The Second Most Difficult Equity Management Decision

The second most difficult decision for any Board of Directors of any Co-op is to acknowledge that continuing to allocate all or nearly all patronage earnings puts the Co-op in a chronically difficult, perhaps even impossible financial position.   

Each Co-op board must make its own decision because each Co-op's financial and economic metrics are different from others.  Some Co-ops need absolutely no capital and are immensely profitable.  These Co-ops distribute 97% of patronage earnings annually in cash.  Incredible!   

Other Co-ops need capital but are profitable enough to redeem allocated equity over an eight to ten year time line, which is usually considered acceptable by the standards of most co-op members and patrons.   Still other co-ops are profitable but expenditures for PPE, and/or maintaining solvency and liquidity targets begin to burden the finances of these co-ops.

But some Co-ops are under a continuing burden to spend large amounts of capital on property, plant and equipment, and/or to provide for the use of modest long term debt capital in the Co-op's capital structure, and/or to provide working capital to finance growth in sales, receivables and inventories.  These Co-ops may reach a point where the Board asks itself whether it is reasonable to expect that these Co-ops can generate enough earnings to finance those expenditures and still redeem allocated equity in a reasonable manner and time.  

This point occurs when the obligation to redeem allocated equity evolves from one that is gladly undertaken, financially comfortable and continued to honor a co-op tradition, to an obligation that is a huge distraction because the Board of Directors believes it should really spend that capital on property, plant and equipment and/or on strengthening the Co-op's solvency and liquidity positions.  When allocated equity is redeemed instead, these Boards of Directors run the risk that they are not properly discharging their fiduciary obligations.  

Nothing about the co-op model assures that it is reasonable for a Co-op to allocate all or nearly all patronage earnings and then redeem the resulting allocated equities in a reasonable time.  Nothing in a Co-op's DNA promises that each co-op can generate enough earnings to reasonably redeem allocated equity.  Everything depends on each Co-ops' capital requirements and its economic and financial metrics. 

Boards of directors make one of two decisions when the Board determines the co-op cannot continue to allocate all or nearly all patronage earnings and reasonably expect the co-op to redeem all that equity.  One decision is to follow a CoBank approach to equity management.  The second, alternate decision is to adopt an approach that creates an appreciable equity interest. 

Appreciable equity interests enable the Co-op to benefit from twofers.  Expenditures on property, plant and equipment not only benefit the co-op by maintaining or improving its competitive position, but those same expenditures also benefit holders of appreciable equity whose interests are more valuable after the Co-op's PPE expenditures than before them. The demands on the Co-op to redeem allocated equity are eliminated or at least mitigated. 

More on these two approaches in upcoming blogs.