Part 2 Internal financing for improved cooperative performance

Most strategies for cooperative business development require increased capital. Therefore, such strategies should focus not only on improving operational efficiency and increasing member patronage, but also on attracting more member capital and new members.

Cooperatives have three main categories or sources of finance.

• The most important source is members as users and investors. Without this base, it is difficult to attract funds from others.

• The second source is retained surpluses, especially “unallocated” funds that are not assigned for distribution to members. These are known as institutional capital, which belongs to the cooperative and can be liquidated only if the cooperative incurs losses or dissolves.

• Finally, external funding can also be readily obtained from commercial sources (though usually at a higher cost) in a number of forms that include: loans, equipment financing and even equity capital. In contrast, external funding from donor or government sources is shrinking, as noted above.

To summarize, capital is required to protect and enlarge a cooperative. Business transactions in commodities and other non-financial goods and services generate and consume finance. Member loyalty - the basis for collective action and a sound cooperative business - is essential for maintaining economies of scale and building market power, both of which are key elements for a successful cooperative. Consequently, promoting increased member patronage so that it encourages member investment in the enterprise should be a key element in the cooperative’s strategy.

1 Serving members

The first step in improving services is to find out what present and future members want. What do they value and what are their priorities? Is the cooperative providing a service that they want, or is similar service provided better or more cheaply elsewhere? Does the cooperative provide these services at competitive prices?

When cooperatives are run as businesses in a democratic way,^[4] elected leaders usually have a good idea of what members want. In large cooperatives, member priorities may still be difficult to communicate. In this case, general meetings of members, establishment of special committees or focus groups for fact-finding or providing advice and gathering information on competitors, can help to initiate and guide changes. Financing these changes is explored later in this booklet.

To be successful, a cooperative must price services in a way that both attracts members and generates capital - either through retention of surplus or increased member investment - in order to maintain or increase its volume of member transactions. With increased market competition, members will tend to seek providers who serve them best, whether they are a cooperative or a private business. As member service-oriented businesses, cooperatives should lead the way in providing what members want, when they want it. This is achieved through continual improvements in services, and by expanding the range of services offered.

Prompt payment to members for produce is a powerful means of maintaining member loyalty. This is especially true when competing buyers pay promptly or even offer cash advances against crops that are not yet harvested. Cooperatives may also offer credit to members as a competitive incentive. However, this is only possible if sufficient capital is available or if outside funding can be obtained, through a cooperative, agricultural or rural bank, or a buyer of the cooperative’s produce. Access to such commercial credit enables a marketing or food-processing cooperative to provide partial advance payments to members during the growing season, with the remaining part repaid to them after the sale of the crop delivered to the cooperative. Input supply cooperatives may provide goods on credit, to be repaid after harvest. However, too much reliance on external credit to finance payments to members can be expensive and risky.

Linking members’ patronage and investment

Increased member patronage provides an important source of member capital. Although greater usage of services also usually requires more working capital and possibly more investment in fixed assets, generally speaking the more the members use and benefit from the cooperative’s services, the more surplus funds the cooperative will generate, and the more members will be encouraged to invest additional funds to maintain or increase those benefits.

The Free Rider Problem can be managed by requiring larger member-users, who benefit most from member services, to contribute more investment capital than members providing little patronage. (For a more detailed description of these techniques for mobilizing member capital see Part II, section 2.)

Improving efficiency is also important for the mobilization of funds because it enables a cooperative to offer competitive prices and to pay promptly, thus securing and keeping members’ loyalty. Cooperatives with sufficient funds are able to invest in training and technology to reduce costs, and to increase or improve production. Well managed, technologically efficient cooperatives are generally more likely to accumulate capital.

“Minimizing costs, maximizing service”

Offering efficient services at attractive prices means keeping costs down, while maintaining or improving quality. This can be achieved in several ways, by:

• More efficient use of existing facilities, equipment, finance, procedures and people

  Many cooperatives have reduced their costs significantly through improved management. Managers and employees will seek improvements when positive incentives and useful information are provided. Well structured management training programmes focused on improved use of available resources can contribute to this end. General member education is important so that democratic control translates into efficient operations and long-term sustainability. Technical skills training help ensure that equipment and facilities are operated as efficiently as possible.

• Improved member access to information on the cooperative business, member usage and investment

  Better communication with members can increase their usage of cooperative services. For example, bulking members’ deliveries into large lots for sale in the market usually creates economies of scale.^[5] If the cost savings that arise from bulk purchasing or selling are communicated to members, they will understand that larger volumes generate much larger net revenues (surplus) for the cooperative and hence for its members.

  Since the member-user is also a member-investor, good communication regarding the benefits of investing in the cooperative is important, too. This is especially so in cooperatives that have traditionally stressed member patronage but not promoted member investment.

  When management demonstrates that the cooperative is well managed, and that investment is required to remain competitive, members are more willing to take a longer-term investment perspective. This permits the cooperative to accumulate cash for investment in more efficient technologies, for instance. This change in perspective is unlikely if management is not transparent. Without transparency, members are likely to become suspicious and lose interest in investing additional funds to upgrade operations.

• Purchase of new or more efficient equipment or buildings

  Replacing old technology can raise efficiency and reduce costs. More efficient equipment can raise the rate, volume or quality of output, or reduce the quantity of inputs (such as labour) used per unit of output.^[6]

  Businesses that cannot purchase more efficient technology are likely to face increased competition from others who can. Those that purchase improved technology but are unable to manage it so that it produces increased returns are unlikely to be competitive. There also has to be sufficient demand for increased or improved production to justify incurring the costs of the new equipment or buildings.

2 Financing cooperative activities more effectively^[7]

As explained above, today most agricultural cooperatives in developing countries have to rely on member generated funds to finance their operations. In fact, the benefits of heavier reliance on member funds as the primary source of capital far outweigh the costs.

Increased members’ financial stakes:

• enforce greater accountability;

• encourage their participation in decision-making; and

• strengthen cooperative financial self-reliance and operational autonomy.

At the same time, a virtuous circle emerges: the greater the amount of capital held by the cooperative, the greater its ability to purchase more efficient technology, invest in staff training and education, and make other improvements in its business. Also, the higher the institutional and member capital, the more outside lenders such as banks and suppliers will be willing to lend to the cooperative.

Commercial cooperatives are motivated to find ways to increase member funding because it is their lowest cost, lowest risk form of capital for operations and investment. It also becomes their best or only practical source of funding as government and donor support declines. Even where outside support of this type is still available, increased reliance on member funding counters the risk of dislocation that would be caused by discontinuation of outside support.

Members can finance the operations and growth of their cooperative in both customary and innovative ways.^[8]

2.1 Customary forms of member capitalization

· Membership and service fees

Membership fees are usually small. Fees for miscellaneous transactions that are not treated as patronage also typically produce small amounts of revenue.

· Member shares

Member share capital represents individual member’s commitment to the cooperative form of business, providing the right to do business with the cooperative and use its services, to participate in cooperative democracy at annual general meetings, and to stand for office. Share capital identifies the individual member’s long-term financial stake and ownership in the cooperative. It is often the primary source of member capital.

In many countries, the investment the member is required to make when joining, or to provide subsequently, is quite modest. This tradition is based on the principle of open membership: poor people should be able to form and join cooperatives. However, where markets are liberalized and agriculture is more commercial, the tradition of small investments in shares is being abandoned.

Some commercial cooperatives obtain term loans from outside sources such as cooperative banks or other financial institutions to finance fixed assets such as buildings and equipment. They repay these loans by issuing shares that are purchased by members over the life of the investment loan. These arrangements are often mandatory: members are required to buy shares according to a formula based on patronage or some other variable.

As mentioned previously, one of the main limitations of traditional member shares is their fixed value. This creates a Free Rider Problem because newer members benefit from the accumulated investments made by past and older members. The problem becomes more apparent as members accumulate shares over time.

In traditional agricultural service cooperatives, and in many commercial ones, shares can be redeemed only when the member dies or leaves the cooperative. However, some cooperatives permit withdrawal of shares in excess of a required minimum under certain circumstances or for specific purposes. Where older members have sizeable holdings accumulated through many years of patronage, more flexible share redemption policies for retiring members may encourage greater capitalization by younger members.

Shares should earn a return. Traditional cooperatives often neglect this, but it is good practice for commercial cooperatives, especially when inflation would otherwise reduce share value. Allowing interest on shares to compound season after season would be one way of increasing the value of shares through appreciation. This can provide an attractive alternative to redemption at par value, as can the use of interest payments to invest in new shares. However, cooperative law in many countries limits interest paid on shares.

· Retention of surplus and creation of institutional capital

“Surplus” is the cooperative term for profit. It refers to the difference between income and expense. A surplus arises when the cooperative is able to retain some of the proceeds from sales of members’ produce or from members’ purchases from the cooperative. The distribution of the surplus is usually determined to a significant extent by cooperative law. The portion remaining, however, after statutory requirements have been met, can either be retained by the cooperative as institutional capital, or paid out in patronage refunds to members after the end of each year.

If cooperatives offer more favourable prices to members than those prevailing elsewhere in the market, either to satisfy their members’ short-term desire for cash or to reduce the impact of taxation on retained earnings, little surplus will be created. Consequently, it will be very difficult to offer patronage refunds. Therefore, whenever possible, these practices should be altered either to build up surpluses or to increase patronage refunds and attract new members.

Funds created as above through retention of cooperative business surpluses that are not directly allocated to members are an important source of cooperative capital. Such unallocated retained surpluses are termed “institutional capital,” the collectively owned wealth of the cooperative.

Institutional capital is usually a permanent source of funds. Most cooperatives’ rules allow it to be distributed only when the cooperative is liquidated. These funds are costless to the cooperative, although they represent a cost to individual members who otherwise would have had that portion of the surplus allocated to them. Members are usually willing to accept the cost of accumulating institutional capital provided the benefits it creates for them are clear and worthwhile.

Institutional capital is the secret weapon of cooperatives. The interesting financial aspect of institutional capital is that it is costless to the cooperative, while similar capital in corporations is the most costly to accumulate (see Box 1). Hence, increasing institutional capital can be a very strong basis for competitive performance by cooperatives. However, as discussed later in this booklet, it has to be well managed, keeping a balance between institutional capital and member capital.

· Accounts payable to members

Accounts payable to members for part or all of their produce are also a large and important source of funding for agricultural service cooperatives. These accounts are created when a cooperative accepts produce from its members but does not pay immediately. The produce is sold to buyers and if they pay before the cooperative pays its members, the cooperative has the use of these funds in the mean time. In this case, the growers are financing the crop for an extended period of time, and this may be critical to the successful operation of the cooperative.

· Member deposits

Member deposits include funds left in accounts by members who do not withdraw their entire balance whenever a payment is made. Some of these funds can be used by the cooperative for business purposes, and some have to be kept as non-income-earning cash to cover withdrawals upon demand. The proportions should be based on two factors. The first is historical performance - how much are members likely to withdraw over the course of the year, on a weekly or monthly basis? The second is a cushion that would be drawn down when unusually large withdrawals occur.

Another way of managing this is to have a maximum daily or weekly withdrawal limit. Where a cooperative’s cash window is located close to a commercial bank or credit union in which the cooperative has an account, members seeking withdrawals when the cash box is running low may be issued cheques to cash at the bank or credit cooperative. Of course, the cooperative has to have adequate funds in its account for this to work.

Prior to the introduction of the Cooperative Banking System in Kenya in the early 1970s, coffee growers were paid in cash four or five times a year for their produce, with disbursements being made at each cooperative’s coffee factory. Much of this money was spent immediately and often unwisely. With the introduction of the Banking System, coffee payments were credited to members’ accounts (which already existed) and members could withdraw funds when they wished at the district cooperative union’s office. The decrease in the number of places at which cash could be drawn was not inconvenient because members were most likely to engage in cash transactions at the district centre, which they visited periodically for commercial and social purposes.

Over time, members left more and more money in their accounts, rather than withdrawing their entire coffee payments. The accumulation of cash that this created greatly benefited the district cooperative unions, while encouraging members of the primary societies to manage their finances more productively.^[9]

Advantages and disadvantages of different forms of cooperative capital

As already stressed, a crucial point that underlies all efforts to capitalize cooperatives is that members are users of their cooperative’s services as well as investors in their cooperative’s enterprise. These dual roles should be balanced. If they are not, they can conflict or fail to coincide, which restricts investment. The user side consists largely of short-term behaviour, whereas the investment side requires a longer time horizon. If funds are devoted primarily to the user side through price-setting and payments that drain the cooperative of cash, the investment side suffers, and with it prospects for a stronger cooperative based on internal funding.

In order to better understand these sometimes complementary and occasionally conflicting roles, this issue is examined more closely below.

Box 2 provides a simple overview of the advantages and disadvantages of the most important sources of funds generated internally. The Box outlines the perspectives of members as users and of members as investors and how these issues may be viewed by the management of the cooperative. The Box does not explore all internal sources of funds, but rather offers a guide to those that are most important from the three perspectives: users, investors, managers.

Box 2. Sources of member capital, their advantages and disadvantages to the member-user, member-investor and cooperative manager^[10]

2.2 Innovative ways of mobilizing member capital

As cooperatives require more funding to be competitive, new approaches are being employed to attract member capital.^[11] The attraction of these new funding methods is that they provide positive incentives for investment by members, in different degrees addressing the Horizon, Portfolio and Free Rider Problems.

These range from deferred payment revolving funds, to proportional investment schemes, to schemes based on the issuance of tradeable “delivery rights,” among others. A brief description of these mechanisms is provided below:

· Deferred payment revolving funds

A surplus creates two opportunities for increasing the capital available to a cooperative. One is to retain the surplus, and the other is to allocate the patronage refund to members’ accounts for payment at a later date.

Cooperatives in North America have been particularly creative in finding ways of retaining cash while allocating patronage refunds. The most important is the use of revolving funds. For example, patronage refunds can be distributed in the form of notes payable over several years. The member receives a portion of the allocation each year, while the cooperative rotates its capital over the same period. Each year’s payment may be an average based on the member’s patronage over a period such as five years and on that portion of the member’s patronage refund that is deferred each year. Bad years and good years, and changes in the retention rate, combine to create a more stable payment each year. Alternatively, the member’s patronage refund invested in revolving fund notes in one year is repaid in a lump sum several years later.

Figure 2: Illustration of a Deferred Patronage Revolving Fund

Some cooperatives issue a portion of their patronage refunds in the form of shares rather than in cash. A disadvantage of this occurs when distributions to members, including shares, are subject to income tax. Some members may find it difficult to accumulate cash to pay taxes on non-cash income.

In all cases, the deferred payments have to be well managed by the cooperative so that its commitments are met on schedule.^[12] In countries in which high inflation is common, it may be difficult to manage a deferred payment system in a way that benefits members.

· Proportional Investment Cooperatives: investments based on patronage Provision of ownership capital based on patronage addresses the Free Rider Problem. A common form, known as the “base capital plan,” is used by large American dairy cooperatives. Its advantage is that it links each member’s patronage with his or her participation in capitalization.

The introduction of a base capital plan begins with the measurement of each member’s patronage over a relatively long period, such as ten years. The projected capital requirements of the cooperative are then divided by each member’s proportion of patronage averaged over the period. A minimum target equity requirement is calculated for each member, based on average patronage. This requirement may be specified as dollars per tonne of produce delivered. Box 3 illustrates how a base capital plan would operate for a hypothetical three member cooperative.

Box 3 Calculation of base capital requirements for a three member marketing cooperative

Let us suppose the three member cooperative has a total average annual production of 1 000 tonnes, of which member A contributes, on average, 250 tonnes (or 25%); member B contributes on average, 400 tonnes (or 40%); and member C contributes 350 tonnes (or 35%). Let us also assume that the cooperative needs US$150 000 in working and investment capital to operate and maintain its market share. Under a base capital plan, the amount of capital contributed by each member would then be in proportion to his/her average patronage, i.e. 25% of US$ 150 000 (or US$37 500) for member A, 40% (or US$60 000) for member B, and 35% (or US$52 500) for member C.

Members’ actual shareholdings, valued at their fixed par value, are then adjusted to fit the minimum base capital requirement. Some members have to buy additional shares, while others redeem their excess shares. This restructuring can also be partially achieved by share sales and purchases among members at their fixed value, or by retentions from the delivery proceeds of under-invested members. This process of adjustment continues as capital requirements change, as individual members’ patronage changes, and as the cooperative’s total patronage changes. Computer software and hardware are required to make these adjustments quickly and accurately.

· Member-Investor Cooperatives: allocation of the surplus based on shareholding

The surplus (net income) of member-investor cooperatives is distributed based on shareholding rather than on patronage. Protection and appreciation of share value are important objectives. Appreciation can be achieved by issuing bonus shares that have a fixed value, or the share price may be marked up to reflect increases in the value of the business. This encourages members to invest in their cooperative by giving them a financial incentive to do so. Participation units have been used in this way since 1991 by Campina Melkunie, a large Dutch milk cooperative.

In New South Wales, Australia, cooperative capital units (CCUs) are flexible instruments authorized by law, as demonstrated by different terms and conditions specified by the cooperatives using them. Some cooperatives issue bonus CCUs based on patronage; others require their purchase based on patronage. Some are restricted to members only, while in other cases CCUs are offered to non-members. Some CCUs are transferable at freely negotiated prices with a “secondary” or resale market being created by a broker.

Redeemable preference shares are also used in Australia. They are nontransferable, interest-bearing, non-voting and redeemable upon the member’s exit from the cooperative. Bonus issues provide capital appreciation. Fronterra, a New Zealand dairy cooperative, uses an independent appraiser to revalue its redeemable preference shares each year. New members are required to purchase their proportionate stake in the business as determined by the annual valuation. Fronterra members who leave or whose production is declining can cash in their shares based on their appraised value.

· New Generation Cooperatives: making member delivery rights transferable

The founder-members of New Generation processing and marketing cooperatives in North America are all engaged in the same business, such as growing maize, or often a higher value crop. They initially capitalize their cooperative by buying delivery rights that have no termination date. Their subscriptions are large. The funds the cooperative raises in this manner are perpetual (non-refundable except in liquidation) and are invested in the fixed assets and working capital of their cooperative.

Delivery rights are denominated in tonnes per season or in a volumetric measure of produce. The member has the right to deliver the amount of produce represented by the rights he or she has purchased. These rights guarantee that the cooperative will purchase a given amount of produce each year, but also oblige the member to provide a certain amount of produce to the cooperative each season. These rights are freely transferable, which gives them a market value. This feature creates an incentive for members to behave in a manner that maintains and increases the market value of their rights.

The progression of innovation in commercial cooperative ownership rights can be described by concepts of membership and the transferability, appreciation and distribution of returns, as shown in Box 4.

Box 4. Cooperative typology based on types of shares

* Shares as described in Box 1. Adapted from Chaddad, F. and Cook, M. 2002 as presented in Ernst and Young, 2002.

The variety of member investment schemes operating in today’s agricultural cooperatives goes well beyond the above brief description. Figure 1 provides a clearer picture of the scope of such arrangements currently operating in US cooperatives.

Figure 1: Typology of member equity ownership rights in US cooperatives

Source: Chaddad and Cook, 2003.