REVOLVING EQUITY - member-users of that cooperative business and A GENERATION OF normally comprises a very small proportion of that total equity base upon which the firm operates. MISUNDERSTANDING Conversely, the bulk of equity capital used by evolved from their use of, and About mid-semester each fall, I introduce to my dependence upon, the revolving capital program undergraduate students the general topic of (RCP). As a means for generating equity capital, “cooperative finance.” By this time, the students RCP has probably been used by virtually all have already been exposed to cooperative agricultural cooperatives at one time or another. principles and have a basic-level grasp of operational practices. As I begin my lecture on Under the RCP, current cooperative patrons revolving cooperative equity, one can tell by the contribute each year to the capital base through perplexed expressions on the students’ faces that the cooperative’s retention of a portion of current my message is not being clearly received. savings or a per-unit retain. The capital thereby Forgetting for the moment my instructional generated each year is retained and used deficiencies, one presumes that the subject is “temporarily” by the cooperative and returned unusually complex or confusing. As college (revolved) to the contributing patron at some future sophomores and juniors, these students associate time when it can be supplanted by new capital with the terms “equity capital” those monies similarly generated in a subsequent year. generated by corporations through their direct sale of common/preferred stock to prospective private investors. As these students soon discover, the Revolving Capital Attributes acquisition and maintenance of adequate equity capital by cooperative businesses is quite a As originally conceived and implemented, the RCP different matter. The cooperative peculiarities are contained a number of attractive features for both numerous and varied. They comprise the financing cooperatives’ operations on an ever- basis for a generation of misunderstandings with revolving pool of equity capital funds. Among the regard to cooperative operations and they account, more attractive attributes of the program were the in large part, for the confused looks on the faces of following: my agricultural students. The objective of this discussion is to point out those major 1. The fulfilling of working capital needs and the cooperative peculiarities as they relate to the financing of modest facilities or equipment generation and maintenance of equity capital. We expansion could be accomplished largely from shall discuss reasons why a cooperative’s equity current savings and/or per-unit retains. This capital base must continue to grow and alternative did not present cooperative patrons with a means for securing this growth. Finally, we shall direct out-of-pocket cash expense and all address a basic cooperative conflict that ultimately equity generated in this manner was assigned evolves between a cooperative’s operational to the patron through the issuance of revolving needs and its philosophical underpinnings. capital certificates (the face value of which the patron could assign to the asset side of his personal accounts). Cooperative Peculiarity

2. Insofar as RCP-generated equity certificates Very little cooperative stock is sold to private were non-interest bearing and not due-dated, investors and little, if any, finds its way into the the cooperative gained access to a low cost commercial markets for the transfer of such and relatively unconstrained pool of funds to securities. That equity generated directly through underwrite their operations. the sale of cooperative stock is usually confined to 1

WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING 3. Perhaps the most attractive alternative of RCP this dilemma. In many cases competitive factors was that it functioned in a manner that was and changes in economic conditions have become philosophically compatible with the so-called external factors contributing towards a cooperative principles. The revolving feature, cooperative’s need to expand rapidly or otherwise itself, meant that as long as the revolve period change its method of operation. Technological remained relatively short, the current patrons changes, for example, have forced many of the cooperative would bear the primary cooperatives to expand large sums of money for burden of financing its current operations. modernization or revised marketing and Moreover, the distribution of this burden would methods. Similarly, many marketing cooperatives, approximate closely the degree to which each which for years merchandised their product at the patron used or was reliant upon the wholesale level, are now finding it necessary to cooperative enterprise. move into the retail market in order to secure a more dependable market for their patron’s product.

A Weakness Overlooked This need for rapid cooperative growth or change, when coupled with a modest ability to generate Implicit in the successful use of RCP were the internally the necessary equity capital, has set the basic assumptions that agricultural cooperatives stage for a basic conflict or weakness in the future would experience modest but gradual growth, financing of many cooperatives. The dilemma savings generated and retained would be sufficient worsened when in 1962; the “consent” provisions to support a disciplined growth in the equity capital of the Revenue Act were implemented. Under base, and inflation or other economic distortions these provisions, cooperative patrons were would not create imbalances in the capital revolve required to report non-cash patronage distributions cycle. Through the mid-1960s, these assumptions (retained savings) as taxable income. Patrons remained relatively valid. But, the converse has could no longer amass, free, assets in the form occurred in the past decade. of cooperative equity capital. These changes generated the existing situation of patrons now In keeping with the basic philosophy underlying seeking higher proportional cash patronage cooperative activity, agribusiness cooperatives payments and/or a more reasonably current have always placed a high priority on service to its (shorter) capital revolve program. member-patrons. Non-cooperative enterprises, during this same period, have operated more directly in search of the financial betterment of their New Financial Policies Required? stockholder-owners. While both forms of organizations went in search of equally meritorious Because of the conflict just noted, by the mid- goals, the basic difference in their search has led 1960s most cooperatives were diligently searching cooperatives to provide extra benefits and services for a new or improved means for accumulating and to their patrons ... oftentimes to the extent that the maintaining equity capital. A quick review of the entities’ financial performance has been adversely literature suggests that a large variety of plans, impacted. In other more serious cases, in their programs, and schemes were devised and search of the ideological aspects of cooperative implemented. activity, management and directors have occasionally subverted the firms’ operational Some early program changes included the creation efficiency. As the ability to generate savings of tax-paid retained earnings much like those deteriorated, so did the cooperative’s ability to generated by conventional corporations. Insofar accumulate capital through retains. At the same as this program change was still linked to the time, this continued search for diversity and an cooperative’s ability to generate savings, it expansion of services provided comprised the comprised only a partial solution. Other program basis for the need of an accelerated rate of growth changes included the full or partial replacement of in capital accumulation. The divergence of these revolving capital with securities (preferred stock) trends soon became apparent as cooperatives bearing no implied or actual revolve obligation. were forced to rely more heavily on debt capital to While this program had some intuitive appeal, it underwrite their expansion. proved to be operationally difficult for many cooperatives. First, these securities had to be A cooperative’s desire to provide full and quality freely transferable. Private investors were not service to its membership is not the sole cause of accustomed to such issuances and specialized

2 markets for their sale never developed. Second, to acceptable procedure. For larger, multi-product be marketable, the securities had to bear dividends cooperatives, the patronage basis may represent set at a competitive level. Insofar as such an erroneous measure of members’ use. securities could be held by nonmembers, and insofar as these represented a prior claimant on For example, products that generate little or no the cooperatives’ operations, they no longer had savings as a result of their sale distort the true access to low-cost equity with which to operate. In usage of the cooperative’s assets. More simply, if addition, some concerns were expressed that a member purchased only relatively low margin these practices violated longstanding cooperative products or services, that member’s usage on a philosophy relating to “services at cost” and patronage basis could be well below that “exclusive member-patron ownership.” proportion of company assets actually employed to provide that product or service. Users of low- Indeed, for fifteen years cooperatives have margin products or services are, therefore, searched for new financial policies that might subsidized by the users of high-margin products or supplant the RCP practices implemented by their services. In an attempt to correct this inequity, founding patrons. Numerous variants in securities, some cooperatives have designed a system for unallocated reserves, and tax-paid retains have capital apportionment that reflects each member’s been attempted ... most have been found wanting. employment of the firm’s assets. Most of these As one reviews the capital bases of cooperatives systems weigh each member’s volume of business today, they are likely to be surprised by the extent by the assets required to provide the needed to which these organizations still rely heavily on products or services and then apportions each some form of RCP. Each cooperative’s current member’s required capital retain in accordance use of an RCP may show some variation in the with each member’s proportionate use of total firm way retains are apportioned amongst its members. assets employed. Equalization of equity held There may also be some variation in the policies normally takes place under these systems by under which such equity is redeemed by patrons. having the under-invested members purchase Because of these variations, and because of the preferred stock from over-invested members - important role fulfilled by RCP, the remainder of subject to some maximum cash limits. Other firms this discussion shall address the remaining may rely on the entire revolve period to allow an misunderstandings still surrounding the practice of over-invested member to recover his equities ... generating and maintaining cooperative equity. which are concurrently replaced by equities secured by under-invested members.

Retained Equity Apportionment Other recent changes in cooperative equity programs relate to the conditions and terms under One of the fundamental concepts of the which equity certificates may be redeemed. Some cooperative way of doing business - one based on cooperative members are less than pleased by fairness and equitability suggests that each their inability to gain a refund on their equity member’s investment in the cooperative be whenever they wish. Others are unhappy that this proportionate to each member’s use of that capital does not earn a dividend during the period cooperative. Most recent adjustments in RCPs it remains with the cooperative. A recent study by used by cooperatives have been designed to the ESCS-USDA suggests there are sound provide a convenient mechanism for apportioning reasons for this discontent as 29 percent of each member’s investment to most accurately marketing and supply cooperatives had been reflect this concept. Were this not attempted, operating in the complete absence of an equity some members would become over-invested and, redemption program. In addition, it was found that in effect, result in their subsidizing others. 10 to 48 percent of their total equities were held by persons who were no longer active in the There are many ways to estimate a member’s cooperative organization. Another study by the “use” of a cooperative’s services. Historically, this General Accounting Office resulted in similar “use” has been tied to dollar business volume, findings and contributed much towards a GAO units of business transacted, assets employed, report to Congress suggesting that redemption and/or patronage generated. Overall, most capital programs should be adopted quickly by apportionment systems are patronage-linked. With cooperatives, either voluntarily, or under the threat single product or service cooperatives, in of legislation mandating it. particular, this is generally found to be an

3 Indeed, I believe those cooperatives with no form threat, there will be more and more need to build of equity redemption program should add such and maintain a healthy capital base. provisions to their RCP. Those cooperatives with specialized or limited plans should consider a more Sky-high interest rates and sky-rocketing inflation comprehensive program ... one incorporating the have also impacted cooperative capital formation. revolving concept, the base capital concept, or The more highly leveraged an organization finds some other similar program that addresses the itself, the more adversely it is impacted by record- adequacy and equitability requirements. Should a high interest rates. As inflation runs rampant, cooperative’s financial position be such that it existing plant and equipment depreciation cannot regularly revolve or adjust the capital base, schedules become obsolete and replacement then it should allow for the redemption of equities requires greater expenditure than that allowed for held by estates for members who retire from in previously existing schedules. Hence both of farming and/or who move away from the area or these phenomena argue in support of a stronger reach a specified age (post-retirement). equity capital base.

As the agribusiness industry grows more complex Revolving Equity and Capital Formation and vertically integrated, cooperative members are asking their organizations to further expand their Proponents of the free enterprise system argue service offerings to include such things as that “control follows ownership.” In privately held expanding exports and underwriting the or publicly owned businesses, ownership and development of facilities for the production of control rests typically with majority stockholders, alternative forms of energy. Quite obviously, such many of whom are serving as managers or officers functions cannot be easily performed by in the company. For the cooperative business, cooperative organizations already short of equity however, ownership is dispersed amongst all capital. member-patrons and control is normally not a function of the number of shares of stock held. Despite numerous attempts to replace revolving Control, therefore, rests with all the holders of capital (or base capital) programs with various equity capital and can be easily sacrificed if this forms of permanent, dividend-generating equity, equity capital is inadequate or inequitably few have met with success. The search continues distributed. for some variation in the RCP that will meet the cooperative’s requirement for capital adequacy This discussion has shown that the RCP provides and equitability. No miraculous discoveries are for both adequacy and equitability under conditions likely to be found, but the cooperative can no of modest cooperative growth and a stable longer “low profile” the organization’s need for economic or marketing environment. Within the equity capital supplementation. Strong capital past decade, these conditions have not prevailed programs do not evolve accidentally. They result and many cooperatives have begun to struggle from the long-term serious study of the with their existing capital programs. Rapid rates of cooperative’s needs and its members’ financial growth and competitive pressures to adopt ability. During the past decade, cooperatives have expensive technological equipment have resulted relied on debt capital to fund those programs or in some cooperatives’ failure to maintain a healthy functions which equity capital could not support. equity capital base. Given such an “exposed” As creditors’ investment in cooperative operations position, the cooperative is ill prepared to deal with now approach two-thirds the value of all assets adverse economic conditions. They remain in a employed, it is easy to see why the trend cannot weakened state and could become easy prey to an extend much further without a heavy infusion of attack by competitive forces or a recessionary member-equity capital. If cooperative members economy. are going to retain control over their cooperatives, the necessary equity capital must be provided. For All cooperatives should adopt equity redemption this, there are no alternatives. programs and adhere to their parameters. Such adaptation requires that the redemption impact be Sincerely, incorporated into a long-range financial plan. As more cooperatives establish such redemption programs, either voluntarily or under legislative Ken D. Duft Extension Marketing Economist

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