Perspectives on Cooperative Finance Cooperative Strategy, Structure and Finance

Perspectives on Perspectives on Cooperative FinanceCooperative Finance

Cooperative Strategy, Structure and Finance

Farmer Cooperatives Conference

November 19, 2008St. Paul, Minnesota

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8:00 a.m. Cooperative Finance: Principals versus Practice

David BartonChris Peterson

9:00 a.m. Equity and Capital Management Strategies

Doug DerscheidTom Houser

10:00 a.m. Break

10:15 a.m. Legal Challenges and Solutions Three Attorneys

11:00 a.m. Closing Session

Session Agenda: Three Panels

Principles versus Practice: David Barton• Principles of cooperative finance: what

(most) experts agree on

• Practices of cooperative businesses: the good, the bad and the ugly

• Point and counter-point: experts and practitioners will disagree

• Your questions

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Five General Recommendations: A Preview

1. Co-ops must be competitive

2. Co-ops should make as much profit as possible

3. Co-ops should use balance sheet management

4. Serving core customers comes first

5. Finance, strategy and risk management should be integrated

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Five Specific Recommendations: A Logical Process1. Make profitable asset investments

2. Finance assets with sufficient equity

3. Choose equity structure, equity investments and income distribution strategies most beneficial to patron-owners— Equity structure: source, ownership rights,

permanency, classes— Purchased versus earned equity— Allocated versus unallocated— Qualified versus nonqualified

4. Calculate a redemption budget using balance sheet management

5. Divide redemption budget among owners using preferred redemption methods (programs)

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Principles of Cooperative Finance: What (Most) Experts Agree On

• Co-op business model

• Finance decision framework

• Income distribution– Strategic choices – Model and process

• Equity management – Strategic choices– Model balance sheet management

process

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Cooperative Business Model: Focus on Benefits and Responsibilities

A cooperative is a business operated primarily to

provide benefits to members through marketing

transactions and through a distribution of patronage

earnings from these transactions; in return, members

have a responsibility to provide ownership capital and

exercise member control (governance).

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Four Unique Roles

Roles Function Action

1. Customer Marketing or Buy/Sell Profit GenerationTransactions

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Most say the customer role is predominant. Serving customers is the end and the roles of patron, owner and member are means to the end.

Which role is predominant in members’ minds?

4. Member Control Vote

3. Owner Ownership Investment &Redemption

2. Patron Profit Distribution Patronage RefundsPer Unit Retains

Challenge: Inherent conflict of interest between customer, patron and owner roles.

Finance Decision Framework

• Investment decision– Assets needed to support business strategy– Expected income and risk

• Financing decision– Debt and equity to finance assets– Expected income, cost and risk

• Income decision– Distribution of income to patrons and owners as

cash or increased ownership– Expected investment and financing needs

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Finance involves making three critically important and interrelated decisions:

Finance Decisions and Interrelationships

1. Investment• Assets

2. Financing Balance Sheet• Liabilities or debt • Equity

– Investment– Redemption

3. Income• Generation Income Statement • Distribution

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Challenge: Access to equity capital - most co-ops get almost all equity investment by retaining some of the income generated by operations.

Balance Sheet Issues1. Asset Investment

• Total assets, intended growth rate• Asset type, profitability and risk

– Regional Investment– Joint venture investment– “Local” current and fixed assets

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2. Debt and Equity Financing• Liquidity: Working capital• Solvency: Equity to assets & debt to equity• Equity Structure

– Allocated: three basic types (redemption expectation)• Permanent: NGC Stock or Preferred Stock• Semi-permanent: Common Stock• Revolving: Retained patronage refunds

– Unallocated: permanent retained earnings• Non-permanent co-op equity is like debt! Owners

expect redemption.Philosophy: (1) Use proactive Balance Sheet Management

(2) Protect the co-op, then redeem excess equity

Income Statement Issues1. Income Generation

• Revenues – Expenses = Total Income

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2. Income Distribution• Non-patronage income (“non-member”)

– Dividends on stock– Retained earnings (unallocated)– Income taxes

• Patronage income (“member”)

Philosophy and Challenge : (1) Be competitive, make as much profit as possible(2) Choose income distribution alternatives that

maximize benefits to patron-owners

13 Model Co-op: Case 1 (S1) 2007 Income Statement (“annual flow”)

Sales $40,000,000 Patronage Refunds $540,000 - Cost of Sales $36,000,000 + Per Unit Retains $0 = Gross Margins $4,000,000 + Dividends on Equity $0 + Other Operating Income $1,000,000 + Retained Earnings $46,400 = Gross Income $5,000,000 + Income Taxes $13,600 - Operating Expenses $4,700,000 = Total Income (Before Taxes) $600,000 = Net Operating Income $300,000 + Regional Income $300,000 + Other Investment Income $0 = Total Income (Before Taxes) $600,000 Cash Patronage Refunds (40%) $216,000 - Income Taxes $13,600 + Retained Patronage Refunds $324,000 = Net Income (After Taxes) $586,400 = Patronage Refunds $540,000

Income Generation: Income Distribution:

Patronage Refund Distribution:

Income Distribution: Four Selected Strategic Choices1. Patronage income allocation goal: high

customer-patron ownership (high allocated) versus high retained earnings (high unallocated or low allocated).

2. Patronage income distribution by source: allocated versus unallocateda. “Local” operating incomeb. Regional (other) cooperative incomec. Other income (investment, etc.)

3. Patronage refund taxability to co-op: qualified versus nonqualified.

4. Qualified cash patronage refund rate

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Operating 40%

Regional

Other

Total 100% $540,000 60%

100% $540,000 60%

0% $0

40%

90% $540,000

0%

0% $0 60%

40%

60%

0% $0 0%

40%

10% $60,000

0%

100% $60,000 77%

23%

Income Taxes (NP-NQ)

$13,600

$0

Unallocated Not Qualified Net Retained Earnings (NP-NQ)

$60,000 $46,400

Dividends (NP-NQ)

100% $0

$600,000

Allocated Patronage Refunds

Not Qualified Retained Patronage Refunds (NP-NQ)

$0 $0

Income Taxes (NP-NQ)

$0

Nonpatronage

$0 $0

Income Taxes (P-NQ)

$0

Total Income Cash Patronage Refunds (NP-NQ)

Unallocated Not Qualified Net Retained Earnings (P-NQ)

$600,000 $324,000

Allocated Patronage Refunds

Net Retained Patronage Refunds (P-NQ)

Nonqualified $0

Income Taxes (P-NQ)

$0

Patronage

Dividends (P-NQ)

$0

$300,000 $216,000

$300,000Qualified

$0 Retained Patronage Refunds (P-Q)

Patronage Income Sources: Cash Patronage Refunds (P-Q)

Barton Co-op Income Distribution Model: Model Co-op Case 1 (S1): High Allocation and Moderate Cash Patronage

Source Allocation Tax Deductability Distribution as:

“Pure Co-op”

16 Model Co-op Case 1 (S1): 2007 Balance Sheet After Income Distribution

Assets % $ Liabilities and Members Equity % $Current Assets 34% $3,586,400 Current Liabilities 21% $2,216,000

Cash 15% $1,586,400 Accounts Payable 9% $1,000,000Receivables 5% $500,000 Loans Payable 9% $1,000,000Inventories 14% $1,500,000 Patronage Refunds Payable 2% $216,000

Equity Redemptions Payable 0% $0

Investments 19% $2,000,000

Regional Stock 19% $2,000,000 Long-Term Liabilities 19% $2,000,000

Other Stock 0% $0 Bank Loans Payable 17% $1,750,000Contracts Payable 2% $250,000

Net Fixed Assets 47% $5,000,000

Land 14% $1,500,000 Members Equity 60% $6,370,400

Buildings 14% $1,500,000 AllocatedEquipment 19% $2,000,000 Common Stock 9% $1,000,000

Preferred Stock 0% $0Retains (RPR & PUR) 41% $4,324,000

UnallocatedRetained Earnings 10% $1,046,400

Total $10,586,400 Total $10,586,400

Financial Structure

Liquidity SolvencyWorking Capital (CA-CL) $1,370,400 Equity to Assets (ME/A) 60.18%Current Ratio (CA/CL) 1.62 Debt to Equity (LTL/ME) 30.14%

Equity to Adjusted Assets (ME/(TA-CL)) 76.10%

Note: New equity totals $370,400.

Equity Management:Six Selected Strategic Choices1. Asset growth trend: high, low, none or

negative

2. Liquidity target and resulting trend: high, moderate or low

3. Solvency target and resulting trend: high, moderate or low

4. Equity structure: a. High allocated versus high unallocatedb. Many allocated equity classes versus few

(especially applies to mergers)

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Equity Management: Six Selected Strategic Choices5. Redemption budget: First manage the balance

sheet, then determine budget and redeem “surplus” equity versus first manage patron accounts with set targets like AP/O age or RF length to determine budget

6. Redemption program and methods:a. High proportionality of investment (AP/P, RF,

BC) versus other goals (AP/O, PP)b. Simple program versus complex program for

each equity classc. Same program for all equity classes versus

unique program for each class

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23 Model Co-op Case 1 (S1): 2007 Balance Sheet After Paying Cash Patronage


Cash 13% $1,370,400 Accounts Payable 10% $1,000,000Receivables 5% $500,000 Loans Payable 10% $1,000,000Inventories 14% $1,500,000 Patronage Refunds Payable 0% $0










Total $10,370,400 Total $10,370,400

Financial Structure



Issue: What is best equity capitalization?

24 Equity Capitalization Classes

• Allocated: Revolving– Retained Patronage Refunds/Per Unit

Retains• Qualified• Nonqualified

– Allocated co-op equity is like debt! It should be serviced through the redemption program.

• Unallocated: Permanent– Retained Earnings

• Allocated: Permanent or Semi-Permanent– Common Stock– Preferred Stock

Equity Capitalization Alternatives25

Preferred Stock

Total Equity

Nonpatronage Income

Unallocated

Purchased Allocated

Allocated

Source Ownership Rights

Unallocated

Patronage Income

Permanent

Common Stock

Revolving

Semi-Permanent

Permanency

Common Stock (P)

Permanent Retained Earnings (P)

Permanent Retained Earnings (NP)

Generic Equity Class

Retains (RPR & PUR)

Balance sheet management assumes all equity is permanent until authorized for redemption.

Capital Structure Factors: Debt versus Equity

Factor

Amount of Equity

1. Least cost financing

- equity costs more than debt

Higher cost, lower equity

2. Risk

- ag co-ops have high risk

Higher risk, higher equity

3. Profitability

- ag co-ops have low profitability

Higher profit, lower equity

Conclusion: Minimize equity, given risk and profitability because of opportunity cost of equity

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Capital Structure Choice Matrix

Low High

Low

Moderate Solvency ETA: 50-60%

High Solvency ETA: 60-75%

High

Low Solvency ETA: 35-50%

Moderate Solvency ETA: 50-60%

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Pro

fita

bil

ity

Risk

If agricultural local co-op

Conclusion: Risk has increased, implying need for higher working capital (liquidity) and equity (solvency), even though profitability has also increased.

Equity Management Process: Balance Sheet Management

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1. Determine income generation and income distribution 2. Determine desired assets3. Determine desired financial structure

– Liquidity: Cash, Working capital, Current ratio– Solvency: Equity to assets, Debt to equity

4. Determine desired equity investment and structure5. Determine desired equity redemption

– First, manage balance sheet: Total redemption budget is “surplus” equity

– Second, manage patron accounts: Redemption program distributes budget.

– Don’t let the tail wag the dog!

Equity management involves making five critically important and interrelated decisions:

Philosophy: Protect the company; owners get what’s left over.Challenge: Implement balance sheet management philosophy.

29 Model Co-op Case 1 (S1): 2007 Balance Sheet After Paying Cash Patronage












Total $10,370,400 Total $10,370,400

Financial Structure



Issue: How much equity should we redeem?

30Beginning Assets $10,000,000

+ Change in Cash (current assets) $0+ Change in Investments $0+ Change in Fixed Assets $0= Ending Assets $10,000,000

Beginning equity to assets 60%Ending equity to assets desired 60%

Beginning Equity Balance $6,000,000+ New Retained Equity (Allocated) $324,000+ New Retained Earnings (Unallocated) $46,400+ New Common Stock Sales $0+ New Preferred Stock Sales $0= Maximum Equity Available $6,370,400- Ending Equity Desired $6,000,000= Redemption Budget $370,400

Redemption Budget Calculation

Note: New equity allows co-op to redeem old equity, increase solvency or finance growth.

31Model Co-op Case 1 (S1): 2007 Balance Sheet with Equity Redemption Payable



Equity Redemptions Payable 4% $370,400




Net Fixed Assets 48% $5,000,000Land 14% $1,500,000 Members Equity 58% $6,000,000




Total $10,370,400 Total $10,370,400

Financial Structure



32 Model Co-op: Case 1 (S1) 2007 Ending Balance Sheet ("snapshot")












Total $10,000,000 Total $10,000,000

Financial Structure



Note: Ending balance sheet liquidity and solvency same as beginning balance sheet except equity structure has changed with lower allocated, higher unallocated.

33Equity Redemption Methods• SP: Special (estate settlements, etc.)

• AP/O: Age of patron - oldest first

• AP/P: Age of patron - prorate

• PP: Percentage pool

• RF: Revolving fund

• BC: Base capital Challenge: Select the combination of redemption methods for each equity class that provide the right balance between (1) simplicity, (2) highest proportionality of investment and (3) highest cash flow to patron-owners.

34 Implications of Model Co-op Analysis

1. Biggest driver of equity management performance is profitability.

2. Cash flow to patron-owners varies little with alternative patronage income allocation strategies.

3. High, medium and low patronage income allocation strategies are all sustainable if growth rate is linked to profitability and cash flow. You can’t enjoy a champagne diet on a beer budget.

Four Cornerstones of Financial Success35

1. Be a profitable business– Manage income generation

2. Return profits to patrons– Manage income distribution

3. Provide sufficient equity financing– Manage balance sheet

4. Require patron equity investment proportional to use– Manage patron equity accounts

• Top three good innovative practices

• Top four bad innovative practices

• Top three ugly traditional practices

39 Practices of Cooperative Businesses: the Good, the Bad and the Ugly

Less than one percent of co-ops do any of these. Maybe 1 in 1,000 do all three.

1. Drop traditional qualified patronage refund distributions and replace with nonqualified distributions.

2. Practice strict balance sheet management on the finance side by (a) setting liquidity solvency targets to derive a total redemption budget first; (b) then choose a redemption program to divide up the budget of the individual patron-owner equity accounts.

3. Divide up the equity redemption budget among patron-owner accounts by using a base capital redemption program.

40Top Three Good Innovative Practices

1. Distribute regional patronage refund income to a separate nonqualified “regional” equity class and classify it not eligible for redemptions except upon company dissolution.

2. Distribute regional patronage refund income to a separate qualified “regional” equity class and tie redemption to redemption of regional investment.

3. Distribute all patronage income to unallocated retained earnings except for a small 100% cash patronage refund; tied to patron-owners having only one share of common stock (e.g., $100)

4. Sell large volume product transactions to patrons on a non-patronage basis and use volume discount pricing at lower net margins than patronage sales.

41Top Four Bad Innovative Ideas

1. Pursuing a high growth, low profit, low solvency, high risk strategy.

2. Redeeming equity using the age of patron, oldest first method.

3. Redeeming equity using the percentage pool method especially to natural persons.

42Top Three Ugly Traditional Practices

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“Destiny is no matter

of chance…

it is a matter of choice.”

-William Jennings Bryan

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QuestionsQuestions

andand

DiscussionDiscussion

Documents

Perspectives on Cooperative Finance Cooperative Strategy, Structure and Finance