Chapter 15 - § 15.8 • EQUITY CAPITAL

• Jurisdiction: Colorado

§ 15.8 • EQUITY CAPITAL

The ways in which cooperatives can develop their equity capital and the redemption of member equity are authorized under state law, but the development and redemption of capital is generally conducted with a substantial awareness of the tax consequences under the Code.⁹⁶

§ 15.8.1—Members Provide Primary Capital — Other Capital Sources

The members of a cooperative provide its primary source of equity capital, based on the cooperative principle that financing of a cooperative is to come first from its member-users.⁹⁷ Cooperatives may also seek capital from outside sources; they can borrow from banks and other lending sources in the same way as other businesses, and can raise capital from private investors through private placement offerings or direct public offerings.⁹⁸ Although it may be difficult to find outside investors who are willing to invest capital in a cooperative without a right to vote (unless the cooperative is a ULCAA coop described in § 15.5 of this chapter), cooperatives may and do obtain equity capital from non-member sources, and examples of external investment in cooperatives continue to grow in numbers and frequency.⁹⁹

Often, cooperatives provide that a person can become a member of a cooperative by paying a modest amount for one share of voting common stock or a membership. Subsequently, as members engage in business with the cooperative, additional capital is provided by the members. Members who market goods through the cooperative can be subject to a charge per unit of goods marketed through the cooperative. The charge is retained from proceeds otherwise payable to a member for the goods marketed. The retained charge is called a "per-unit retain" and is credited to an equity account for the member. This approach is not used widely in Colorado but is used extensively by cooperatives of fruit and vegetable growers in California and Florida.

Many cooperatives use a "patronage dividend" system by which, at the end of the year, some or all of the cooperative's net income resulting from business done with its members is allocated among the members as patronage dividends or refunds,¹⁰⁰ with portions being paid to the members in cash and a portion retained and credited to an equity account in each member's name. The members are given notice of the amounts allocated, paid out, and retained. The retained amounts are credited to a member's capital account on the books of the cooperative and are variously called "retained patronage," "retained patronage dividends," and "capital credits."¹⁰¹ In these ways, cooperatives build their capital base from member investments and patronage over a period of time.

If a cooperative utilizes a patronage dividend system, a patronage valuation methodology must be devised and adopted by which to allocate the net income among the members. This involves determining how much of the net income is allocated to each member. The amount must be based on the value of transactions between the member and the cooperative. The determination may be based on the number of units of goods or services purchased by the cooperative from the member or sold by the cooperative to the member. It can also be based on the dollar volume of the transactions or, in the case of a worker cooperative, the value of an individual's labor or services to the cooperative.¹⁰² Generally, the patronage refund methodology reflects the uniform valuation of a member's contributions to or use of the cooperative.

By way of example, a cooperative that purchases widgets for resale from members could adopt the following allocation method. Assume that the cooperative's net income from member business is $500,000 and that the particular member accounted for $100,000 of gross sales of widgets to the cooperative and the cooperative's total purchases of widgets from its members were $10 million. If the cooperative uses the total gross sales from members as the basis for its allocations among members, this particular member would be entitled to an allocation of 1 percent of the $500,000 of net income of the cooperative, or $5,000. As will be discussed in the next subsection, because of federal income tax rules, under Subchapter T the cooperative may be required to pay at least 20 percent of the allocated amount of $5,000 ($1,000) to the member in cash and retain the unpaid portion as a member contribution to the equity capital of the cooperative that may be redeemed or repurchased at a future time. The cooperative has the authority to pay the entire allocated amount in cash, as business cash flow dictates.

The allocations can differ among different departments within a cooperative. For example, assume that a grocery cooperative has a meat and poultry department, a fresh produce department, and an all other items department. The cooperative could have different percentages of allocations of net income for each of the different departments. These differences in allocations are usually based on there being differing costs, profit margins, and other factors among the departments justifying the different allocation rates among them. The formula that sets forth the relative allocations between departments or classes within a cooperative may be set in the bylaws, by board-adopted policy, or periodically by the cooperative's board of directors.

In some cases, when a cooperative plans to incur substantial capital expenditures, the initial capital contribution to become a member may be substantial. Thus, it is not uncommon for the cooperative to grant members who have contributed substantial capital a "defined right to use" some or all of a cooperative facilities or services, in addition to a membership (or share of voting common stock). Sometimes, these defined rights to use accumulate substantial value on their own as a limited commodity not available to all persons. Sugar beet growers throughout the country — including those in Colorado and farmers in the Red River Valley of Minnesota, Idaho, and the Dakotas — who own their processing facilities through a cooperative invest both in a membership and for acreage rights to plant sugar beets for processing. The acreage rights may increase in value, thereby providing the member with an opportunity to realize over time a gain on the investment in the acreage rights if the member wishes to sell them to another person with the approval of the cooperative. Of course, the value may also decrease over the years. Another example of a right to use might be a cooperative using member capital to purchase a kitchen that is then used by members who are independent caterers for their businesses. The bylaws might define the specific right to use (hours per week, for example) for each member. Each member has a membership interest in the cooperative and a "right to use" the kitchen.

Recent developments in cooperative finance have brought outside, non-patron-member capital to bear as part of a cooperative's equity structure.¹⁰³ This can be accomplished in at least two ways. First, cooperatives are able to issue non-voting preferred stock to members or non-patron members. This structure does not violate the...