital?

V

-

What are the future needs for expanding the business through

new investments or acquisitions?

How much risk capital is needed to cushion against losses during poor operating periods?

l How flexible is the cooperative’s equity structure in responding to

0

increased or decreased capital needs?

How quickly can additional capital be obtained to take advantage of acquisition opportunities or meet internal expansion

needs?

-

Is there an equitable method of returning excess capital to the

owners on a timely basis?

Does the capital program seek to keep ownership in the hands of current users? Can ownership interests of former members be transferred

to current members? Examples are where one member is permitted to

purchase the equity credits of another who is quitting farming, or having a provision for transferring equities from one membership generation to another.

5
Does the capital program promote a forward-looking, business-like

relationship with the membership?

How equitable is the capital program? Is there a way to keep investment proportional to use?

Is the capital program practical and cost-effective to administer?

Is the program easily explained and understood by the membership

and employees?

A capital program’s objectives should address all of these questions-capital adequacy, flexibility, proportionality, equitability, practicality, and ease of understanding. These questions should be asked

whether a capital program is being evaluated, developed, modified, or

administered.

How a Base Capital Plan Operates

A base capital plan operates on a simple principle, to keep the

patron’s equity investment proportional to use of the cooperative. The

plan also serves as an equity management and financial planning tool.

Implementing and operating a base capital plan is more systematic

than typical equity accumulation and redemption activity (revolving

fund, special programs, etc.). The result is a better-capitalized cooperative that has more control over its financial future. It can adjust capital

requirements in a planned and equitable manner to meet changing needs.

When the board has decided what capitalization objectives it wants

to achieve, it is necessary to determine how they will be incorporated into

a canital program. This involves determining how equity will be accumula ted

three

and redeemed to achieve these objectives.

First, select the method of accumulating equity capital. There are

different ways:

(1.) direct investment by members;

(2.) retention of net income; and/or

(3.) deductions made in the form of per-unit capital retains.

Accumulation Methods

Direct /nvesfmefff Direct investment is normally used to collect an

initial, nominal membership fee. Sometimes, however, to become a

6
member of a cooperative, a large initial direct investment may be

required. This can occur where large fixed asset expenditures will be or

have been made for facilities used to carry out value-added processing.

Occasionally, special assessments for direct investments may be made to

fund a specific capital project or to shore up a weakened equity position.

Retention of Net /ncome Retention of net income, in the form of

retained patronage refunds, is the most frequently used method to

accumulate capital. Nearly 70 percent of cooperatives whose equity is

subject to redemption accumulate equity capital using this method [4]. A

distinction is made for cooperatives whose equity is subject to

redemption, because the 1991 study showed that the equity of 14 percent

of all agricultural cooperatives is not subject to redemption [4]. These

cooperatives are generally low- or no-equity organizations that pay out

all net income in cash, or have small amounts of net income from large

membership bases that make allocation impractical.

While net income retention is the most popular way to accumulate

equity, it is not always the most reliable. Fluctuations in earnings can

produce more or less capital than the organization’s financial plan

requires.

Per-Unit capita/ Retains A per-unit capital retain is generally

considered the most reliable of the three methods. It is used primarily by

cooperatives that market fruit and vegetables and dairy products. It may

be used by itself or combined with retained net income.

Per-unit capital retains are deducted from sales proceeds due

members. They can be calculated on a physical-unit basis, such as so

many dollars per ton, or as a percentage of the dollar value of the product. Per-unit retains are a more stable source of capital than retention of

income, because the amount retained can be adjusted up or down to offset changes in volume or dollar value of the product.

Redemption Methods

Capital retained from members by any of the above methods is normally repaid to members at some future date through the equity redemption process. A review of the common methods used is presented to serve

as a comparison with the equity redemption features of a base capital

plan.

7
Most common is the revolving fund. The oldest year’s equities are

paid first (first-in, first-out). In 1991,44 percent of cooperatives whose

equity was subject to redemption used the revolving fund method [4]. A

small number of cooperatives use the percent-f-all-equities program in

which a percentage of all equity outstanding, regardless of the year

issued, is redeemed. The third redemption method is the base capital

plan.

In addition to regular programs, many cooperatives use special

equity redemption programs. Special redemption programs redeem equity based on an event that happens to a member. These programs may be

used by themselves or combined with one or more regular programs.

Special programs, however, are rarely combined with a base capital plan.

All capital accumulation and redemption programs have strengths

and weaknesses. They need to be evaluated and weighed against the capital program objectives already established by the board. The advantages

and disadvantages of the revolving fund and percent-of-all-equities

methods summarized in table 1 provide a comparison with the base capital plan.

Establishing a Base Period

One of the first decisions to be made is setting the length of the base

period the cooperative will use to calculate each member’s share of total

patronage. The patronage base period will vary with the type of cooperative and the volatility of changes in its capital needs. Base periods reported by cooperatives in the 1991 equity redemption study ranged from 1 to

10 years. The average was 7 years. Dairy cooperatives had the shortest

average period at 4 years and grain marketing and cotton cooperatives

the longest at 8 years. Caution should be used in interpreting this data,

however, because of the small number of cooperatives using base capital

programs [4].
Table I-Advantages and disadvantages of equity redemption

program&

Type of Plan Advantages Disadvantages

Revolving Fund Easily understood and

administered

Proportional when

revolving period short

No direct cash

investment

Percent-ofall-equities

Easily understood and

administered

Attractive to new

members

Well-suited to

cooperatives relying on

retained patronage

refunds

Easily manipulated

Disparities occur

when earnings

vary or revolving

period is extended

Unrealistic member

expectations revolving

cycle will be

maintained

Proportionality

takes longer to

achieve

Contributions

unresponsive to

changes in patronage

Plan must be

combined with

special programs

for inactive members

to receive equity in a

timely basis

l Source: Equity Redemption: Cobia, David W., et al. Issues and Alternatives for

Farmer Cooperatives. ACS RR 23, USDA, Washington, DC, October, 1982.
Short base periods (1 year) permit adjustment of capital levels in

response to rapid changes in patronage levels. It is also easier to calculate

proportional patronage levels for l-year versus multi-year periods.

Base periods longer than 5 years may not be responsive enough to

patronage-level changes and could hinder the cooperative’s ability to

adjust members’ equity levels rapidly to meet changing circumstances.

On the other hand, a longer base period may help smooth out wide fluctuations in patronage levels and provide a more representative picture of

long-term average use of the cooperative.

This would be the case with an annual or seasonal commodity such

as tomatoes, where year-to-year acreage and yield may change significantly. The smoothing effect of a longer base period could also benefit situations involving permanent crop plantings where weather-related factors can impact year-to-year yields.

Each cooperative must decide on the length of base period best

suited to the products it handles, the nature of production cycles, and the

type of business it operates. Base periods should be as short as possible.

This makes the program more responsive to changes in patronage levels

and keeps ownership in the hands of current users. It also provides some

flexibility if the base period must be extended to meet unforeseen capital

requirements.

Setting a Measurement Unit

A measurement unit is usually chosen at the same time a base period is being selected. This unit serves as a common denominator for measuring each member’s proportionate use of the cooperative over the

established base period. In a fruit and vegetable processing operation this

might be a ton of raw product delivered. For fresh-marketed products,

the measurement unit could be the packed carton sold. In service or supply cooperatives, the unit could be the physical item being purchased or

the type or amount of service being provided.

A physical measurement unit, such as the examples mentioned earlier, may not always protect against the fluctuating capital requirements

that can arise with changes in product volume. Lower product volume

may result in higher prices and require more capital to support inventories. To compensate, some cooperatives use product value as the measurement unit. In this way, the average value of the product over the base

period becomes the method for measuring proportional use of the cooperative.

10
Determining Investment Levels

Once the base period and measurement unit have been set, the

cooperative has the tools to calculate the member’s current level of

investment. This calculation determines the relationship between each

member’s investment and use of the cooperative. It will show the variation between each member’s current investment level and the proportional investment required under a base capital program.

Table 2, for instance, uses a 5-year base patronage measurement

period. Member A’s $10,000 current investment represents 10 percent of

total allocated equity. Member A’s patronage over the 5-year base period, however, averaged 15 percent. Use of the cooperative increased faster

than the rate of equity investment. On a proportional-use basis, Member

A is $5,000 under-invested and needs to contribute that amount to reach

the required investment level of $15,000.

Member C, on the other hand, is over-invested by $15,000 because

patronage during the 5-year base period averaged only 20 percent of the

cooperative’s total, while the level of investment stands at 35 percent.

This may occur because of reduced patronage or indicate the member has

stopped doing business with the cooperative. Regardless of the reason, to

achieve proportionality, the member would be due an equity redemption

of $15,000.

In this hypothetical situation (table 2), three of the members are

underinvested and two are overinvested. If all adjustments are made to

achieve proportionality, the under-invested members’ required contributions would provide the funds to repay the over-invested amounts.

There would be no change in total allocated equity.

In reality, the adjustments would probably be made over some prescribed time period, instead of all at once. This spreads out the contribution burden for under-invested members and helps younger or newer

members who may be substantially underinvested and have limited capital resources to invest.

If the difference in investment levels between members is large, it

may be difficult to make a member’s investment proportional to use. One

of the first implementation steps, therefore, is to determine the difference

between investment levels and patronage. If the disparity is too great,

interim steps may be needed to achieve closer investment equality before

final implementation can occur. Otherwise, the base capital plan may

never function as intended.

11
Table P-Example of current equity investment level compared

with base period usage of cooperative, 5-year patronage base

period

Member

Allocated equity Average 5-year base Amount over (+) or

investment level period patronage under (-) invested

Total Percent Percent of

dollars of total total patronage Percent Dollars

A 10,000 10 15 -5 -5,000

B 30,000 30 25 +5 +5,000

C 35,000 35 20 +15 +15,000

D 20,000 20 30 -10 -10,000

E 5,000 5 10 -5 -5,000

Total 100,000 100 100 0 0

Interim capital accumulation steps can take the form of a higher

level of capital retention from members who are significantly undercapitalized (for example, a per-unit capital retain of $20 per ton compared

with $10 per ton for fully invested members). Another method would be

to require the under- invested member to make an additional direct

investment in the cooperative. The funds for this investment may come

from the member’s own capital resources or from proceeds of a loan

obtained for that purpose. Such borrowing may occur to provide the substantial amount of initial investment required to capitalize the organization and start-up of value-added cooperatives. The objective, in any case,

is for members to quickly reach proportionality. Once proportionality is

achieved, a base capital program is designed to permanently maintain

that relationship.

Another interim accumulation method is an advance capital

requirement, explained in detail on page 17.

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Implementing a Base Capital Plan

When the base period and measurement unit have been set and the

proportionality of members’ current investment has been determined, the

initial framework for a base capital program is in place. The cooperative

now has the basic tools to develop the remaining elements of a program.

Modifying Corporate Documents

At the same time tools are being selected for operating the plan, the

cooperative should review its articles of incorporation, bylaws, and any

marketing or membership agreements to determine how they should be

amended to fit the new capital plan. Appendix A contains bylaw excerpts

from cooperatives with base capital plans for use as a guide. The cooperative’s attorney should draft the specific language to modify existing documents to accommodate the new base capital plan. These changes will be

approved by the board of directors and in some cases by the membership.

Determining Equity Capital Needs

One of the most critical components of a base capital program is the

establishment of the equity capital needs of the cooperative. The management team (the board of directors and manager) sets this amount each

year based on its short- and long- term financial plans. A typical planning cycle would begin in the second half of the current operating year.

Some indication of operating results for the year should be known, and

preliminary capital requirements for the coming year can be identified.

The cooperative should estimate capital uses for the coming year,

such as planned fixed asset expenditures, long-term debt servicing

needs, and any equity redemption required under the base capital plan.

Next, an estimate of capital sources should be made. These would

include patronage and nonpatronage earnings to be retained, per-unit

capital retains to be collected, and new long-term debt to be obtained.

Combining the sources and uses of capital provides an estimate of equity 6

capital required for the coming year.

Establishing Investment Levels

Using the estimate of equity capital needed for the coming year, the

cooperative can calculate each member’s required investment level to

achieve proportionality. This calculation will show that certain members

73
are underinvested, others are overinvested, and some are fully invested.

A statement should be prepared showing each member’s current

year-investment and the proportionate amount of capital needed to meet

the required level of investment for the new fiscal period. For the

under-invested member, the statement should show how any required

additional investment is to be collected (direct investment, retained

patronage refunds, and/or per-unit capital retains) and the timeframe

for satisfying the obligation. The over-invested member should be

advised of the plan for refunding all or part of the over-invested amount.

Table 3 shows extended hypothetical information from table 2. For

instance, in table 3, Member A’s investment at the end of the current year

was $10,000, but the required investment lev.el to support capital needs in

the coming year will be $18,000 (15 percent of the $120,000 required equity level determined by the board). Member A needs to satisfy the $8,000

shortfall. This could be accomplished through a per-unit capital retain,

retained patronage refund, direct investment or assessment, or a combination of these methods.

Member C, the only member of the cooperative overinvested in

relation to required equity needs for the coming year, would be due an

$11,000 redemption. The board determines the method and timing of that

redemption.

As shown in table 3, the cooperative collects $31,000 from

under-invested members. After redeeming the $11,000 to Member C, the

cooperative would have the $20,000 in additional equity needed for the

new fiscal year.

Operating a Base Capital Plan

A base capital plan’s operating procedures determine how the plan

works on a day-to-day basis. Many options exist and choosing the right

combination for a specific cooperative will require study and analysis. In

most cases, financial projections should be made to estimate the impact,

on both the cooperative and its members, of different combinations. The

following are some factors to consider in designing the operating elements of a typical base capital program.

14
Patronage Refunds vs. Per-unit Retains

As discussed earlier, cooperatives can use three methods for accumulating equity capital: direct investment, retained patronage refunds,

and per-unit capital retains. For base capital plans, either retained

patronage refunds or per-unit capital retains or some combination of

both are used. Direct investment is normally used only for the initial

investment or advance capital requirements of a new member, but can be

used to fund special projects such as for investing in value-added processing capability.

Per-unit capital retains are preferred for accumulating capital for

base capital plans because they are a more stable source of equity capital

than retained patronage refunds. Even more stability is realized if the

per-unit capital retain is established as a percentage of the value of the

Table 3-Example of required equity investment level vs.

existing investment level, Syear patronage base period

Member

Share of Current Next

required Fiscal Fiscal

equity Year Year Amount over Amount

@-year allocated allocated (+) or under retained Equity Ending

base equity equity (-) invested or added redeemed equity

period)’ level level2

percent _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ -Do/&s _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

A 15 10,000 18,000 -8,000 8,000 0 18,000

B 25 30,000 30,000 0 0 0 30,000

C 20 35,000 24,000 +I 1,000 0 11,000 24,000

D 30 20,000 36,000 -16,000 16,000 0 36,000

E 10 5,000 12,000 -7,000 7,000 0 12,000

Total 100 100,000 120,000 -20,000 31,000 11,000 120,000

l Share of required allocated equity capital based on average use or patronage

over the past 5 years.

2 The board of directors has determined that a total of $120,000 in equity capital is

needed for the next fiscal period to adequately capitalize operations.

15
commodity instead of a fixed amount per physical unit. By establishing

the per-unit capital retain as a percentage of the product’s value, the

retain amount increases when product value goes up. The cooperative

obtains more capital to support the larger investment required to carry

the higher valued product.

Some cooperatives use a combination of retained patronage refunds

and per-unit capital retains. This provides more capital and permits a

member to reach a fully invested position sooner. Once a member reaches

that level, some cooperatives stop withholding per-unit capital retains

and/or pay a higher percentage in cash patronage refunds than is paid to

under-invested members.

Cash Pafronage Levels A variable cash patronage payment program

is designed to accomplish two objectives. It helps an under-invested

member reach a fully invested position more rapidly by paying a smaller

cash patronage percentage and retaining more equity in the cooperative.

Secondly, it keeps fully or over-invested members from accumulating a

larger than required investment in the cooperative.

The use of a variable cash patronage payment program within a

base capital plan can be shown with an example. Keep in mind that the

payment combinations must be set at levels that will satisfy the cooperative’s capital needs.

Target Investment Level: 10 percent of average annual patronage

over past 5 years. (Example: Average annual patronage = $200,000

x 10 percent = $20,000.)

lnves tmen t Level Rang-g Cash PatronaPe

(As a percent of patronage) Percen tape Paid

Less than 5 percent 20 percent

5 - 7.5 percent 25 percent

7.5 - 10 percent 30 percent

10 - 12 percent 50 percent

More than 12 percent 100 percent

In addition to a larger cash-patronage payment, over-invested

members could receive a redemption for all or part of the over-invested

amount. This would help bring their investment level closer to the targeted level more rapidly.

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The variable cash patronage payment program can be employed,

even when a base capital plan is not used, to help keep investment levels

more proportional to use. Such a tool can be viewed as a “partial base

capital plan.”

Advance Capital Requirements

Under a base capital plan, the objective is to keep each member’s

investment proportional to use of the cooperative. At any given time,

however, most members will be either over- or under-invested. The goal,

therefore, should be to have each member’s investment track close to a

fully invested position. If an investment position gets too far out of balance, over-invested members are penalized by carrying too much of the

equity investment load. They are subsidizing the capital investment

obligation of significantly under-invested members. To deal with this

potential problem, a base capital plan should contain an advance capital

provision. Whatever form it takes, this requirement is meant to keep each

member’s investment position from getting too far out of balance.

An advance capital requirement for a new member benefits the

cooperative and can take several forms. One approach is to require a new

member to invest a specified minimum amount of equity capital as a condition of membership. For example, a cooperative’s target level of investment for each member might be allocated equity equal to 10 percent of

the dollar value of the member’s estimated annual patronage. The

advance capital requirement for a new member could be set at 5 percent,

or half the amount required to be fully invested. This would provide the

cooperative with an initial amount of equity capital to support the new

member’s patronage.

This initial investment may be collected in a lump sum as a condition of membership, or paid in installments over several years. The

method used will depend on the existing capital level of the cooperative,

the relative demands the new member’s patronage places on capital, and

the ability of the new member to make the contribution.

A higher retain level is another type of advance capital required

that can be used with new members, perhaps in addition to the initial

advance capital contribution. One method used would have a per-unit

capital retain deducted that is higher than for the fully invested member.

Or, the new member can receive a lower percentage of the cash patronage

allocation if the retained patronage refund method is used to accumulate

capital.

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Regardless of the method used, advance capital permits the new

member’s investment to reach a fully invested position more rapidly. It

also provides the funds, depending on other capital requirements, for the

cooperative to stay more current in retiring equity to over-invested members.

Advance capital can also be applied to an existing member whose

investment level falls below an established minimum level set by the

board of directors. This situation occurs when a member’s use of the

cooperative increases rapidly and regular capital contributions are not

sufficient to maintain the investment in proportion to use. a

Advance capital requirements should be administered fairly. For

example, the initial investment level can be set so high that it acts as a

barrier to gaining new members. However, the initial investment requirement should provide sufficient capital to support at least part of the new

member’s patronage. This keeps the new member’s patronage from being

materially subsidized by other patrons’ investments.

Under certain circumstances, the cooperative may consider obtaining part of the required initial investment by “loaning” the money to the

member in the form of a capital note. This note would be repayable, with

interest, from retained patronage income or per-unit capital retains that

are offset against the capital notes and become part of the member’s equity investment in the cooperative. However, capital notes as a substitute

for actual cash investment should only be used as a last resort for capitalizing or recapitalizing a cooperative. This is because the “loaned” capital

doesn’t actually strengthen the cooperative’s equity position until the

capital note is repaid. Also, members’ commitment will be diluted if their

own funds are not invested in the cooperative.

Equity Redemption Considerations

Returning capital to over-invested members on a timely basis is

one of the key factors in successfully operating a base capital plan.

However, capital constraints may limit a cooperative’s ability to fulfill

this obligation. For instance, a fast-growing operation with increasing

capital needs may have difficulty obtaining sufficient capital from

under-invested members to simultaneously meet growth needs and satisfy redemption obligations to over-invested members.

This situation can be addressed in several ways. One method is to

extend the base period, which is similar to lengthening a revolving cycle.

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A longer base period is not very desirable. It reduces the cooperative’s

ability to adjust members’ required investment levels because of changes

in patronage levels.

A better approach is to redeem equity to over-invested members

using one of several formulas. Amounts can be prorated among the most

over-invested members. Another method is to prorate the payout to all

over-invested members in proportion to the amount each is over-invested, either on an unweighted or weighted basis. The weighted calculation

would provide higher proportional payments to the most over-invested

members. This reduces any disparity more quickly.

Other delayed or deferred payment options can be used if insufficient capital exists to repay all over-invested members. Some cooperatives have used interest-bearing promissory notes issued with due dates

several years later, in lieu of actual cash redemptions. The member’s

lender may view the note as a more secure form of collateral than the

actual equity itself because it has a specific repayment date.

special Program Payments In adopting or administering a base

capital plan, the cooperative must decide how to address the issue of

special program payments (estates, retirements, etc.). If a cooperative has

a fairly short base or adjustment period (5 years or less), the pressure to

redeem equity under special circumstances is lessened. When a member

ceases doing business with the cooperative under special circumstances

such as retiring from farming or death, equity paid under a plan with a

short base period provides for a timely return of equities.

Several issues must be addressed if the cooperative has a longer

base period, or still wishes to redeem under special circumstances even

though its base period is short. First, establish a priority under which

equity will be redeemed. A few cooperatives with base capital plans

choose to pay estates immediately, regardless of the base-period criteria.

These payments are made before any regular base capital adjustments [2].

A cooperative should have current information on its estate payment

exposure to ensure this procedure will not unnecessarily weaken the equity capital position. Members retiring from farming are usually paid their

equity over the base period instead of in a lump sum as with estates [2].

Membership Termriraf:ions Another redemption event occurs when

members take their business elsewhere (some cooperatives call them

“quitters”). Although similar to a retirement, it raises philosophical

19
questions that cooperatives should address. Normally, if a member stops

using the cooperative, the equity is repaid over the length of the base

period. In recent years, however, some cooperative boards and

memberships have questioned the right of terminating members to have

capital returned on the same basis as continuing members. In this

situation, continuing members would have to replace the capital being

paid to quitting members to keep the cooperative’s equity at required

levels.

Several cooperatives have addressed the issue by lengthening the

base period for departing members. This extends the period of time over

which “quitters” are repaid their capital. This practice raises some

equal-treatment questions, but no known formal legal complaints have

been brought against cooperatives taking this approach.

Combination Plans

In the 1991 equity redemption study, 24 percent of cooperatives

with base capital plans also used a revolving fund program to manage a

part of their equity capital [4]. Most said they operated with both programs to keep two equity sources separate, such as capital obtained from

per-unit capital retains vs. that coming from retained patronage refunds.

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Per-unit capital retains were most often used with base capital programs,

while retained patronage refunds were usually associated with revolving

fund programs.

For cooperatives with both plans, the average base capital plan

adjustment period was 5 years compared with a revolving fund period of

11 years [4]. It was unclear from the 1991 study why there was such a

wide disparity between the length of the two redemption cycles.

In other instances, a base capital plan and revolving fund program

were being used concurrently while the cooperative switched from one

capital plan to the other. In a few situations, dual programs were temporarily used to accommodate merger partners with different programs.

A Challenge to Cooperatives

Operating a base capital plan as the primary equity management

program should make sense to many cooperatives. Unfortunately, only a

few have used it during the more than 30 years since the concept was

introduced. In the interim, numerous presentations, articles, and publications have praised the merits of these programs as the most equitable and

prudent capital management program for many cooperatives.

From interviews and written comments received by USDA’s

Cooperative Services Program during the late 1980s and early 199Os, most

respondents confirmed the base capital plan’s superiority as an equity

accumulation and management tool. If this is the case, why aren’t base

capital plans in wider use?

A major obstacle to base capital plans has always been the perception that they are too complex to administer and difficult to understand.

While these plans are somewhat more complicated to operate, that is far

outweighed by their superiority as an equity management tool.

The challenge to boards of directors and managers is to thoroughly

and honestly evaluate the appropriateness of a base capital plan for their

cooperatives. The alleged complexity and difficulty of understanding can

be overcome readily with adequate education and communication.

First, board members and management should learn and understand the concepts and operating characteristics of base capital plans.

This will prepare them to be advocates for the new program if it proves

21
to be an appropriate alternative to the cooperative’s current method of

capitalization. Anything less is a breach of the board’s fiduciary responsibility to the member- owners.

Next, conduct a detailed study of how a base capital plan operates

and the financing and capitalization benefits it could provide. This study

should consider both the cooperative’s and the members’ perspective.

Several sources can provide assistance in carrying out this assignment.

The cooperative’s accounting firm can play an important role, as well as

its attorney, for drafting bylaw changes, etc. There are also private consultants and university extension personnel who specialize in cooperative

financial matters.

Publications from USDA’s RBCDS-Cooperative Services describe

the base capital method of capitalization. Cooperative Services also provides technical assistance to cooperatives in exploring the considerations

and factors involved in developing a base capital plan.

The benefits of such a plan are worth the time and resources it

takes to perform a comprehensive investigation.

References

1. Hulbert, Helim H., Nelda Griffin, and Kelsey B. Gardner.

Revolving Fund Method of Financing Farmer Cooperatives. FCS GR 41,

USDA, Washington, DC, March, 1958.

2. Cobia, David W., et al. Equity Redemption: Issues and

Alternatives for Farmer Cooperatives. ACS RR 23, USDA, Washington,

DC, October, 1982.

3. Brown, Phillip F. and David Volkin. Equity Redemption Practices

of Agricultural Cooperatives. FCS RR 41, USDA, Washington, DC, April,

1977.

4. Rathbone, Robert C. and Roger A. Wissman. Equity Redemption

and Member Equity Allocation Practices of Agricultural Cooperatives.

ACS RR 124, USDA, Washington, DC, October, 1993.

5. Krueger, Kenneth I? The Adjustable Capital Program. Spokane

Bank for Cooperatives, Spokane, WA, 1982.

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Appendix A:

Examples of Bylaw Provisions for a Base Capital Plan

These examples of bylaw provisions relating to base capital plans

are provided for reference only. Before adopting any specific provisions,

a cooperative should consult with its attorney to ensure the changes are

compatible with state statutes and all corporate documents such as articles of incorporation, other bylaw provisions, and membership or marketing agreements.

EXAMPLE 1

Section -0 BASE CAPITAL. The Board of Directors shall determine

annually the base capital requirements of the Cooperative and shall further determine annually an equitable allocation of suchrequ

among members of the Cooperative and other patrons, such

irements

allocation to

be computed on the basis of the average volume of product furnished by

each member during any number of prior fiscal years of association, not

exceeding ten (lo), as conclusively determined by the Board of Directors

to be most representative. Each member shall maintain a capital account,

in the form herein described, in accordance with such allocations.

The Board of Directors shall follow such reasonable standards in

setting such allocations seeking, in as practicable a manner as possible, to

have members’ capital accounts bear a percentage or pro-rata relationship to their overall patronage of the Cooperative.

The Cooperative, at the discretion of its Board of Directors, shall be

entitled to continue as outstanding, and not pay off, any Capital Equity

Credits necessary to satisfy base capital requirements for any member or

members, notwithstanding that similar credits of the same year or years

are refunded or paid off; provided, however, that outstanding Capital

Equity Credits which have been retained to satisfy base capital requirements shall have priority, except in dissolution, and shall be paid off and

redeemed, when no longer required to satisfy a member’s base capital

requirement, prior to the paying off and redeeming more recently issued

credits.

Once the member has met his/her base capital as herein above

determined by the Board of Directors, no further per-unit capital retains

and/or patronage dividends shall be withheld until the Board of

Directors has determined that the member’s Capital Equity Credits are

not equal to his/her reestablished base capital requirement.

Section -0 BASE CAPITAL REQUIREMENT. Each year the Board

of Directors shall establish the “base capital required by the

23
Cooperative.” The base capital and per-unit capital retained for each fiscal year beginning April,, shall be established by the Board of

Directors prior to the following May 1.

EXAMPLE 2

Section -0 CAPITAL EQUITY CREDITS. The Board of Directors

shall annually establish the amount of capital deemed adequate to

finance the Association’s business as well as to redeem such capital as is

no longer necessary to meet base capital requirements (as hereinafter set

forth) or which is held by persons or organizations who are not current

members of this Association. The Association shall establish and maintain a capital account for each member.

A record of all holders of capital equity credits shall be kept and

maintained by the Association. Such credits shall be transferable only to

the Association or to an eligible member of the Association on the books

of the Association in the manner established by the Board of Directors

and no transfer thereof shall be binding upon the Association unless so

transferred. Capital equity credits can be transferred from one member to

another member provided the transfer is reported in writing to the Board

of Directors.

A member may also transfer and/or use capital equity credits he

owns in one form of business organization to another type of organization so long as the transfer is from a member of the Association to another member of the Association and the transfer is reported in writing to

the Board of Directors. No interest shall be paid on capital equity credits.

All debts of the Association, both secured and unsecured, shall be entitled to priority over all outstanding capital equity credits.

Section -0 CAPITAL FROM MEMBERS. All capital of the

Association allocated to a member regardless of the form or type of capital (qualified or nonqualified) will be a part of such member’s base capital.

All business transacted by the Association with or for members

shall be transacted on a cost basis as determined by the Association’s certified public accountants, and the Board of Directors may determine an

amount to be retained from net margins arising from all such business

transacted by the Association with or for members. All such net margins

shall be allocated to members on a patronage basis at the end of each fiscal year and shall be paid to such members in cash; by credit to the capi-
tal accounts of each member; or in such other form as may be determined

by the Board of Directors; or partly in cash and partly in credit or other

form, within 8 l/2 months following the close of the fiscal year (or within

such other time as may be permitted by the Internal Revenue Code). Such

patronage dividends may be paid on either a qualified or nonqualified

basis as determined by the Board of Directors.

Section -0 BASE CAPITAL. The Board of Directors shall determine

annually the base capital requirements of the Association and shall further determine annually an equitable allocation of such requirements

among member-stockholders of the Association and other patrons, such

allocation to be computed on the basis of the average volume of product

furnished by each member-stockholder during any number of prior fiscal

years of Association, not exceeding ten (lo), as conclusively determined

by the Board of Directors to be most representative. Each member-stockholder shall maintain capital accounts, in the form hereinafter described,

in accordance with such allocations. The Board of Directors shall follow

such reasonable standards in setting such allocations (and may set such

standards by type of service rendered by Association for member-stockholders), seeking in as practicable a manner as possible to have memberstockholders’ capital accounts bear a percentage or pro rata relationship

to their over-all patronage of the Association.

The Association, at the discretion of its Board of Directors, shall be

entitled to continue as outstanding and not pay off any capital equity

credits necessary to satisfy base capital requirements for any member or

members, notwithstanding that similar credits of the same year or years

are refunded or paid off; provided, however, that outstanding capital

equity credits which have been retained to satisfy base capital requirements shall have priority, except in dissolution, and shall be paid off and

redeemed, when no longer required to satisfy a member’s base capital

requirement, prior to paying off and redeeming more recently issued

credits.

Section -. BASE CAPITAL REQUIREMENTS. Each year the Board

of Directors with the assistance of the Association’s certified public

accountants shall establish the “base capital required by the Association.”

The base capital for each fiscal year ended August 31 shall be established

on or before December 1 of the following fiscal year, and prior to the allocation and distribution of the patronage dividend and per-unit capital

retains for such prior fiscal year.

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EXAMPLE 3

The Board of Directors shall annually establish the amount of capital deemed adequate to finance the Cooperative’s business as well as to

redeem such capital as is no longer necessary to meet base capital

requirements or which is held by persons or organizations who are not

current members of this Cooperative.

The Cooperative shall establish and maintain a Producer

Investment Equity account for each member. Each member shall receive

an annual notice from the Cooperative summarizing the status of his

Producer Investment Equity account.

A record of all holders of Producer Investment Equity Credits shall

be kept and maintained by the Cooperative. Such credits shall be transferable only to the Cooperative or to a member of the Cooperative on the

books of the Cooperative in the manner established by the Board of

Directors, and no transfer thereof shall be binding upon the Cooperative

unless so transferred.

No interest shall be paid on Producer Investment Equity Credits.

All debts of the Cooperative, both secured and unsecured, shall be entitled to priority over all outstanding Producer Investment Equity Credits.