Should I Join a New Processing Cooperative?

A renewed interest in cooperative agri-businesses is sweeping across the Northern Plains. These new cooperatives are structured differently than traditional farm supply and elevator cooperatives. They are focused on processing and marketing processed products rather than supplying production inputs or marketing raw agricultural commodities. They require producer members to supply raw commodities for processing through marketing contracts and tie the amount of commodity supplied to the purchase of equity stock in the cooperative. The new cooperatives are selling enough equity stock shares and related delivery rights to meet the cooperatives’ financial needs and ensure peak use of processing facilities.

A combination of factors makes the decision about becoming a member in a new venture cooperative unique and complex. This article is designed to identify the key aspects of that decision by asking five questions.
  1. What are the potential returns from membership in a cooperative?
  2. To what risks is the cooperative business exposed?
  3. How will cooperative membership influence the farm/ranch operation?
  4. How will a lender view involvement in the cooperative?
  5. How will cooperative membership impact personal and business goals?
Questions 1 and 2 focus on the new venture cooperative and the industry it will be involved in. These questions are asked to determine if the expected returns from cooperative membership are great enough to justify the risks surrounding the cooperative’s operations and your equity stock investment. These questions are often difficult for farm/ranch managers to answer because they go beyond the more familiar market factors that affect raw agricultural commodities. Questions 3 and 4 are intended to identify the short-term and long-term impacts the cooperative’s marketing contract and equity stock investment have on your farm/ranch operation and finances. Question 5 deals with your unique personal and business goals and how those goals may influence a decision about cooperative membership.


What are the Potential Returns from Membership in a Cooperative?
Accurately estimating the financial returns of cooperative membership is not as easy as it may seem, because returns appear in several forms and are received at different times. Cooperatives can return financial benefits to members in the form of favorable prices, net returns from operations (both cash and retained) and appreciation in equity stock. Most new venture cooperatives choose to offer competitive, rather than favorable, prices to members and pass on benefits in the form of operating net returns and equity stock appreciation. Therefore, we will focus on these two forms of benefit.

Cooperatives distribute net returns to members based on patronage, or use. A portion of the net returns are distributed in cash, while the remainder is retained by the cooperative to be used in continuing business operations. This retained portion is returned to the member, but at some time in the future. Also, because there is a limited supply, equity stock typically appreciates in value if the cooperative is successful. However, equity stock appreciation is not realized until it is sold at a future date.

The time between the purchase of equity stock and when all financial benefits are received in the future is typically overlooked when analyzing potential returns. This oversight can have considerable impact on a cooperative investment evaluation and final membership decision.

A process called “net present value” is used to compare the outflow of money today with the inflow of money in the future. The basic concept is that income received today is worth more than income received in the future. This is because the income received today could be invested now, earn interest and be worth more in the future. To compare the flow of money that occurs at different times on an equal basis, you must adjust the future cash flows downward to correct for the fact they are not available for use today. A brief example should demonstrate this important concept.

Example
A new venture processing cooperative is requesting a $200 common stock, or membership, fee plus a minimum purchase of 500 shares of preferred stock at $20 per share. This results in a minimum total investment of $10,200. Each share of preferred stock requires the member to deliver one unit of commodity to the cooperative for processing. In this example, the member plans to sell the equity stock in 20 years for an estimated value of $32,500. A 30 percent marginal income tax rate was also used.

Table 1 shows the annual after-tax net cash flow without considering the influence of time on the inflow and outflow of money. The false impression is that cooperative membership will result in a net benefit of $34,414 (Column E, Table 1) after 20 years. However, this is not the number that should be used to make a membership decision.

The annual after-tax net cash flow including the influence of time is shown in Table 2. This example uses an 8 percent discount factor, which will be discussed in more detail shortly. The correct analysis shows a positive $1,214.67 net present value. This means that the money invested in the cooperative will generate at least an 8 percent after-tax return.

If the net present value had been negative, the cooperative would provide something less than an 8 percent after-tax return, and your money may generate a higher return within your current farm/ranch operation or in other ways. A negative net present value does not mean that you should not become a member in the cooperative, only that the cooperative will not generate the selected rate of return. Your personal and business goals, as well as the potential impacts on the farm/ranch, should also be considered.

As you can see, the impact of time on the outflow and inflow of money can be dramatic. It is critical that the influence of time be included in your analysis, and that a net present value process be used.

The Sources of Information
The cooperative’s business plan is the source of information we will use to evaluate both its risks and returns. This manual offers information and options in pulling together your business plan.


Net After-Tax Cash Flow and Present Value Calculations (JPEG)


The cooperative’s prospectus will provide most of the information needed for a net present value calculation. It will include the amount of the initial membership fee, the value of each share of stock and any minimum stock requirements. An economic feasibility study should include projected per-unit net return for several years of operation into the future. And, the cooperative’s by-laws should explain how the net returns will be distributed and how retained patronage earnings will be refunded.

The decision about the division of net returns between cash refunds and retained refunds is left to the cooperative’s board of directors. The percentage of cash versus retained refunds normally changes from year to year depending on the cooperative’s net returns and strategic business plan. This makes the net present value analysis more difficult because estimates of this division need to be made for each year of membership.

Typically, cooperatives return net income to members based on patronage. These cooperatives must distribute at least 20 percent of their net income in cash, unless the cooperative is paying the income tax. Many new venture processing cooperatives attempt to distribute larger cash patronage refunds because of the initial membership investment. Therefore, a 20 percent cash patronage refund should be considered a minimum, and a larger percentage is reasonable to expect.

Other cooperatives distribute net income on a per-unit basis. Net income is distributed periodically in cash with a portion, called a per-unit capital retain, being withheld for use by the cooperative. The amount of cash payments and capital retains will change from one year to the next depending on the cooperative’s operations and long-term business goals.

Another important fact to include is that the cooperative’s allocated net returns are considered taxable income to the member. This includes both the cash and retained portions. This element can have significant impacts on short-term cash flow, as well as the final net present value. In some cases, cooperatives have not returned a large enough cash refund to cover all of the member’s current income tax liability.

Selecting a Discount Factor
Selecting an appropriate discount factor is important because it has considerable impact on the results of the analysis. For instance, if the discount rate in our example is increased from 8 to 9 percent, the net present value would decrease from $1,214.67 to -$429.93.

There are two common approaches to selecting an appropriate discount rate. One approach is to choose a discount rate that is equal to the highest interest rate paid on debt capital. This approach emphasizes the fact that there are alternative uses of money. It assumes that the cooperative membership investment funds would be used to pay farm/ranch debt if it were not used within the cooperative. Therefore, the cooperative should generate at least the same rate of return as the next best use of the funds.

An alternative approach is to choose a discount rate that reflects your desired rate of return on investment. This allows you to incorporate all of the risk factors surrounding the cooperative business into the analysis; the higher the risk, the larger the discount factor. This approach is more subjective but allows you to compare the cooperative membership investment to other investments with similar risks. This leads to the next question.

To What Risks Is the Cooperative Business Exposed?
Determining the risks surrounding a new venture cooperative is one of the most difficult things to do, because there are many sources of risk, and each is hard to measure. To make things easier, the sources of risk can be grouped into two broad categories: business risks and financial risks.

Business risks are those associated with conducting business operations, without considering the financial structure. The five sources of business risk are:
  1. Production (including both construction and operation)
  2. Market or price
  3. Technological
  4. Legal and social
  5. Human
Financial risk is the magnification of business risks caused by debt financing. This includes the uncertainties surrounding the availability of borrowed capital, credit terms and changing interest rates.

The Cooperative’s Business Risk
Each of the five sources of business risk should play a role in your analysis of the new venture cooperative.

Production risk refers to the unforeseen events that can change the projected construction, start-up and operating costs and efficiencies. These events can influence both product quantity and quality. A realistic and thorough economic feasibility analysis will provide information about projected construction and startup costs, typical operating costs and efficiencies, and operating margins. The projected operating margins should be based on realistic forecasts and be sufficient to cover unforeseen cost overruns and operating problems. Typically, the cost projections for the first several years of operation are larger than average to compensate for these risks.

Market or price risk refers to both sales volume and product price. The fundamental information needed to analyze price or market risk is included in the marketing plan. The marketing plan should discuss the size of the current market, the market growth factors, the major competitors, the cooperative’s market advantage, how market share will be established and how co-products from processing will be marketed. Once again, it is not unusual to see lower than normal price projections for the first several years. This allows the cooperative to establish market share and customer loyalty, and compensate for unforeseen reactions by competitors.

Another aspect of market risk is the ability of the cooperative to adjust its product, or product line, to meet changing customer preferences. The ability to profitably adjust products is directly tied to the technology used, which leads to technological risk.

Technological risk is the potential for current efficiencies to be offset by improvements in future technology. The cooperative must consider the tradeoffs between adopting the most current technology to gain possible efficiencies with the increased cost of that technology and the risk that the new technology is not completely tested and proven.

Legal and social risks are those which refer to changes in local, state and federal laws and regulations governing the cooperative business and its industry. These include changes in tax law, environmental regulations, interstate commerce, import/export regulations or industry subsidies. The key is to look at how sensitive the cooperative’s business plan, and resulting net return, is to changes in relevant laws and regulations. The cooperative’s business plan should be flexible enough to adjust to changing legal and regulatory conditions.

The final source of business risk is human risk. Human risk is associated with the availability and quality of labor, management and board of directors. The first human risk is the selection of high quality personnel. The second human risk is the impact on the cooperative if one, or several, of the key people leave the business.

Human business risks are frequently underestimated. One of the most commonly cited reasons for a successful business is the abilities of the people on the management team. The management team of a cooperative, both hired managers and the elected board of directors, is especially critical. The cooperative management team must not only be concerned with the efficient operation of the business, but also with the sometimes conflicting needs of the members/patrons. Always remember, it’s the people who make the plan work.

The Cooperative’s Financial Risks
Financial risk is the second category of risks and is defined as the increase in business risk caused by debt financing. The lowest risk situation for the cooperative is to be completely equity financed and not borrow any money. However, this is difficult to accomplish, especially for large projects, and may put unwanted restrictions on the cooperative’s business plan.

From a member’s point of view, financial risk may not seem large, relative to the business risks discussed earlier. However, financial risk and the ability of the cooperative to adjust to business risks using borrowed capital can have a substantial impact on performance and ability to succeed.

It is important that the cooperative have a lender or lenders who have experience with the unique aspects of financing cooperatives. It is also important that the total financing package, both debt and equity, meet the needs of the cooperative and leave it flexible enough to adjust to changing business conditions. This usually means that the business plan needs to have solid member investment capital and sufficient operating funds or working capital.

How Will Cooperative Membership Influence the Farm/Ranch Operation?
The impacts of new venture cooperative membership on the farm/ranch operation can range from minor to far-reaching, depending on your current farm/ranch operation and the structure of the cooperative and its membership agreement. To capture all of the potential consequences, we evaluate the impacts on farm/ranch production, marketing and finance individually.

Production
In most cases, a new venture processing cooperative requires its members to deliver consistent, high quality commodities. High quality products allow the cooperative to capture and maintain market share. Because of this, the cooperative may develop recommended production practices to increase overall quality and quantity and to reduce quality variation among members.

It is important to determine if these production practices are voluntary or mandatory. You must gauge how easy it is to incorporate proposed changes into your current operation and estimate changes in the commodity’s per-unit cost of production.

Changes in production practices could be as simple and low cost as changing animal vaccinations, or as complex and expensive as altering machinery complements or building and facility configurations.

The spin-off impact on the production and cost efficiencies of other enterprises on the farm/ranch is typically underestimated or even overlooked. A common example is an increase on the demands of the farm/ranch’s labor and management. If changes in production practices increase the demands on labor and management at the expense of another enterprise, the net result may not be positive.

The timing of delivery and final point of delivery for the commodity can also have significant impacts on the cost of production. If the commodity must be stored from the time of production until delivery, the added costs of storage, handling, interest and the risk of reduced quality should be included. The cost of transporting the commodity from the point of production to the point of delivery should be adjusted if delivery is required outside your normal trade area.

Some farmers have found that the cooperative’s recommended production practices have improved enterprise and whole-farm efficiencies.

Marketing
It is important that the terms and conditions of any marketing agreement are completely understood. In most cases, the responsibility for profitably marketing the commodity is turned over to the cooperative through its processing activities. This allows the farm/ ranch to diversify its commodity marketing activities.

It is not unusual for the cooperative’s business plan to provide partial payment for the commodity at the time of delivery, with the remainder received as cash and retained patronage at some time in the future. The timing and level of these payments can have a significant impact on the farm/ranch cash flow. It may be necessary to alter the normal marketing plan of other commodities or change short-term borrowing needs to adjust to the cooperative’s payment schedule.

Another important issue is what happens if you are unable to deliver the specified quantity or quality of product listed in the marketing contract. Some cooperatives have established a member marketing pool to fill shortfalls. In this case, the cooperative buys the commodity from the pool, in your name, and reduces your payments by that amount, plus a handling fee. Other cooperatives require the delivery of the commodity, and you are responsible to purchase and deliver any shortfalls.

Finances
There are both long-term and short-term impacts on farm/ranch finances. The extent of these impacts will vary greatly from one farm/ranch operation to the next. The best way to capture all of the long-term financial impacts is to use whole farm/ranch budgeting.
This process provides estimates of the long-term profitability of the operation and gives an indication of its financial progress and staying power.

Two long-term budgets should be prepared. The first reflects business as usual and includes normal farm/ranch operating practices, machinery replacement and building or facilities renovation. The second will add the new cooperative investment with all of the adjustments to production and marketing for each enterprise on the farm/ranch. These two estimates should be prepared assuming that changes are fully implemented. This means that the cooperative is in operation and is generating and distributing returns as projected. We are trying to assess what the farm/ranch business may look like in the future.

The main objective of this process is to estimate the net effect of cooperative membership on the long-term financial health of the farm/ranch. By comparing the results of the two budgets, we see the influence the cooperative has on net farm income, change in net worth and long-term cash flow. It is the combination of these three measures that provides an indication of long-term financial health. If the long-term benefits are positive, we need to make sure that the farm/ranch can meet all of its shortterm cash flow needs.

It is not unusual for a new venture cooperative to need several years of start-up and operation before its net returns are positive. Because of this, members typically will not receive returns from the cooperative until several years after the initial investment has been made. It is critical that the farm/ranch operation be able to meet all of its financial obligations on time during this period. A short-term cash flow projection will show if this is possible.

Every farm/ranch operation has some level of short-term borrowing and cash flow limitations. Because of this, the cooperative membership investment must compete with other uses for limited short-term capital. If a conservatively prepared short-term cash flow is positive, the chance of major cash flow problems is small. However, if the cash flow is slightly positive or negative, decisions must be made between the alternative uses of money.

Preparing whole farm budgets and cash flows is not a small process and will take some time and effort. However, these statements will ensure that all direct and indirect impacts of changes in production, marketing and financing are included. Time spent now, with a sharp pencil, could prevent problems in the future.

How Will My Lender View the Cooperative Investment?
It is important to discuss the new venture cooperative investment with your lender. This should be done regardless of whether the investment is self-financed or debt-financed. The investment in a new venture cooperative typically results in a notable change in your financial condition and should be reviewed with your lender to maintain good working relations.

Your lender will have many of the same questions we already have discussed. There are two additional questions the lender may have which are important to you and may influence a loan decision and credit terms. The first is, “How will possible losses from the cooperative be distributed?” and second, “How easy or difficult is it to transfer membership stock?”

The first question concerning distribution of losses is important because it helps define the maximum loss potential. In some cases, the method for distributing cooperative losses is defined in the by-laws. In other cases, this decision is the responsibility of the
board of directors. In either situation, it is important to understand what may happen to your initial investment and any retained earnings if the cooperative sustains losses.

The second question concerning stock transfer is important because your lender is trying to determine the liquidity of the stock. If the cooperative stock is easily transferred from one producer to another, the lender views it as more liquid and lower risk. This is because the stock could be sold quickly and easily if it is necessary to limit losses.

Every lending institution or system treats a loan for cooperative membership investment differently. Some lenders have even developed special loan terms that meet the unique cash flow needs of a membership investment.

If you are requesting a loan, these four key issues need to be discussed:
  1. The annual interest rate of the loan and whether it is fixed or variable.
  2. The length of the loan.
  3. The number and timing of payments.
  4. The source(s) and amount of collateral.
The first three issues will determine the annual loan payment and influence the farm/ ranch cash flow. The final issue, concerning collateral, will influence solvency and future borrowing capacity. Some lenders use only the cooperative stock as security for a loan. However, most lenders require that additional farm/ranch assets be pledged. The amount of needed collateral will depend on the current financial strength of the farm/ranch, your credit history and the risks surrounding the cooperative business.

How Will Cooperative Membership Impact My Personal and Business Goals?
Up to this point, we have focused primarily on the financial aspects of cooperative membership. However, there are several nonfinancial factors that may play a role in your final decision.

One of the most commonly cited personal benefits of cooperative membership is the ability to have a voice in the operation of the business.

Many local communities, regions and even states are actively involved in the development and promotion of new venture processing cooperatives. Their goal is to bring economic development and more jobs into their area. In some situations, the cooperative has already selected a specific site to locate facilities and headquarters. In other situations, the site has not yet been decided.

Many cooperative members list community economic benefits and increased job prospects as factors in their membership decision. However, it is also important to realize that the cooperative may not locate in your area and that not all of the community impacts are positive.

It is true that a new business creates more jobs, more people living within the community and increased retail business volume. However, some communities have found that increased business activity and larger populations strain the community infrastructure, such as water, sewage, fire fighting, police, medical services and schools. An expanded job market can also increase the competition for labor and put additional financial pressure on existing businesses.

Because of the long-term nature of agri-business development and growth, some farmers and ranchers will not enjoy the complete benefit of cooperative membership during their farming/ranching career. Yet, they are active participants in the process. The desires to improve communities and assist the next farming/ranching generation are factors that influence their membership decision.


Sources of Additional Information
EB-67, July 1996
www.ag.ndsu.nodak.edu/qbcc
Frayne Olson, Assistant Director
Quentin Burdick Center For Cooperatives

Net Present Value
Barry, Peter J., Paul N. Ellinger, John A. Hopkin, and C.B. Baker, Financial Management in Agriculture; Interstate Publishers Inc.; Danville, IL; 1995.

Boehlje, Michael D., and Vernon R. Eidman, Farm Management; John Wiley & Sons; New York, NY; 1984.

Hardie, Wallace C., Arlen G. Leholm, and David M. Saxowsky, The Time Value of Money; North Dakota State University Extension Service; EC-895; 1986.

Rice, Billy B., Interpretation and Use of the Amortization Table; Farm Management Planning Guide, Sec. VIII, No. 7; North Dakota State University Extension Service; 1980.

Long-Term and Short-Term Budgeting and Cash Flow
Carver, Robert D., and Billy B. Rice, A Complete Farm Budget: Steps In Planning and Reorganizing The Farm Business; Farm Management Planning Guide Sec. III, No. 2; North Dakota State University Extension Service.

Hardie, Wallace, Arlen Leholm, and Tom Reff, Your Cash Flow; North Dakota State University Extension Service; EC-820; 1984.

Leholm, Arlen, Tom Reff, and Glen Pederson, Your Balance Sheet; North Dakota State University Extension Service; EC-818; 1983.

Reff, Tom, Arlen Leholm, and Glen Pederson, Your Income Statement; North Dakota State University Extension Service; EC-819; 1983.

Reff, Tom, and David M. Saxowsky, Analyzing Your Farm Financial Statements; North Dakota State University Extension Service; EC-920; 1987.

Risk Management
Barry, Peter J., Risk Management in Agriculture; Iowa State University Press; Ames, IA; 1984.

Cooperatives
Cobia, David W., Cooperatives in Agriculture; Prentice Hall; Englewood Cliffs, NJ: 1989.