A cooperative, like any business, requires money, or capital, for start-up, stability, and growth. Cooperatives can use both debt and equity to meet their capital needs.
Debt is money that is borrowed and must be paid back to the lender with additional interest payments. Usually these loans come from banks or other financial institutions. While lenders may be financing a significant portion of a cooperative’s capital needs, they do not have ownership rights.
Equity is money that is invested in a business without a guarantee of payback or financial return. The “at risk” capital entitles the investor to share in ownership, control, and any business profits or losses. Equity provides businesses with capital without interest expense or fixed payback obligations.
Cooperative members make equity contributions that give them ownership and control rights in their cooperative. These rights enable them to prioritize cooperative operations that meet their needs instead of increasing investment returns.
Sources of Cooperative Equity
Membership equity requirements
Membership in a cooperative requires an equity payment, usually through purchasing common stock or a membership certificate. The stock cannot be traded and does not appreciate. Each co-op determines the cost of becoming a member and must balance its need for capital with the members’ ability to pay.
When a business is profitable, the owners may decide to retain all or a portion of the earnings and reinvest them in the business. In a cooperative, profits may be allocated to members based on their use, or patronage, of the cooperative. These patronage allocations may be distributed to the member as a refund, retained as allocated equity in the member’s name, or a combination of both. A portion of net profits may be retained and collectively held as unallocated equity in the cooperative. Typically, unallocated equity is the profit from business conducted with non-members.
The board of directors makes decisions annually about profit allocations and redemption of past retained patronage allocations. The board considers the co-op’s capital needs, its members’ needs, and its tax position.
Per unit retains
Per unit retains are often used by producer co-ops. The co-op retains a percentage of each financial transaction with a member for products that it receives or purchases. The retained payments are credited to member equity accounts.
Wisconsin co-ops may raise equity capital by selling preferred stock to members and non-members. Preferred stock offers a dividend but does not grant member voting rights. Dividends are paid out of the cooperative’s net profits, but are not guaranteed and are made at the discretion of the board.
Other Approaches to Cooperative Financing
Cooperative start-ups that are capital intensive may require more equity than members can provide. Accumulating the retained earnings needed for new capital-intensive investments may be difficult for cooperatives, which operate to benefit members rather than to maximize profits. Some states, including Wisconsin, have adopted hybrid cooperative laws that allow both investor and patron members. Patron members determine whether non-patron members may vote and receive a portion of net profits based on investment. In Wisconsin, these hybrid cooperatives are called Unincorporated Cooperative Associations.
Cooperative Profit Distribution and Taxation
Cooperatives are taxed differently than other types of business. A cooperative pays taxes at the corporate rate on the net profit that is retained as unallocated equity. Members pay taxes on the net profit that is allocated to them on the basis of patronage. Allocated patronage can be designated qualified or nonqualified.
Members pay taxes on patronage allocations that are retained and designated as qualified. At least 20% of the qualified allocation must be distributed to members in cash to help pay the taxes they owe on the entire patronage allocation. This method provides a way for members to make ongoing equity investments in the co-op in proportion to their patronage. There is an expectation that the retained allocations will be redeemed over time, since the member has paid taxes on them.
If patronage allocations are retained and designated as nonqualified, the co-op initially pays the taxes at the corporate rate. When nonqualified retained allocations are distributed to members at some point in the future, the member pays the required tax and the cooperative receives a tax credit. Since the member has not paid taxes on nonqualified retained allocations, there is less pressure to redeem this type of retained equity.
In consumer cooperatives, where members conduct business for personal use, patronage allocations are treated like refunds and are not subject to income tax.