Preface

Do you manage your cooperative’s equity or does it manage the cooperative? All too often, equity is not managed in such a way that a member’s

investment is maintained in proportion to use, and ownership and control

are kept in the hands of current users. The purpose of this publication is to

provide a guide for cooperative management teams so that they can do a

more effective job of managing equity capital. Regardless of the type of

capital program used, there are pointers provided to help achieve and then

maintain the type of balance in the equity accounts that allow adherence to

cooperative principles. For some cooperatives, achieving this result may

seem daunting, but ignoring the problem now will make it even more difficult to address down the road.
Contents

What Is Equity in a Cooperative? ................................ 1

What Is the Purpose of Equity? .................................1

What Does Managing Equity Mean? .............................2

Handle or Direct with a Degree of Skill ....................... .2

Treat with Care ..........................................3

Exercise Executive, Administrative, and Supervisory Direction ..... 3

Achieve One’s Purpose ...................................4

Effective Equity Management ..................................4

Equity Management and Cooperative Principles ............... .4

The Importance of Financial Planning ....................... .4

What Is Financial Planning? ................................5

EquityTypes ............................................ .

Types and Uses of Allocated Equity ..................... .6

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

Retained Patronage Refunds ........................7

Per-Unit Capital Retains ............................8

Unallocated Equity ....................................8

Base Capital Plans ...................................9

Equity Redemption Programs ..........................10

Types of Equity Redemption Programs ............... 10

Revolving Fund Programs ......................... IO

Percent-of-all-Equities Program ..................... 11

Special Redemption Programs ......................12

Equity Management Considerations ............................I2

Managing Proportionality .................................I3

Closing the Gap .....................................13

Changing Cash Patronage Percentages .............. 14

ii
Contents

Using Per-Unit Capital Retains ...................... I4

Managing the Revolving Cycle8 ..................... .15

Changing To a Base Capital Plan ................... 15

Use of Unallocated Equity .........................16

Advance Capital .................................16

Managing Equity Accumulation ............................I7

Retained Patronage ................................. .I7

Per-Unit Capital Retains ..............................17

Direct Investments in Value-Added Cooperatives ........... 18

Managing Base Capital Programs ..........................2O

Choosing a Base Period ..............................2O

Selecting a Measurement Unit .........................21

Determining Proportionality ............................22

Managing Equity Redemption ..............................22

Regular Redemption Programs .........................22

Revolving Fund .................................23

Percent-of-all-Equities ............................24

Special Redemption Programs .........................25

Estates ...................................... ..2 5

Ageof Patron ................................. ..2 6

Retirement .....................................26

Moveaways .................................. ..2 7

Hardships ......................................27

Summary and Conclusions ...................................28

. . .

III
Managing Your

Cooperative’s Equity

What Is Equity in a Cooperative?

Equity is the net worth, or risk capital, of the organization and represents the members’ ownership interest in the total assets of the company. In balance sheet terms, equity is total assets less total liabilities.

Cooperative equity comes in two forms, allocated and unallocated.

Allocated equity is the amount assigned, on a proportional basis, to each

member. Unallocated equity is not designated to specific member

accounts.

What Is the Purpose of Equity?

Because it is the risk capital invested in the business by its owners,

equity serves to protect the interests of the liability holders-the entities

to which the cooperative owes money. In a cooperative, just like other

forms of business, it is desirable for the members to have a larger ownership stake in the organization than the creditors or liability holders. This

gives the owners more control and flexibility in determining how the

business is operated and financed.

Equity in a cooperative should be at least 50 percent of total assets.

In many cooperatives, equity far exceeds this amount, but in 1994, based

on the latest survey by USDA’s Rural Business-Cooperative Service

(RBS), the average equity level for all agricultural cooperatives was only

43 percent.

1
What Does Managing Equity Mean?

Webster’s dictionary offers several insights into what it means to

manage. For example, managing is the ability to:

1. Handle or direct with a degree of skill;

2. Treat with care;

3. Exercise executive, administrative, and supervisory direction;

and

4. Achieve one’s purpose.

All four of these definitions apply directly to the management

team’s responsibility in managing the cooperative’s equity. The cooperative’s management team consists of the board of directors and the professional management staff.

The board’s role differs from that of the management staff. The

board establishes policy on how to manage equity and monitors how

these policies are carried out. Management’s role carries out the board’s

policies and keeps it informed of the results. Although the roles are different, the objective of effectively managing equity is the same-to ensure

the cooperative is properly capitalized at all times to achieve its purpose

of serving the members’ needs effectively and efficiently.

Each definition of “managing” can be used to illustrate the difference between board and management roles in fulfilling the responsibility

of properly managing the cooperative’s equity.

1. Handle or Direct with a Degree of Skill

Board of Director’s Role- The board has n fiduciary responsibility

to safeguard the assets of the cooperative and preserve the members’

investment. To carry out this responsibility, board members should have

at least a basic knowledge and understanding of cooperative finance.

They must also insist on receiving periodic reports from management on

the cooperative’s financial condition and progress toward achieving its

capital goals. ESoard members use their knowledge of finance and the

information from financial reports to satisfy themselves that the cooperative is in sound financial condition and has sufficient equity invested in

the business to operate profitably.

Management’s Role- The cooperative’s management should possess a thorough knowledge and understanding of cooperative finance to

accurately monitor, report, and forecast the cooperative’s financial results

2
and equity capital requirements. Management must also have the ability

to develop and operate the cooperative’s equity programs to guarantee

sufficient equity capital is acquired and retained in the business.

2. Treat with Care

Board of Director’s Role- Treating with care deals with the

board’s fiduciary responsibility and means to manage sensibly and conservatively. This would apply to policy decisions involving both equity

capital accumulation and distribution. The need for care in equity management should be clearly communicated to the membership so they

fully understand the important role of equity capital in cooperative operations. Without this understanding, members may have unrealistic

expectations on their required level of investment and when and how

much of their equity may be redeemed. Members must understand the

need for retaining sufficient equity in the cooperative to operate the business profitably, finance growth, and provide a cushion against financial

difficulty.

Management’s Role- There is a close parallel between the board’s

and management’s role in exercising care, but management is more concerned with day-to-day operating performance. Management should continually evaluate the cooperative’s competiveness in obtaining maximum

returns from the assets in which the members have their equity invested.

3. Exercise Executive, Administrative,

and Supervisory Direction

Board of Director’s Role- Setting equity management policy is

how a board of directors exercises its executive direction. Written policies

should be adopted that address all aspects of the capital program, including long-range financial planning, fixed asset expenditures, capital retention methods and guidelines, borrowing sources and limits, and equity

redemption practices. The board also needs to monitor adherence to these

policies as part of its supervisory responsibility.

Management’s Role- In carrying out the board’s capital program

policies, management provides all three types of direction. Executive

direction is given by establishing the procedures needed to carry out the

board’s policies. Management also supervises the work performed to

carry out the procedures and has the administrative responsibility to

report ongoing results to the board.

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4. Achieve One’s Purpose

With this definition, the roles of the board of directors and management become the same. The purpose achieved by effective equity management is a well-capitalized, competitive business in which each member’s investment in the cooperative is maintained in proportion to use.

Effective Equity Management

Before addressing the strategic and operational considerations of

effective equity management practices, it is important to review some

basic tenets as well as characteristics of equity accumulation and redemption methods.

Equity Management and Cooperative Principles

Adhering to cooperative principles is a critical aspect of effective

equity management. At the heart of equity management are: (1) the

owner-user principle; (2) the user-control principle; and (3) the user-benefit principle.

The key element of the owner-user principle is that equity (ownership financing) is supplied by the current users of the cooperative in proportion to use. If the owner-user principle is followed, then the user-control principle is usually being followed. This principle means that voting

control in the cooperative is maintained in the hands of current users.

The user-benefit principle means that net income should be distributed or

allocated to members on the basis of current use.

The Importance of Financial Planning

Managing cooperative equity effectively highly depends on sound

financial planning. The complete management team, both the board of

directors and the professional management staff, should participate fully

in this planning effort. The board’s role is to set longer term (3 to 5 years)

financial goals for the organization that are consistent with the overall

strategic plan. Management staff develops shorter term (1 to 3 years),

detailed financial plans for achieving the long-term goals established by

the board. The financial plan will identify the equity levels necessary to

achieve the short- and long-term goals. Achieving these goals is where

effective equity management comes into play.
What Is Financial Planning?

It is the identification, analysis, and evaluation of the capital

sources and requirements of the business. Financial planning identifies

all the sources and uses of capita1 involved in the successful operation

the cooperative. Typical sources include net income to be retained

of

(whether allocated or unallocated), capital retains, sale of assets, investments by members, and various types of debt. Capital uses include fixed

asset expenditures, debt servicing, investment in other cooperatives, and

equity redemption. The specific types or sources of equity capital available to a cooperative normally are determined by the type of capital program(s) being used. These relationships will be discussed later in the

report.

Debt is used to supplement equity used in helping the cooperative

meet its capital needs. Determinations involving the use of debt capital

include decisions regarding the correct mix of short- and long-term debt,

interest rates, repayment terms, and loan restrictions or covenants. Debt

capital is an integral part of the overall equity management strategy.

im

Financin 1 planninfi is a yea r-round

portance in the second ha1 f of the orga

activity, but takes on

niza tion ‘s fiscal year.

greater

Specific

planning for the new fiscal year can begin because preliminary results for

the current year can be reasonably estimated and expectations for the

coming year can be iden tified.

In its broadest sense, equity is divided into two categories-allocated and

unallocated. Allocated equity is capital recorded on the cooperative’s

books which is assigned, or allocated, to each member on a proportional

basis according to use. It is acquired in three different ways. Allocated

equity may come from a direct investment by the member, through

patronage refunds, and/or from per-unit capital retains.

Unallocated equity is capital not assigned or designated to specific

member accounts. It may originate from net income earned on nonmember or nonpatronage business, patronage income

decides not to allocate, or capital obtained from a

the board of

special even

direchtors

.t like the

profit from the sale of an asset. The mix between allocated and unallocated equity capital in one cooperative compared with another may present

a significantly different equity management situation.

5
Types and Uses of Allocated Equity

l Direct Investment

A direct investment in cooperative equity can be made through the

purchase of common or preferred stock, membership certificates, or other

means that evidence the investment. It is most often used to record the

initial purchase of equity a member makes when joining the cooperative

and usually carries a voting right. A direct investment can also serve

other important

ber investment,

purposes.

related or unrelated,

It also can be used to acquire additional m.emto patronage of the cooperative. The

purpose may be to further strengthen the equity position, fund expansion

or an acquisition, or shore up a weakened financial condition. Direct

investments can also be made by nonmembers as a way to supplement

member equity. These investments, usually in the form of preferred

stock, often pay a dividend, but do not usually provide a voting right.

Recently, with the increased formation of new, value-added, processing and marketing cooperatives, direct investments have taken on

more significance as a source of equity. These types of cooperatives often

require a large, up-front investment of capital as a condition of membership. The capital is used to help finance the construction and initial operation of the value-added processing facilities. This investment generally

gives the member the right and obligation to delivery a prescribed

amount of product to the cooperative for the value-added processing and

marketing activity.

Effectively managing the equity acquired by direct investment can

either be an easy task, such as with a membership share, or a complex

undertaking in the case of a value-added cooperative. The membership

share is usually a nominal amount compared with the total equity

amount and is often repaid when membership ceases.

Managing direct investment capital acquired from members or

nonmembers as preferred stock can be more complicated. If the stock

pays a dividend, the rate of dividend and whether it is cumulative or

noncumulative presents different management situations. Cumulative

dividends put more pressure on earnings to meet the cooperative’ capital

needs and still keep dividend payments current. Another management

consideration with preferred stock is the manner in which it can

redeemed, if at all, in situations other than the liquidation of the coopera-
tive. Regardless of the situation, the board of directors must have the

approval authority over the redemption event to protect the financial

integrity of the cooperative.

Direct investments made by members in a value-added cooperative

provides the greatest equity management challenge. Much depends on

the type of capital plan adopted by the cooperative. Does it permit, with

board approval, trading equity among members along with the attendant

delivery rights? Is the capital program operated as a base capital plan

where members must maintain a proportional share of the required equity needed by the cooperative? Or, are retained patronage refunds, with

their potential variability, the only new equity source after the initial

investment? Do the marketing agreement or bylaws permit the cooperative to call for additional direct investment as capital requirements

increase? These provisions need to be adequately addressed in designing

a capital program in a value-added cooperative.

l Retained Patronage Refunds

Patronage refunds are amounts allocated to members, in proportion to use, from the net income of the cooperative. In most instances, a

portion of the patronage refund is paid in cash and the rest is retained as

allocated equity. Retained patronage refunds are most commonly used to

acquire equity capital. Managing the accumulation of equity using this

method can be demanding because the amount of capital available

depends on the level of net income achieved. A shortfall in net income or

a net loss can leave the cooperative in a difficult situation in meeting capital outflow requirements such as fixed asset purchases or equity

redemption. Supply and service cooperatives that normally have more

stable earnings are better suited to use patronage refunds, but many marketing cooperatives also use them.

Paying out a smaller percentage of the patronage refund in cash

and/or postponing equity redemption are methods used to provide some

flexibility in managing the amount of equity available if net income falls

short of expectations. Options available to the cooperative when faced

with a net loss will be addressed later.

The cooperative also has other options available in handling

patronage refunds. They can be allocated either in qualified or nonqualified form. The cooperative can deduct a qualified allocation from net

income in determining its tax liability. To qualify for the tax deduction,

the cooperative must provide a written notice of allocation within @/2

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months of the cooperative’s fiscal year end, a minimum of 20 percent

must be paid in cash, and the member must have given prior consent to

pay income tax on the entire allocation in the year it is received.

With a nonqualified patronage refund, the cooperative is not

required to make a minimum cash payment. The cooperative pays

income tax on the full amount of the patronage allocation and the member has no tax liability until that nonqualified allocation is redeemed. At

that point, the cooperative qualifies for a tax credit. Nonqualified allocations can serve as an equity management tool in several ways. If the

cooperative’s income tax rate is a lower percentage than the cash payment it would have paid members, a nonqualified allocation will permit

more equity to remain in the cooperative. In other instances, a tax credit

may be available to offset the tax liability arising from issuing nonqualifieds, also allowing more equity to stay in the cooperative.

l Per-Unit Capifal Retains

Per-unit capital retains are investments made by a member based

either on a physical unit of product delivered or on a percentage of the

sales value of that commodity. In a marketing cooperative, the retain is

withheld from the sales proceeds due the members on the raw product

delivered for processing and marketing. The advantage of this type of

retain is its stability because equity accumulation is not dependent on the

net income of the cooperative. It is also more flexible because the amount

deducted can be increased or decreased to compensate for fluctuations in

volume or price of the commodity being handled. Marketing cooperatives are the predominant users of per-unit capital retains, often in combination with retained patronage refunds. Per-unit capital retains are taxable income to the member in the year in which they are withheld.

Unallocated Equity

Unallocated equity is not assigned to a member’s account, but usually redeemed only upon liquidation of the cooperative. While it is primarily retained as the after-tax portion of nonpatronage net income,

some cooperatives specifically designate a portion of patronage income

as unallocated. This requirement is usually outlined in the bylaws and

may be specified in State statutes. The purpose for the cooperative is to

build a tax-paid reserve to cushion allocated equity from operating losses. Unallocated equity also serves as a “permanent” capital base.
The unallocated equity accounts should be administered cautiously, however, because there is a danger of members losing control if the

unallocated equity portion becomes too large a percentage of total equity.

When members’ allocated ownership interest diminishes as a proportion

of total equity, loyalty to the cooperative may also weaken. If member

control is diluted, there is a danger that management, rather than the

board of directors, will begin making more decisions affecting the cooperative’s capital. If too much of the cooperative’s net income is designated as nonpatronage, the benefits of “operating at cost” are also lost to the

member. In other

according to use.

words, patronage refunds are not being distributed

Base Capital Plans

The base capital method of capitalization functions as a complete

equity management tool because it serves as both an equity accumulation

and an equity redemption technique. When operated as designed, it

keeps member investment proportional to use on a continuing basis. The

1991 study showed only about 1 percent of all agricultural cooperatives

use this type of capital plan-primarily cooperatives marketing dairy

products and fruits and vegetables. Also, some of the value-added cooperatives organized in recent years have selected this method.

Operating a base capital plan involves periodic adjustments to a

member’s required investment to keep it aligned with the proportional

use of the cooperative. Proportional use is determined by measuring each

member’s average patronage over a base period that may range from 1 to

10 years depending on the type of cooperative. At least annually, equity

capital requirements for the business are projected and each member’s

proportional share is calculated. Based on this calculation, the member

will be either under-invested, over-invested, or at the required investment level. The under-invested member will be required to invest sufficient capital to become fully invested, while the over-invested member

will be due a refund or redemption of equity.

The advantages and disadvantages of base capital plans are:

Advantages l Links member investment directly to use

l Keeps ownership and control in hands of

current users

l Allows for systematically adjusting capital

requirements
Disadvantages Does not work well if there is constant and

large member turnover

May require large initial investment by

new member

Difficult to understand and complex to

administer

Equity Redemption Programs

Just as important as equity accumulation are the types of equity

redemption programs a cooperative uses to maintain and control the

level of equity. Combined, these two activities constitute the primary

tools available to the management team in carrying out its equity management responsibilities. In its simplest term, equity redemption is the

payment to members, in cash or other property, of previously issued

equities. The decision to redeem equities is made by the board of directors after determining that the cooperative’s financial condition warrants

the action.

Types of Equity Redemption Programs

Equity redemption programs are divided into two categories-systematic and special. A systematic program periodically redeems equities,

subject to financial ability and approval by the board of directors.

Systematic programs include the revolving fund method, and percent-ofall-equities. In a special program, redemption is triggered by an event

that happens to individual members such as death, retiring from farming,

or reaching a prescribed age. How these programs are used, if at all, individually or in combination, is fundamental to any equity management

consideration.

l Revolving Fund Programs

Equity redemption using the revolving fund method consists of

paying out equity on a first-in, first-out basis. The oldest year of equity is

repaid before equities issued in subsequent years are redeemed. The

board may adopt a policy that sets a target revolving fund period, for

example 10 years, and attempts to adhere to it as long as financial conditions allow. Revolving funds are the most common type of systematic

redemption program used. A study conducted by RBS based on 1991

financial data showed that 92 percent of cooperatives with systematic

redemption programs used the revolving fund method. The study also

10
showed the average revolving period for all cooperatives was 16 years,

but varied from 2 years to more than 25 years. Fruit, vegetable and nut

marketing cooperatives had the shortest average revolving period at 10

years, while grain marketing and farm supply had the longest average

period at 19 years each. More than half of the cooperatives with revolving

fund programs used them in combination with one or more special

redemption programs. Cooperatives primarily use retained patronage

refunds and per-unit capital retains as the methods for accumulating allocated equity that is redeemed on a revolving fund basis.

The revolving fund method has advantages and disadvantages as a

tool in managing a cooperative’s equity:

Advantages

Disadvantages

l

0

l

Easy to understand

Keeps investment proportional when

revolving period is short

Requires no cash outlay by member

Easily manipulated

Disparities occur when earnings vary or

revolving period is extended

Unrealistic member expectations revolving

cycle will be maintained

l Percent-of-all-Equities Program

Compared with the revolving fund method, the percent-of-all-equities program is used by only a limited number of cooperatives. The board

of directors establishes a percentage of all allocated equities to be

redeemed regardless of the year they were issued. Based on RBS data, the

average percentage redeemed annually was 10 percent. This would be

similar to a W-year revolving fund. Percentages redeemed ranged from 2

to 15 percent. The 1991 study results indicated that cooperatives paying a

lower percentage usually combined this program with one or more special programs. The primary benefit is, regardless of how long members

have patronized the cooperative, they get an equity redemption amount.

This is particularly beneficial to younger members because it returns capital to their farming operations more rapidly. This feature could serve as

an important membership recruitment and retention tool.

Advantages and disadvantages of this method are:

Advantages l Easily understood and administered

l Attractive to new members

11
Disadvantages

Well-suited to cooperatives relying on

retained patronage refunds

Proportionality takes longer to achieve

Contributions unresponsive to changes in

patronage

Plan must be combined with special

programs for inactive members to receive

equity on a timely basis

l Special Redemption Programs

The use of special equity redemption programs is quite prevalent

among agricultural cooperatives. The 1991 study data indicated that 72

percent of all cooperatives whose equity was subject to redemption used

one or more types of special programs, often in combination with regular

redemption programs. The most common method, used by 95 percent of

cooperatives with special programs, was payment to estates. Age-ofpatron was the second most common, followed by redemption upon

retirement from farming. Other types of special programs included

redeeming to members moving out of the cooperative’s trade territory

and to members suffering some type of hardship such as foreclosure.

Although the basic use of these special programs was the same

among cooperatives, the manner in which they are administered varies

greatly. This variability provides some good examples of different equity

management techniques, which will be discussed in more detail later in

the report.

Equity Management Considerations

This section will discuss, analyze, and evaluate the considerations

the board of directors and management must address in making the decisions involved in managing the cooperative’s equity.

The key objective of managing equity effectively is to keep members’ investment proportional to use of the cooperative. In most

instances, achieving and maintaining proportionality is easier to talk

about than to accomplish because of the uncertainty of financial outcomes. But, it should still be the underlying goal of equity management.

How it is accomplished will depend on many factors. A cooperative that

has been in business for many years and has accumulated equity with no

12
regard to proportionality will have a difficult task achieving this objective. A new or relatively young cooperative will have a much easier job in

achieving, and then maintaining, members’ investments in proportion to

use. Likewise, a cooperative that has been operating with an active equity

redemption program may only need to fine tune its capital program to

achieve proportionality.

Managing Proportionality

Where should a cooperative begin in its efforts to achieve a closer

relationship between a member’s investment and use of the cooperative?

Start by identifying the difference between each member’s investment

and use level. Depending on the number of active and inactive members

and the length of time the cooperative has been in business, this may be a

daunting task. The project will be even more difficult if the membership

records have not been kept current. Regardless of the obstacles, however,

this exercise must be performed to provide a starting point to begin managing the cooperative’s equity.

The greatest amount of disproportionality usually occurs in a cooperative that does not redeem equities, or only redeems using special programs such as estates or age-of-patron. This situation can only be corrected by adopting an aggressive capital program such as a revolving fund or

base capital plan. Such a program must have the capability to acquire sufficient equity from current users of the cooperative (on a proportional

basis) to redeem the equity of former and retired members who are no

longer patrons. The cooperative should prepare a long-term financial

plan that provides a road map as to how the objective will be achieved.

The plan should set a goal to achieve proportionality in a specified number of years. The plan should be reviewed at least annually and changed

to incorporate actual results from the past year and changes in assumptions and expectations for future years.

Closing the Gap

Achieving proportionality among members’ equity investments is

accomplished by using a combination of equity accumulation and equity

redemption techniques. Regardless of the ways used to achieve proportionality, the overriding consideration is the need to accumulate sufficient equity capital to make it possible.

Asking current users to bear the additional investment burden to

achieve the objective may meet with resistance. Therefore, it is extremely

13
important to continually educate members on their obligation to provide

equity capital according to use. This is in keeping with the equitable

treatment principle on which cooperatives are organized and should be

operated. If current members are under-invested in proportion to their

use of the cooperative, they are being subsidized by retired members

and/or other members whose use of the cooperative has declined.

Likewise, it is unfair to inactive members to be providing a majority of

the equity capital to finance the organization.

It will take, at the very least, several years before cooperatives that

have significant disparity between members’ investment and use to make

noticeable progress towards “closing the gap.” Progress against the

financial plan should be continually monitored with the results communicated to the membership on a regular basis. Here are some tips.

l Changing Cash Patronage Percentages

The cooperative has a number of tools at its disposal to assist in

making members’ equity investments more proportional. One way is to

control the percentage of the patronage refund paid in cash. For example,

if only the minimum amount of 20 percent is paid in cash (to qualify the

distribution for tax purposes), current users will be adding to their

investment at a more rapid pace than if a higher percentage is paid. This

may make more equity capital available, sooner, for redemption to inactive members, either through regular or special programs. For instance,

the objective might be to reduce the number of years in the revolving

fund by a specified amount (from 15 to 10 years), or if a cooperative is

redeeming to members at age 72 under an age-of-patron program, the

goal could be to lower the age to 65.

Another method is to vary the cash patronage percentage paid to

different members. Those who are under-invested would receive only the

minimum amount, usually the 20 percent. On a graduated scale, members who are fully invested or over-invested would receive a higher percentage of the patronage refund in cash. A member that is significantly

over-invested may even receive 100 percent of the patronage refund in

cash to prevent more disproportionality from occurring.

l Using Per-hit Capital Retains

Another way to increase the amount of equity accumulated is to

use a per-unit capital retain, either in lieu of retained patronage refunds,

or in addition to them. Because per-unit capital retains are a more stable

14
source of equity than retained patronage, equity has the potential of accumulating at a faster rate. Although a per-unit capital retain is used primarily by marketing cooperatives, others have successfully adopted this

method.

The amount of the retain can also be varied. An under-invested

member can be required to invest at a higher per-unit capital retain rate

than one who is fully invested. An over-invested member may not even

have a per-unit retain deducted from sales proceeds.

l Managing the Revolving Cycle

The amount of retained patronage refunds and/or per-unit capital

retains added to the revolving fund each year will vary depending on

earnings levels, the amount paid in cash, and the volume and value of the

commodities handled. This results in some years’ revolving funds being

large and others containing lesser amounts. These differing amounts may

provide the opportunity to combine two or more full and/or partial years

of retained equity into one redemption. This will speed the return of

equity to inactive or less active members and achieve proportionality

more rapidly.

As with other methods available for reducing disparities, shortening the revolving cycle requires current users to provide sufficient capital

to achieve this result and still maintain the cooperative’s financial soundness. In any given year, the ability to shorten the revolving cycle will also

be governed by other factors such as out-of-the ordinary capital expenditures and the demands of any special redemption programs.

Shortening the revolving cycle when financial conditions permit

also gives the cooperative more flexibility in future years. If available

capital in a specific year falls short of expectations, the revolving fund

can be lengthened by a partial or full year with less impact on proportionality. In addition, members should be more willing to accept a lengthening of the cycle if it has been shortened in previous years. Once again,

, member communications is the key to more ready acceptance of this situation.

l Changing To a Base Capital Plan

Another approach would be to convert the current equity program

to a base capital plan. One of the first steps is to calculate the relationship

between each member’s investment in, and use of, the cooperative. Even

if a base capital plan is not adopted, the cooperative will have done the

15,
calculations to determine how disproportional member’s investments are

compared to use and will have taken an important equity management

step.

l Use of Unallocated Equity

Cooperatives can designate a certain portion of each year’s net

income as unallocated equity. The primary purpose, in most instances, is

to cushion allocated equity from losses, but other benefits may be realized. If a certain amount of the equity pool is unallocated, allocated equity becomes a smaller percentage of total equity. The smaller allocated

equity pool can often be redeemed more rapidly than if the whole equity

amount was subject to redemption. This helps to keep equity more in the

hands of current users. Caution needs to be exercised, however, to prevent the unallocated equity level from becoming the dominant form of

equity because members may risk losing control of the cooperative.

Unallocated equity should be maintained in a range of no more than 15 to

25 percent.

l Advance Capital

A form of advance capital payment may be used to require underinvested members to more quickly bring their investment in line. The

most common time for its use would be when a new member joins the

cooperative. An advance capital payment might be used to set the initial

investment at a prescribed minimum so the new member can help provide the capital necessary to support the additional business volume

being contributed. Another situation occurs when an existing member’s

volume increases significantly in a short time and the cooperative needs

additional capital to finance it. In each instance, the regular methods such

as retained patronage refunds or per-unit capital retains may not be sufficient to adequately capitalize the additional volume. The existing member could be required, on a basis similar to the new member, to make a

direct payment to bring the investment up to a prescribed minimum.

The advance capital payment requirement may be too costly for the

member to contribute all at once. In these instances, installment payments can be used to allow the member to fulfill the obligation within a

prescribed period. The intent is still the same, to have the member’s

investment approach a proportional level on an accelerated basis.

Authority to assess an advance capital payment can be placed in the

16
organization’s bylaws or membership agreement with parameters established as to when and how the advance capital requirement will be triggered.

Managing Equity Accumulation

In the section “Managing Proportionality,” some aspects of equity

accumulation were touched on, but there are many other considerations

involved in raising equity that are important to an effective equity management strategy. Equity accumulation is the most important aspect of a

cooperative’s equity program. Without new equity being provided in

some manner, the business can neither grow nor be proportionally maintained through the redemption of equity to less active members. All other

equity management considerations depend on results of the equity accumulation efforts, i.e., equity redemption, capital asset purchases, obtaining and repaying debt capital.

Retained Patronage

How equity accumulation is managed largely depends on the

methods used for retaining equity in the cooperative. For example, if

retained patronage refunds are used, one technique is to delay making

the cash patronage payment until the full @/2 months after the end of the

fiscal year, as permitted under the tax laws. In this way, the cooperative

has full use of the entire patronage allocation for that period, instead of

paying the cash portion immediately. The cooperative saves by reducing

borrowed operating capital and accompanying interest costs.

Per-Unit Capital Retains

If per-unit capital retains are used, how and when the retain is

deducted from sales can have a significant capital impact. This is particularly true in marketing cooperatives that use the pooling method of

accounting for sales and returns to members. By deducting the per-unit

retain from the initial payment made to members, the cooperative has use

of that capital much sooner than if it waits to deduct the retain from the

final payment when the pool is closed. A dairy marketing cooperative

has a built-in advantage in this respect, because per-unit retains are usually deducted from each month’s milk check, providing a ongoing source

of equity capital throughout the year.

The pooling method also offers another capital management advantage. In most pooling operations, members receive an initial payment on

17
their product shortly after it is delivered. Throughout the rest of the pooling period (the fiscal year, or longer, depending on the marketing cycle of

the commodity), progress payments

justify. Delaying, or reducing the lev

are made to members

el of prosress paymen

as

.ts

sales

from

results

the

maximum amount that could be paid based on sales allows the cooperative to operate for short periods of time on the members’ capital.

Members, in essence, provide short-term operating capital. Less debt capital is borrowed and interest expense is reduced. This strategy should be

used carefully, however, or

does not stay competitive.

the cooperative may risk losing members if it

The type of per-unit capital retain used provides another equity

management consideration. A cooperative may choose to set the retain on

the basis of physical volume of product delivered or purchased or a percentage of the item’s dollar value. The physical volume method is the

most straight forward, but has some weaknesses. A shortfall in the needed amount of equity may occur in a year in which the physical volume of

the product is less than projected. This may hamper the cooperative’s

abili ty to make needed capital purchases or may curtail equity redemption plans. If lower volume is anticipated, the option exists to raise the

monetary amount of the retain, per unit of physical volume, to regain the

potential loss of capital.

A better tool for managing equity accumulation is to base the retain

on a percentage of the product’s sales value. In years when physical volume is lower, the value of the product normally increases. Using a retain

based on a percentage of product value could result in the same, or more,

equity being raised by the cooperative compared with a normal volume

year. This would not hold true if the lower volume occurs as an isolated

incident for the cooperative, while the rest of the industry has normal

volume.

Direct Investments in Value-Added Cooperatives

With the proliferation of value-added cooperatives in recent years,

a new set of equity management challenges is emerging. Most of these

cooperatives need a large, up-front capital investment by members to

provide the equity necessary to construct expensive, value-added, processing facilities. Raising this capital is often a lengthy and difficult

process, requiring the dedicated efforts of producers and professional

advisors who believe in the project. The effort usually begins with a

grassroots’ campaign to generate interest in the project and to solicit seed
capital from potential members. This initial drive for capital is a means to

gauge interest and to fund feasibility studies and hire consultants and

interim management.

When this effort is successful, the studies have been performed,

and project feasibility confirmed, the real task of raising capital begins. In

most instances, lenders expect equity capital to represent at least SO percent of the required investment for these value-added facilities and the

operating capital needed to get the project under way.

The organizational and operational characteristics of capital raised

by these “new generation” cooperatives provide unique equity management situations. First of all, membership is usually closed-the number

of members is fixed. The capital invested entitles, and obligates, each

member to deliver a prescribed amount of product to the cooperative for

processing. For example, for every $1,000 invested, the member may be

purchasing the right to deliver 1,000 bushels of wheat. The investment is

therefore said to carry a delivery right. In most of these cooperatives,

delivery rights may be traded among members. This enables a member

wanting to get out of production to sell the delivery rights for the commodity to another member wanting to increase production, or to a new

member wishing to join the cooperative.

These transactions, including setting the sales price per unit, are

conducted between members, but the transfer, exclusive of the sales

price, is subject to board of directors approval. The cooperative’s only

other role in the purchase and sale of delivery rights may be to serve as

an information clearinghouse for potential buyers and sellers.

If the cooperative is successful, the value of the delivery right may

appreciate, permitting the member to realize a gain on the original

investment that granted the delivery right. If unsuccessful, the delivery

right may sell below the original cost of the investment, or may be

unsalenble, resulting in the member losing all or part of the investment.

This reinforces the point made earlier that equity capital is risk capital.

Appreciation of the delivery right over time can present a challenge

for both the cooperative and its members. It is a matter on which recently

or newly organized value-added cooperatives need to be aware and

address in their organizational structure. It involves a situation in which,

after years of successful operation, the value of the delivery right

becomes so high new members can not afford to buy. Likewise, long-time

members are reluctant to sell their rights because the capital gains tax on

the original investment would be very costly.
A cooperative can address this possibility early in its organizational

efforts by including provisions in the corporate documents requiring

members to sell their rights when they are no longer delivering product.

Another approach would be to set a high nondelivery penalty to act as a

disincentive for continuing to hold the delivery right if there is no bylaw

provision requiring the sale of the delivery right when product is no

longer being delivered. A third possibility would be to suggest that the

long-term member sell the right on an installment contract to defer some

of the gain, although it is recommended that a professional tax advisor be

consulted before any transaction is carried out.

Provisions should be made for allowing new members to purchase

the delivery right on a time payment plan of some kind, or make the purchase on an installment contract.

After obtaining the initial investment, the cooperative must decide

how it is going to retain additional capital from operations; through

patronage retains, per-unit capital retains, additional direct investment,

or a combination of methods.

Managing Base Capital Programs

The equity management considerations with a base capital plan are

quite varied. The options a cooperative chooses may depend largely on

the capital investment requirements of the commodities being marketed,

as well as the marketing cycle of the products produced. These characteristics affect the length of the base period, what type of measurement period is used to determine each member’s patronage level over the base

period, and the type of equity accumulation method(s) to be used.

Choosing a Base Period

Products marketed in fresh form such as milk, fruits, or vegetables

usually involve a relatively short base period (1 to 5 years). The purpose

of a shorter base period for fresh products is to provide the flexibility to

adjust more rapidly to seasonal or year-to-year fluctuations in volume

and/or price in setting the required investment level for members. A

short period may be preferred by a cooperative handling a commodity

that is subject to large swings in production levels, even though it is marketed in processed form. Examples would include certain tree crops that

have alternate-year bearing characteristics. A shorter period also permits

under invested members-those who have recently joined the coopera20
tive---to build up their proportionate share of equity more rapidly.

Conversely, members who are decreasing volume or quitting production

completely can expect to have their equity investment returned sooner.

In contrast, products with an extended marketing cycle, such as in a

winery cooperative, may want to consider a longer base period (5 to 10

years). Winery products are normally stored for several years before

being marketed. A longer base period will help smooth out fluctuations

in capital and provide the stable equity base needed to finance the storage activity, including the multiple-year cost of carrying the inventory

and the capital needed for the investment in the storage facilities themselves.

Plans with shorter base periods (1 to 5 years) may not need to be

combined with some type of special program, such as payments to

estates or upon retirement, because the return of a member’s investment

occurs fairly rapidly. Cooperatives with longer base periods (more than 5

years), however, may want to consider the use of one or more special

programs to expedite the return of equity to members who die or retire

from farming.

Selecting a Measurement Unit

Another important management consideration is selecting the measurement unit used to calculate each member’s equity requirement based

on the member’s proportional use of the cooperative during the selected

base period. This will vary among cooperatives, particularly between different commodity types. A cooperative first must decide between either a

physical unit of measurement or one based on a percentage of the commodity’s value. A physical unit could be a bushel or hundredweight for

grain cooperatives, or a ton of product delivered to a fruit and vegetable

processing and marketing cooperative. A unit based on value could be

calculated as a percentage of the dollar value of the raw product delivered. The advantages and disadvantages of these methods were discussed earlier.

The physical measurement unit should be a common denominator

that applies equally to all members under the plan. If several commodities are involved, different measurement units may be needed for each,

such as bushels or hundredweights.

21
Determining Proportionality

With the base period and measurement unit(s) selected, management has the tools to calculate the proportionality of each member’s

investment. At this point, the real management activities of a base capital

plan begin by determining a member’s investment compared with use of

the cooperative over the prescribed base period and how to correct any

disparities. Depending on whether a member is fully invested, over

invested, or under invested, a program must be developed to bring each

member close to being fully invested in a practical time period.

A program for the under invested member may be used to accelerate equity contributions-higher per-unit capital retain or smaller cash

patronage payment. For the over invested member, it would be a plan to

redeem the over invested portion in a reasonable time period without

undermining the capital strength of the cooperative.

In administering the base capital program, it is important to monitor the proportionality of each member’s investment on a regular basis.

At least annually, members should be provided with an individualized

statement showing their investment in relationship to a fully invested

position. Issuing this statement should coincide with the time of the year

when the board of directors establishes the desired level of equity for the

cooperative for the coming year. The statement should show the cooperative’s overall equity capital needs and each member’s required investment level. The statement should include a message explaining capital

expenditure plans for the coming fiscal year. This message should also

explain what method will be used to bring members to a fully invested

position if they are either under or over invested.

Managing Equity Redemption

This section will discuss strategies and other considerations for regular and special equity redemption programs. Regular redemption programs include revolving funds and percent-of-all equities. Special programs to be covered are estates, retirements, age-of-patron, moveaways,

and hardships.

Regular Redemption Programs

In regular equity redemption programs, equity is redeemed by

orderly methods, often called systematic programs. Each type of program

22
has advantages and disadvantages as discussed earlier. In this section,

two,regular types-the revolving fund and percent-of-all equities-will

be examined along with approaches used to manage them.

l Revolving Fund

The revolving fund method offers an array of possibilities for

redeeming equities, even though the basic concept is always the same.

The oldest equities are redeemed first. Specific aspects of one cooperative’s revolving fund plan compared with another will often differ widely. Variations exist not only between cooperatives handling different

commodities, but also among those of the same type. Practices may also

differ greatly from one part of the country to another. A cooperative’s

current and historical financial condition also influences the way a

revolving fund is administered. How equity is acquired-either retained

patronage refunds or by per-unit capital retains, or both-will also

impact the revolving fund operation. Operations may also be affected if

other regular or special redemption programs are used. For example, special program redemptions usually have priority over regular redemptions

and may reduce the amount of capital available to redeem under a

revolving fund program. That is why cooperatives with a combination of

regular and special programs may have longer revolving fund cycles.

The most common measure of a revolving fund program’s effectiveness is the length of the revolving cycle. From a member’s viewpoint,

the shorter the revolving cycle the better because it returns capital faster

for reinvestment in the member’s production operation. However, a

shorter cycle may not always be the best from the business’ standpoint.

The pressure to maintain a short revolving cycle may strain the cooperative’s resources and undermine opportunities for worthwhile projects.

Therefore, the cooperative must balance the members’ expectations

against the capital requirements of the organization. This may not be an

easy task, particularly from a member relations perspective. Regular

communication with the membership will help.

A shorter revolving cycle also has some other benefits by keeping

members’ investment more proportional to use and therefore addresses

one of the key aspects of effective equity management.

The key to operating an effective revolving fund is to actively manage it, instead of letting the revolving fund control the actions of the

cooperative. Active management means a target is established for the

length of the revolving cycle. This is accomplished by the board of direc23
tors establishing the goal and directing management to develop a financial plan to achieve it. This plan should incorporate planned capital outlays, including equity redemption amounts required to achieve and/or

maintain the target revolving fund cycle, and expected sources of capital,

both equity and debt. Too often, financial planning only identifies capital

expenditures for such items as the purchase of fixed assets and the servicing of long-term debt. Equity redemption amounts (regardless of the type

of plan used) are derived from any capital remaining after all sources and

other uses are accounted for. In this case, the revolving fund is doing the

managing.

A cooperative can operate two or more revolving funds simultaneously. Generally, the purpose for these funds is to keep track of equity

obtained from multiple sources. Examples are having separate revolving

funds for equity retained as patronage refunds and per-unit capital

retains. Other cooperatives may choose to put equity retained from local

operations on a different basis than that received from patronizing a

regional cooperative. This has an advantage when the regional’s redemption cycle is significantly longer than the local cooperative’s. By revolving

only local equity, the cooperative relieves itself of the cash flow burden of

repaying regional equity before it is received.

Multiple revolving funds could also be established for each commodity handled by a marketing cooperative. For example, it might be

appropriate to have a longer revolving fund for a commodity with an

extended processing and marketing cycle.

This program has many of the same equity management aspects as

a revolving fund because the percentage of equity redeemed in a given

year approximates a revolving fund cycle. For example, a 10 percent

redemption of all equities is roughly equivalent to a 10-year cycle. The

higher the percentage redeemed, the better the performance is judged, at

least by the member. The cooperative has the same challenge of balancing

the needs of the cooperative against the expectations of the member.

One advantage the percent-of-all-equities program has over a

revolving fund is that newer members have some equity redeemed sooner than under a revolving fund. This feature, however, works against

achieving proportionality of investment as quickly as with a revolving

fund. Also, the plan provides the cooperative more flexibility in redeeming equity on an annual basis because the percentage-of-all-equity

24
redeemed can be adjusted up or down depending on operating results for

the year. A smaller percentage could be paid in years when earnings are

below average, but at least some equity is redeemed.

This program, however, encourages having some other program in

combination, so when a member quits patronizing the cooperative, a system is in place for returning equity on a more timely basis than paying

out a percentage of an ever decreasing equity amount. A percent-of-allequity plan could be combined with a special program such as estates or

age-of-patron.

Special Redemption Programs

There are management considerations for five special equity

redemption programs-estates, retirements, patron’s age, moveaways,

and hardship. Each involves a different situation related to the member,

but equity management considerations are quite similar. The similarity

exists because the time when the special event will occur is not known in

advance, except for the patron’s age program, and therefore more difficult to predict when and in what amount requests for equity redemption

will be made. Given this uncertainty, planning and budgeting for a special program redemption is more difficult, although the board of directors decides when the equity is actually paid. There are a number of ways

that cooperatives can deal with this uncertainty. First, develop a good

membership profile that provides the birth date of each member, amount

of equity investment, and other personal data that will give management

a better feel for the exposure under each program. Even with this information, some uncertainty will still exist.

0 Estates

When the cooperative’s average membership age is rising, frequently the case with the farm population, so does the exposure for

redeeming to estates. A cooperative can manage that exposure by limiting the maximum amount of equity to be redeemed to estates during a

fiscal year. This amount can be arbitrary, represent a set percentage of

total equity, or a percentage of the patronage allocation for that year. If

no limit is established, a decision must be made whether to redeem to

estates when the claim is made, or hold all claims until the fiscal year

ends. Holding off gives management and the board the opportunity to

determine if the amounts requested exceed what can reasonably be

redeemed without undermining the cooperative’s equity base. If the
claim amounts are too high, payments may be prorated among all estates

filing claims during the fiscal year or made on a first-come, first-served

basis determined by when the claim was filed. By delaying the decision

to redeem to estates until fiscal year end, the cooperative has longer use

of the capital. This could reduce the amount needed to be borrowed during the year which could lower interest expense and increase net income.

Another equity management decision with estates involves the

redemption approval process. The policy may be that the board must

approve all claims regardless of the amount, or it can delegate this

authority to management within prescribed parameters. Which option

the board chooses may depend on the estimated exposure to claims in a

given year and the estimated amount of equity per claim. In either case,

the board of directors must retain the fiduciary responsibility for the

financial integrity of the cooperative.

l Age of Patron

Although estates are the most common form of special programs,

they are often combined with other special redemption programs. One

standard combination is with an age of patron program which is a more

predictable factor. Using both reduces the ultimate exposure for estate

redemptions if the age of patron level is set low enough. If the program is

going to work as a retirement plan, the age level should be in the 62 to 65

year range. When a member reaches the prescribed age, but continues to

be active, existing equity would be redeemed and all subsequent patronage dividends paid 100 percent in cash. The total amount of equity in the

member’s account does not necessarily need to be redeemed when the

prescribed age is reached. Instead, a percentage may be paid each year

over a prescribed period in equal percentages or weighted more heavily

in the earlier years. Delaying redemption keeps more capital invested in

the business and allows time for the cooperative to accumulated replacement equity.

l Retirement

Redeeming equity when a member retires from farming is also a

common special redemption program in agricultural cooperatives. Equity

can be paid in a lump sum when the member retires or redeemed over a

period of time. Redemption of equity under this program may include

the condition that the retiring member no longer owns or controls the

land on which the farming operation was located. This program has the
same uncertainty as estates in that the cooperative does not necessarily

have advance knowledge of when the member will retire. The uncertainty as to when redemption will occur makes the equity management function more difficult, particularly if regular redemption programs are also

operating.

l Moveaways

Programs that redeem equity to members who move out of the

cooperative’s trade area are less common than other special programs,

but still have equity management considerations. Uncertainty also

becomes a factor with this program if the event is unplanned. As with

redemption based on age of patron, “moveaways” do not necessarily

receive immediate payment. Waiting periods, perhaps as long as 5 years,

may be imposed before the former member is paid. This differs from the

normal practice with age of patron programs where payments are usually

made in installments.

l Hardships

Another special program deals with redeeming equity in hardship

situations to facilitate the timely settlement of legal matters such as bankruptcy, foreclosure, or divorce, or if the member suffers a disability. The

type of hardship involved will usually determine how the program is

managed from an equity standpoint. For instance, one hardship might be

a member’s bankruptcy or foreclosure of the farming operation. Where

financial difficulty is the cause, the member may be unable to repay

debts, including amounts owed the cooperative. Under these circumstances, the cooperative must have the right to offset the member’s equity

investment against the debt. The authorization for a right of offset should

be contained in every cooperative’s bylaws and/or membership agreement.

In hardship cases, the board’s decision to redeem equities early

should be considered on a case-by-case basis with no precedent established from one situation to the next. This distinguishes it from other special programs where, subject to board approval and the availability of

funds, equity is redeemed as a matter of normal policy.

For hardship redemptions, as well as other unforeseen early

redemption situations such as “moveaways,” consideration should be

given to discounting the amount redeemed to its present value.

Discounting the equity provides fairer treatment for all members who

27
have to wait the normal time period for the return of their equity. It also

lessens the cooperative’s financial burden on the amount it has to pay.

The cooperative’s right to redeem out of sequence equities at a discounted value should be clearly stated in the bylaws and/or membership

agreement. The rate at which equities are discounted for early redemptions is a matter for the board to decide, but a discount rate comparable

to prevailing interest rates such as the prime rate should be used. This

rate is applied to the equities to be redeemed for the time period involved

between when payment is made and the estimated time for normal

redemption. Discount factors to be applied to the equity can be obtained

from a standard present value table. Before discounting equities, however, a tax adviser should be consulted to determine the tax consequences

for both the cooperative and its members.

Summary and Conclusions

Every cooperative needs to devote the necessary time and resources

to manage its equity in a manner that will benefit both the organization

and its member/users. Depending on the type of equity structure, how

equity is accumulated, and what redemption programs are used, the task

of managing equity can range from straightforward to extremely complex.

The board has the ultimate responsibility for managing the cooperative’s equity with guidance from management. It is essential for the

board, in carrying out this responsibility, to have a good understanding

of the unique features of cooperative finance and the importance of

adhering to coopern tive principles.

The primary objective of equity management is to ensure the cooperative has adequate equity capital invested in it to serve the members in

an efficient and effective manner. The greatest challenge is to manage the

accumulation and redemption of equity capital in a manner that achieves

and then maintains the member’s investment in proportion to use. The

RBS study on equity redemption showed that U.S. cooperatives have a

long way to go in meeting this challenge. No planned method for accumulating equity, lengthy revolving fund cycles, using only special programs to redeem equity, and the limited use of base capital plans are only

a few examples that show there is much more cooperative boards and

managers could be doing to “manage” their cooperatives’ equity.
At the heart of effective equity management is a sound financial

plan that serves as the primary equity management tool. Equity management doesn’t end with the development of a financial plan. A financial

plan should be a dynamic tool, referred to often and updated as necessary. The plan should serve as the focal point for all decisions concerning

both equity and debt capital.

An active approach to managing equity is more important than the

methods used to accumulate and/or redeem equity. The key to active

management of equity is knowing the relationship between each member’s use of the cooperative compared with the level of equity investment. Measuring this relationship and then adjusting the program to

reduce any disparity is the key to an active versus passive approach.

An important aspect of any equity management effort is ongoing,

consistent, and forthright communications with members on the capital

needs of the cooperative. This information should come from both the

board and management. Members must understand why the cooperative

needs their equity investment and how it is applied in operating the business.

If a cooperative is going to operate according to the cooperative

principles on which it was founded, the board of directors and management need to manage equity on a continuing basis. To not do so violates

the board’s fiduciary responsibility and is a disservice to the entire membership.

29