Understanding Cooperative Equity Phil Kenkel Bill Fitzwater Cooperative Chair Oklahoma State University

Legal business Forms n Individual n Partnership n Limited Liability Company n Corporation Cooperative Investor Owned

What is a Cooperative? A Cooperative is an association of members (corporation) owned and controlled by the people who use its services. Corporation $ $ Investor Customer $ Corporation- Cooperative Member Customer Investor $ $

A COOPERATIVE  A business that is owned and democratically controlled by the people who use its services and whose benefits are derived and distributed equitable on the basis of use.  The more they use the cooperative the more service they receive  Earnings are allocated based on the amount of business done with the co-op.

COOPERATIVES are... Private Businesses owned and controlled by users and operated principally to provide benefits to users.

One-third of Americans are directly served by co-ops NCB

What is Different About a Cooperative  Profits are distributed in proportion to use (business volume)  Limited or no return on equity  Equity is temporary (revolves)  Voting is not in proportion to equity investment  Limitation on non-member business  Cooperation between cooperatives

What is Equity  Owner’s investment in the business  Cushion fund that declines if the business suffers a loss  High debt to equity ratios increase the risk of the business and make the banker nervous

Equity in an Investor Owned Firm  In investor-owned firms the profits are distributed in proportion to the equity investment  Investors purchase equity with the anticipation of future returns  Investors may buy or sell their equity to other investors

Why is Cooperative Equity Different  Profits are distributed in proportion to business volume so there is may be no advantage in holding more equity  Many cooperatives require a very low equity investment to join  Cooperatives create equity investment out of the profit stream by retaining cash and issuing the patron stock  There is generally no market for cooperative stock  Each cooperative creates a system to redeem stock at face value

Co-op income statement Income Expenses Net Savings (Non-Member) Taxes Retain Earnings (Unallocated Equity) (Members) Cash Patronage Refunds Retained Patronage Refunds (Qualified or non-qualified stock)

Co-op equity One-Time Stock Sales Per-Unit RetainsRetained Patronage Dividends Inflows Base Capital Plan Revolving Funds Special Plans Outflows

How Do Cooperatives Distribute Profits  Unallocated Equity (Retained Earnings)  Cash Patronage  Stock (Retained Patronage)

Retained Patronage  Share of profits distributed as stock  Creates funds for the cooperative to finance infrastructure  Usually taxable to the member when the stock is issued

How Does the Cooperative Distributions Impact My Taxable Income  IRS treats cooperative like an extension of the farm business  Member is taxed on the cash patronage they receive  Most cooperative issue “qualified stock” which is also taxable  Cooperatives issuing qualified stock must pay 20% in cash  Qualified stock is not taxable income when redeemed for cash because the member has already pre-paid the taxes.

Unallocated Equity  Also called retained earnings  Permanent capital because it does not revolves  Created from profits from non-member business and by channeling a portion of the profits to this reserve fund

Purpose of Unallocated Equity  Lenders like non-revolving capital because the cooperative’s debt/equity ratio increases every time stock is redeemed  Because the cooperative stock is redeemed at face value the auditors require the cooperative to either write down stock or reduce unallocated equity every time the cooperative shows a loss  Unallocated equity serves as the cushion fund that prevents frequent stock write downs

Why Equity Redemption?  Equity Redemption is the process of Returning equity in cash to member-patrons who have previously invested.  Over invested or inactive members should not be responsible for financing a cooperative they do not use  Redemption is essential since there is no market for cooperative stock

Equity Redemption Systems  Age of patron  Age of stock  Percentage of all equities  Special Situation (death, hardship, move out of trade territory)

Age of Patron Advantages :  Easy to understand and administer  Equities somewhat proportional to use for short revolving periods  Co-op can set the age level Disadvantages :  Equity investment is not very proportional to use  Not popular with young members  Members may expect fixed revolving regardless of financial conditions

Age of Stock Advantages:  Keeps equity investment more proportional to use  Co-op can manage redemption budget by redeeming partial year or multiple years Disadvantages:  Requires tracking year of issue  Difficult to maintain a fixed period because of the good year-bad year problem

Percentage of All Equities Disadvantages: Redeeming a portion of new members equity when they should be investing more Transfer of ownership cannot be completed without additional provisions. Advantages:  Rewards new patrons  Easy to understand and administer  Works well for cooperatives with a stable membership and patronage

Special Situations  Estate, hardship, moved out of territory  Usually at the discretion of the board unless specified in bylaws or state cooperative law  If the cooperative has limited financial resources the board may redeem estates in a first-in first- out order  Cooperative stock may be allocated in a divorce settlement but the cooperative will not change the timing of redemption

Understanding a Cooperative Stock Write Down

Profits Create Equity Income From Operations Cash Regional Dividends Stock Regional Dividends PROFIT Cash Patronage Dividend Retained Patronage Dividend Balance Sheet Equity

Impact of Profits on the Balance Sheet Physical Assets Stock in Regional Cooperatives Debt Allocated Equity Unallocated Equity Cash

Losses Destroy Equity Loss From Operations Regional Loss and Stock Write Down LOSS Cash Patronage Dividend Balance Sheet Equity Loss From Operations Retained Patronage Dividend Stock Regional Dividend

Impact of Loss on the Balance Sheet Physical Assets Stock in Regional Cooperatives Debt Allocated Equity Unallocated Equity From Cash

Impact of a Stock Write Down on the Member  Face value of stock is reduced  Amount eventually redeemed will be less  Generates an immediate ordinary income taxable loss  Immediate tax benefit cushions the blow of the lower eventual redemption

Understanding Cooperative Equity Summary  Cooperatives distribute earnings in cash and stock  Stock is redeemed at face value under a specific system and the board’s discretion  Stock is usually taxable income when received, not when redeemed  Loss may require a stock write down which generates an ordinary income taxable loss