Think: You Are "New" Management Each Day

When I think back, it is startling to think about the number of times I have seen boards of directors find themselves disappointed with their Co-op's previous General Manager because the new General Manager immediately starts to poke around.  That is what "new" General Managers are supposed to do.  It is startling the number of times how the Board is disappointed that their previous General Manager was "managing" how sales and expenses were accounted for between and among departments.

"New" General Managers are free to ask questions.  They are not afraid to tear apart financial statements.  To look underneath the hood.  For six to twelve months after they are hired, they enjoy a grace period when every issue or weakness they find is the previous General Manager's.  You can be the "new" General Manager each day as you walk through the door.

When General Managers walk into the front door of their Co-op each day, consider thinking of yourself as a brand new General Manager who is brought in to the Co-op to breath new life into the Co-op.  This advice applies to almost every aspect of your job.  But in particular I'm thinking about the methods for accounting for sales and expenses between and among departments of your Co-op.    

The market - particularly the market in which farm supply and grain cooperatives operate - is changing constantly.  Each day Co-ops are having to reinvent themselves. It is hard enough to make money and generate profits without handicapping yourself with assets or employees that are not producing income for the co-op.  No one likes to sell assets or move employees around.  Challenge yourself each day to think about yourself as the "new" General Manager.  Today is your first day on the job.  Is the departmental information your accounting department produces really an accurate portrayal of your profit centers?  Your loss departments?  

These "previous" General Managers were well intentioned. They were not malicious. They were not stupid.  But in each case, those General Managers were trying to protect pet departments, hide purchases of assets that were a mistake in retrospect, protect key or pet employees.  Those previous General Managers may even have been protecting the board of directors from having to make hard decisions, or protecting the co-op's reputation with members.  Stop it.  (But be careful with reputation and members - that spooks me the most)

As often as not, perhaps there are genuine questions about to which department sales really should be credited or expenses charged.  What should a General Manager do with sales that, for example, were acquired from a purchase of assets but now those sales could be credited to an existing department rather than the purchased assets because you realize that your sales folks have successfully transitioned the business to the assets your previously owned.  You've succeeded in gaining efficiencies from purchases of competitors.  Are the "new" assets that you acquired needed anymore?  Are the new assets now obsolete?  

When I think back, those "new" General Managers did not know more than the "previous" General Manager. They were not more talented than the previous General Manager.  Their most important strength was that the new general managers had fresh eyes and a fresh, inquisitive mind.  Their second most important strength was that they were not afraid to bring questions to the Board of Directors.  Sometimes there are not clear cut answers.  Sometimes the Board of Directors just needs to know that there are open questions and that the answers will become clear somewhere down the road.  

You don't have to be a "new" General Manager to have "fresh" eyes.  You just need to think of yourself as a "new" General Manager.  Each day.  

Directors of Cooperatives - Fascinating and Frustrating

One of the many $10,000 questions that fascinates and frustrates any one who works with directors of agricultural cooperatives is how to persuade directors to open their mouths and say what's on their minds during a board meeting.  How does one push directors to engage in meaningful discussion and to actually deliberate business issues that not only are on the agenda but not on the agenda but deserve discussion nonetheless?

Agricultural cooperatives are where the challenge is greatest.  Directors of food cooperatives - for just one example - tend to be more willing to express themselves. When my frustration with directors of agricultural co-ops is greatest and my exasperation highest, I often end up concluding that directors of agricultural co-ops wouldn't say shit if their mouth was full of it.  Perhaps it is more accurate to say that agricultural producers ("farmers")  will say shit when their mouths are full, but when they are pushed to that point, it is often times too late to change the course of events that will save the cooperative from extreme financial stress, or worse, ruin.

In other words, why will farmers choose to engage and voice their opinions, express their concerns, ask questions, and challenge each other or management only when the co-op is immersed in financial stress or within shouting distance of it or worse, the end? Why is it that farmers will not challenge each other and management all along - even when the Co-op is prospering - to avoid ever facing the prospect of financial stress or failure?  Why would farmers rather wait until the co-op is closer up to the edge of extreme stress or ruin and the need for honest, frank discussion is only more obvious but not more necessary than it is when the cooperative is enjoying success?

One reason may be that far more agricultural cooperatives than non-agricultural cooperatives have existed for fifty to one hundred years, and farmers tend to think of themselves and their director position as more honorary than "real". The closer the co-op is to its inception, the more challenging it is for the co-op as a business and hence the more vocal directors must be to (1) help guide the cooperative toward financial success and legitimacy and (2) protect their own pocket books from the specter of personal liability associated with the cooperative's financial failure.  

As the co-op ages, matures and gains its own momentum, it is easier for farmers to slip into thinking of their position as one that is honorary rather than a position that has the same legal and business responsibilities as their earliest counterparts.  It is an honor - and it should be - for farmers to be respected enough by their fellow farmers to be elected to the board of directors of the cooperative.  At the same time, who is a farmer, for example, to think that he or she can or should question where the agricultural cooperative is headed if all the directors who served before them apparently did not have questions about what businesses the cooperative is in or should be in? For these farmers, their director position is more honorary than "real".

Parenthetically, farmers would be far less prone to think of their position as honorary if they were elected to be a trustee of a trust that owned and operated a large farm because they could apply their own experiences to their trustee position.  They would be less respectful of the decisions made by previous trustees because they would be more confident of their own views about the trust's farm.  They would be more willing to challenge each other at board meetings.  Farmers would more vigorously manage risk for the farm and themselves because they would be far more comfortable in that position.

The issue of director participation is not only of academic interest; it goes to the issue of risk management as well.  We cannot ignore the fact that risk management requires director participation.  Higher quality director participation and discussion is preferred to lower quality participation and little or no discussion, or discussion about irrelevant issues.  The importance of asking the hard question, of challenging each other, of choosing discomfort in the board room over comfort all produce a more rich, more vigorous environment in which to evaluate risk than the alternatives.

But that change in approach to create a richer risk management environment requires that directors look at themselves less in an honorary capacity and more in a position of "real" responsibility.  A more "real" director is one who asserts him or herself, one who is willing to push questions and ask for answers, willing to challenge each other and risk having to ask fellow directors for forgiveness later, willing to admit what they don't know or assert their right to know what they do not know, and willing to assert their right to understand what they do not understand.    

None of this is easy.  All of it requires work and attention.   Work and attention by each director, by the officers of the board and by the board of directors as a whole.

Best Wishes for 2011!

We hope that 2011 is a great year for your cooperative, your members, your board of directors and management.

Look for upcoming discussions and further blogging on this site.  Also, please look for Case Study #2 on my website.  This study is illustrates the impact of making alternative allocations of patronage earnings, and of distributing 0%, 15% or 20% of the patronage earnings that are allocated with preferred stock (in this case paying a 5% annual dividend) rather than allocated equity credits paying no dividends.  You can link to the power point here:   https://sites.google.com/a/blackdogcooplaw.com/blackdogcooplaw2-com/case-study-you-decide-how-much-patronage-earnings-to-allocate.  

Case Study #2 Bottom Line:  Over twenty years, allocating 50% of patronage earnings and using preferred stock for 15% of the allocation rather than allocating 70% of the patronage earnings with no preferred stock conserves approximately $15 million for expenditures and beefing up the balance sheet.  Here the Cooperative knows that it will have numerous opportunities to acquire businesses that it now competes against.  

Further, if you look at where the Cooperative is in 20 years from now, the 50% allocation with 15% preferred stock results in $34 million of allocated equity to redeem in subsequent years, while the 70% allocation leaves the Cooperative with $44 million of allocated equity to redeem in subsequent years. 

Bottom Bottom Line:  The smaller allocation conserves $15.0 million over twenty years plus it positions the Cooperative with $10.0 million less allocated equity obligation at the end of 20 years.  .   

Again, Best Wishes for 2011!

One Juicy Rationalization

When anyone discusses the challenges that cooperatives have with redeeming allocated equity, the opposing argument is "don't worry about redemptions; agricultural producers are more interested in price and service than in equity redemptions".

Here is one of the biggest, most juicy rationalizations pushed along by many in the co-op community.  

Every holder of allocated equity who is interested in price and service today will eventually jettison their concern with price and service and become interested in redemption of their allocated equity when they retire or eventually pass away.  

Hence, cooperatives (most particularly centralized cooperatives whose members are natural persons with finite lives) must be simultaneously concerned with price and service AND equity redemptions.

In fact, look at any established cooperative and you will see that the mix of stakeholders includes younger patrons who are currently doing business with the cooperative and are interested in price and service.  And you will see older patrons who are less interested in price and service and increasingly interested in equity redemptions.  And you will also see retired patrons who are no longer interested in price and service but are now focused on the redemption of their allocated equity.  The board of directors responsibilities encompass all of these stakeholder subsets.  

Diamond Walnut Growers - A Larger Role for Academics with Finance Expertise

Professor Shermain Hardesty has the best interests of co-op members in mind when she writes that the principal-agent problem is an issue that needs to be addressed in co-op conversions. Professor Hardesty is really saying that co-op members may not be knowledgeable enough to assess whether their co-op should convert to a corporation. Professor Hardesty says that . . . [c]lose working relationships with university academics knowledgeable about cooperatives, marketing, and finance, would be beneficial to fostering such innovations.  http://www.agecon.ucdavis.edu/people/faculty/facultydocs/hardesty/the-conversion-of-diamond-walnut-growers.pdf

Professor Hardesty is carving out a role for her and others like her in the next conversion. Fair enough. We can never have too much good analysis for co-op conversions. To halt the next conversion, however, I hope that Professor Hardesty brings along some of her finance guru colleagues from the business school. The issue for Professor Hardesty will not be just to stop the next conversion.

The issue for Hardesty and other ag economics professors is not just to defend the co-op business model in its purest form. Rather, the role that Professor Hardesty must embrace is simultaneously to defend the co-op business model in its purest form IF IT IS DEFENSIBLE, but also to facilitate further evolution of the co-op business model to enable the creation of appreciating equity interests for co-ops.

For the latter task, we need finance gurus from business schools to assist co-ops and their boards of directors to strike a balance for the board and co-op members. Boards must be permitted to discharge their fiduciary obligations to the cooperative and to members. Members must be enabled to enjoy their co-op's success through appreciation of their equity in the co-op, and to sell that interest when they need capital. An appreciating equity interest is one of the bridges between those two opposing interests.

A Two for One Bang for the Buck - Appreciating Equity Interests for Co-ops

By way of review, redemptions of allocated equity are always the lowest priority after first providing for the cooperative’s liquidity, its solvency and its need to replace, update or expand its property, plant and equipment (“PPE”). The Board's fiduciary obligations run to the Cooperative first, then to members and patrons (equity holders).

Wouldn’t it be great if your cooperative could strengthen its liquidity and/or its solvency and/or update or expand PPE and simultaneously add to the value of your member’s equity? That is how an appreciating co-op equity interest benefits your cooperative. And its members.

No longer does the board of directors choose between paying down debt, spending money for PPE improvements or redeeming equity. An appreciating equity interest could work for the benefit of the Cooperative and its members (assuming, of course, the Cooperative's capital requirements prevent the Board from doing everything with cash. Straight cash is always better, right?)

The challenge for existing cooperatives without appreciating interests and their members is that the accretion in value will be owned by patrons at dissolution of the Cooperative, but not before. In other words, the Cooperative should be growing in value as it spends money on PPE or building its balance sheet strength. That growth in value, however, is not reflected in the value of allocated equity. Until dissolution, the value of each member's allocated equity depreciates in value each year until the equity is redeemed with cash.

You might say, but the "value", if any, arises from the Cooperative generating more cash flow to redeem more allocated equity in the future. True in the abstract. But that rarely happens in practice. PPE investments are not that chunky and insular. The Co-op spends $4.0 million this year on a new hub fertilizer plant, but it does not end there. The Co-op can thereafter easily spend $500,000 to $1.0 million per year to keep up with rolling stock, floaters, repairs and improvements. This constant pressure prolongs the desired balance sheet strengthening that one might expect to occur more quickly after a large PPE expenditure.

Growth in PPE usually means growth in permanent accounts receivable and inventory. So in addition to PPE, the Co-op must also finance growth in working capital to maintain adequate liquidity. This can prolong the desired balance sheet strengthening that one might expect to occur more quickly after a large PPE expenditure.

Moreover, diversified co-ops are under constant pressure. If its not agronomy this year, then it will be feed or petroleum. Remember, we have been and continue to discuss co-ops that are in capital intensive businesses with nearly insatiable appetites for more capital to build more PPE. About the time that the co-op pays down the debt from one large PPE expenditure or project or expansion, the co-op is heading back into another large PPE expenditure before the allocated equity holders benefit from a speed up of the redemption of their equity.

And all the while that PPE expenditures are evaluated and undertaken, the Board of Directors and Management are constantly managing the Co-op's solvency and liquidity. The bank wants the Co-op to strengthen solvency while not weakening liquidity.

If expenditures on PPE and/or to strengthen solvency and/or liquidity could also benefit holders of allocated equity, if that is the equity interests of members appreciated in value, the Board of Directors could discharge its fiduciary obligations more easily and comfortably by receiving two benefits (stronger co-op and growing value of member's equity) from one expenditure. But allocated equity does not appreciate in value. It is only valued when it is redeemed for cash by the Co-op.

In fact, before dissolution, expenditures on PPE or improving the Cooperative's balance sheet compete with redemptions of allocated equity while the Cooperative is operating in the ordinary course of business.

Until the cooperative dissolves, no one knows precisely who is or will be entitled to the remaining proceeds (after all debts, preferred stock, dividends and allocated equity are paid). We do know, however, that at dissolution the remaining proceeds are distributed on the basis of historical patronage, theoretically going back to the formation of the Cooperative unless the articles of inc or bylaws shorten that window.

The approach of allocating all patronage earnings and then redeeming everything with cash is a great approach so long as your cooperative’s financial and economic metrics allow the cooperative to generate sufficient cash to redeem equity in accordance with member expectations.

The hard, cold, brutal truth is that it is very difficult for cooperatives operating in capital intensive commodity businesses to simultaneously maintain and build balance sheet strength, replace and update PPE and also redeem equity with cash fast enough to satisfy members and patrons reasonable expectations.

Hence, appreciating equity interests may well have a place in the cooperative community.

The Distinction Between Endogenous and Exogenous

Time to elaborate on the distinction between endogenous and exogenous equity management approaches. We've been circling around these distinctions in this blog; just as well bring them to the forefront. Think of endogenous as "it is what it is". Think of exogenous as "we will make it what we want it to be". For equity management issues, endogenous is passive while exogenous is aggressive in its approach.

Had an extended exchange of e-mails with Professor Barton a few years ago. Professor Barton consistently asserted that equity redemptions must be and are endogenous. Prof. Barton meant that all patronage earnings should be allocated with QNAs, and that redemptions should be determined exclusively by the Co-op's excess cash flow. Barton believes so strongly in the endogenous approach to equity redemptions that he accused me of trying to make water run uphill when I asserted that the Co-op should also manage the size of their allocated equity obligation as well by paying some income tax.

Professor Barton appears to believe that not only does any (regardless of the Co-op's capital requirements) Co-op's DNA allow for the redemption of allocated equity in a reasonable time, but the Co-op's DNA affirmatively enables the Co-op to redeem the allocated equity on time (lets say long before the member's death) provided the Co-op is managed in an efficient manner. Professor Barton's philosophy toward equity management is endogenous.  "It is what it is", and if the Co-op is not redeeming allocated equity by the time of the member's death - at the outside - the Co-op is either not efficient or it is going through a building project and it will catch up redemptions as soon as the Co-op pays down the debt.

CHS's approach to equity management is endogenous. CHS does not manage the size of its allocated equity obligation because it allocates all patronage earnings with QNAs and pays no income tax on any of its patronage earnings. CHS manages the size of its allocated equity obligation solely by redeeming its allocated equity as and when it can from excess cash flow. Barton would agree with this approach.

A few years ago in fact, Barton asserted that CHS was speeding up its turn over of equity. Hence, its redemption situation was improving and the endogenous approach vindicated. Professor Barton is correct if you measure progress looking backward. I do not believe CHS has ever been in a stronger position with its turnover of allocated equity. CHS is paid up through earnings and allocated equity that were distributed as recently as 1995 - only fifteen years ago (approximately). I'd bet a hundred dollars that is as good as it will get for CHS.

My opinion is - looking forward rather than backward - that CHS's equity management situation has never been in a more difficult position. I do not believe that CHS's allocated equity has ever been higher than it is now: $2.3 billion of allocated equity, which is more than double the amount of its allocated equity just six years ago. So looking forward from here, it is not clear to me that CHS's position has improved, and we don't know what the future holds for an obligation that large.

In fact, I'd bet that $2.3 billion of allocated equity will look larger and larger in CHS's rear view mirror. We can expect that member insistence - completely understandable and expected - to redeem that allocated equity will be the cause of irritation and distraction to the Board of Directors over the next twenty five years or more as capital for redemptions competes with capital that is needed for PPE and/or building CHS's solvency and/or liquidity.

CoBank's approach is exogenous because it manages the size of its allocated obligation by not allocating all of its patronage earnings with QNAs. Rather, CoBank pays some income tax and allocates some of its patronage earnings with NQNAs that will never be redeemed . . . unless and until CoBank dissolves. One reason I asserted a few blogs ago that exogenous approaches like CoBank's appeared to blow by agricultural economists is that they doggedly hold on to an endogenous approach in the face of evidence to the contrary. Why would Barton and others seem to be almost oblivious to CoBank's equity management approach?

CoBank's allocated equity increased by only 25% during the time that CHS's allocated equity was more than doubling. This is what an exogenous approach looks like. Not only does the Co-op strive to be efficient, profitable and to carefully manage PPE expenditures so that its budget for redemptions of allocated equity is as large as possible, but the Co-op also manages the size of the allocated obligation itself by paying income tax on a portion of patronage earnings rather than allocating everything with QNAs.

You can expect Professor Barton and other colleagues of his to make arguments about equilibrium, but its not clear what equilibrium means as an argument against CoBank's exogenous approach. It appears pretty conclusive that CoBank's approach creates a stronger value proposition by distributing more net, net cash more quickly,and it creates a stronger capital structure by reducing the size of the allocated equity obligation. CoBank's approach also reduces the pressure on boards of directors to redeem equity when doing so could be a failure to discharge their fiduciary obligations. All that seems hard to dispute.