Non-Patron Equity Capital in Cooperatives and the
Changing Definition of Cooperatives
Recent changes in cooperative statutes, first in Wyoming and later in Minnesota, have stimulated much discussion about the role and definition of cooperatives. The new statutes allow non-patron investors to invest and to serve on the board of directors of these cooperatives. Cooperatives have always been defined by their principles and practices, not the legal form of incorporation. In fact, cooperatives can be formed under general corporation statutes and be considered a cooperative if they operate under the cooperative principles and practices. The Rochdale Society, while not the first cooperative, is considered the grandfather of cooperatives because they formulated the first set of written principles that were published in 1860 and widely distributed. Their twelve principles have been reduced to seven core principles adopted by the International Cooperative Alliance. These are: 1. Voluntary and open membership based upon usage of the cooperative In United States the emphasis has been placed upon the first three of these principles, summarized as user or patron ownership, control and benefit. The current discussion about the role of "outside investors" has been stimulated by the high capital requirements of modern business, particularly the value-added "New Generation" processing cooperatives, and the changing cooperative goals from service and efficiency orientation to profit maximization and return on investment. Background Equity capital for start-up cooperatives has always been an issue. Sometimes it is forgotten that our traditional supply and marketing cooperatives, whose current equity is based upon retained patronage and unallocated reserves, also needed substantial quantities of equity capital at start-up. For example, Cass-Clay Creamery Cooperative is a regional dairy processing cooperative based in Fargo, North Dakota. Its current member equity is based on unallocated reserves and retained patronage, redeemable sometime in the future. However at start-up, 38 committed farmers invested $1,000 each to build the plant and start operating. The membership fee in this open cooperative was $1.00 in 1933 and is still $1.00 in 2003. This original investment was paid back to the 38 farmers as affordable by the cooperative. The original New Generation cooperative in the Northern Plains was American Crystal Sugar. Following a European model, they bought American Crystal, an existing corporation, and converted it to a closed membership cooperative. In order to generate the initial investment capital, ACS sold stock at $150 which represented one acre of sugar beets to be delivered to the plant for processing. This stock was not redeemable by the cooperative, but could be sold at a market dictated price to other farmers capable of growing and delivering beets. Direct returns to growers were in the form of a delayed pricing system where essentially all economic surplus was returned in the form of price per ton. However, a second economic return could be obtained from increases in stock value. Initially, all stockholders were active farmers and growers of beets, however as time passed, holders of stock were allowed to keep stock ownership and "joint venture" the actual growing of beets by nonmembers. This has created a number of members that are quasi "pure investors" receiving "rent" from stock ownership and are taking the risk of variability in stock ownership. The next shift from traditional principles occurred with the formation of Dakota Growers Pasta (DGP). DGP raised equity capital in the same way as ACS, selling stock that represented one bushel of durum wheat to be delivered for processing. DGP created a marketing pool that could buy wheat in the name of a member who could not meet his delivery requirements. Although this mechanism was intended to cover emergency situations such as drought, or desease, it provided a means for several members with large quantities of stock to not grow or deliver product. They instead became "pure investors" with the right to be a member of the cooperative board of directors. As the number of New Generation processing cooperatives expanded, equity capital problems led many other groups to adopt the marketing pool or use a limited liability company as the legal entity in order obtain equity capital from non-producers. In some cases, a farmer cooperative was a member of the LLC with other investors or in other cases farmers were direct members of the LLC with other non-farmer investors. The goal of maximizing return on investment was primary in these entities. Both the DGP example and the use of LLCs were complex and had potential legal/tax issues. The solution first adopted in Wyoming and later in Minnesota was to create new cooperative statutes to allow cooperatives to formally include "pure investors" as members in the cooperative and be on the board of directors. The objective was to make acquiring equity capital easier, either as a substitute for debt or to expand the total capital pool. These statutes essentially formalized what was occurring several New Generation cooperatives on informal basis. The resulting legal entity is very similar to a limited liability company, but with some restrictions on the rights of pure investors. It reinforces the goals of profit maximization and stock values. Potential Implications & Impacts Returns to Capital--Very few cooperatives earn returns at a level sufficient to attract significant pure investment capital. Robert Doane with CoBank indicated an expected return of 15 to 25 percent was required to attract investor capital to high risk start-up companies. In a study of major regional and national agriculture cooperatives, Bernard Loyd with McKinsey & Company, Inc., stated at the Farmers Cooperatives Conference in 2001 that cooperatives, instead of capital creation, destroy capital due to generating returns substantially lower than other alternatives. These major cooperatives probably have the capability to generate higher returns, but would have to change from service and efficiency orientation, returning benefits to members directly through service and price, to a profit maximization goal and focus on only the most profitable components of their business. Due the inherent nature of most local supply and marketing cooperatives, small, specialized, and operating in low margin industries, they would not be likely candidates for investment by "pure investors". An exception to this generalization might be the community investor whose primary motivation is to support economic development in their community, not to maximize the return on his investment. A very positive impact of "pure investors" upon the financial position of the cooperative is to reduce debt and increase the equity to total assets ratio. This reduces financial risk to the business. Another advantage is that it diversifies the board of directors and may bring individuals with specific business skills and expertise to the business. On the other hand, boards with mixed objectives, perspectives, attitudes toward risk, time horizons, etc., can make decision-making by the board even more difficult. The cooperative is no longer an extension of the farm business as described in the Capper-Volstead Act of 1922, but a separate profit-maximizing business. Legal and Society Issues--At the federal level, laws such as Capper-Volstead and other laws giving special rights to cooperatives define cooperatives by their principles and practices. This includes tax laws and even the lending authority of specialized lending entities such as CoBank and National Bank for Cooperatives. Even though organizations are formed under the Wyoming and Minnesota statutes as a cooperative, will they be recognized at the federal level as a cooperative. At this time, it is quite clear that cooperatives formed under these new statutes will not qualify for the protections given cooperatives under Capper-Volstead for farmer owned associations, or lending authority of CoBank and National Bank for Cooperatives. It appears that they do qualify for the pass-through single taxation benefit award to both cooperatives and limited liability companies. Cooperatives have "brand" value according to a recent National Cooperative Business Association sponsored survey released in the October 2003 issue of the Cooperative Business Journal. There was an approximately twenty percentage point advantage for cooperatives over investor owned corporations with respect to meeting their customers needs, highest quality of service, community involvement, best interests of their customers in mind, run in a trustworthy manner, and ethically governed. A high pecent, 50 to 70 percent, stated that they would be more likely to patronize a business if they knew it was a cooperative. Sixty four percent said the food produced by a farmer-owned cooperative was better quality than food produced by other types of companies. Does changing the definition of a cooperative place this value at risk? As cooperatives begin to look and act more like corporations, will the general public still distinguish between the two? Will the current legal and tax advantages of the cooperative form of business still be maintained? There is no question that a business entity that contains both patrons and investors has value and is appropriate for many capital intensive businesses. The question is not whether a mixed ownership business should exist, the question is should a business organization that violates most of the principles of a cooperative relative to ownership, control and benefit be called a cooperative? Will the short-term advantages of gaining access to a larger pool of investment capital be outweighed by the long term disadvantages of changing perceptions of cooperatives, changing "brand" value, and changes in legal and tax benefits? This could be the subject of one or more major research studies. |
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