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In this week’s Principle 6 Newsletter, born for labor, pledged to democracy and dancing with capital

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Image show many hands coming together, each holding a different piece of a puzzle.
Successful co-ops create tangible value for their members.

In this week’s newsletter, Mike Mercer explores how cooperatives navigate their need for capital while preserving their commitment to labor and democracy.

“Democratic governance and profit distribution according to usage sews the seeds for one of the biggest frustrations of the cooperative business model: access to affordable financial capital for growth and investment,” he writes.

Could the co-op system create a capital facility that would dramatically improve the affordability and sustainability of capital resources? Read the full issue of Principle 6 Newsletter below to find out.

And while you’re thinking about “cooperation among cooperatives,” take a moment to consider how you and your cooperative practice this principle. NCBA CLUSA is on a mission to document Principle 6 collaborations across the country so we can identify trends, document best practices and share this knowledge with you—our fellow cooperators!

Share your example of Principle 6

 

Principle 6 Newsletter – Born for Labor, Pledged to Democracy, Dancing with Capital

Issue 29 – September 8, 2021

The growth of the cooperative movement would parallel the immense changes associated with the Victorian Era. On Coronation Day in 1837 she (Queen Victoria) ascended to the throne amidst great ceremony. Amongst the poor workers of the North there was a pause to celebrate the glory of Britain. It was also a time to recognize that much more had to be done to better their lives. The next day they went back to work and to building their co-ops, unions, and friendly societies. – David J. Thompson, “Weavers of Dreams,” 1994

From the history of cooperatives in the United States, we learned that they are indeed able to offer a more stable income and a dignified workplace. – Scholz and Schneider, “Ours to Hack and to Own,” 2017

Entrepreneurs who are considering launching shared ownership businesses say access to financing is the primary obstacle holding them back. The resulting undercapitalization impedes business development.  – “About Cooperatives,” Start.coop website, 9-6-21

The hybrid member-investor cooperative form has two classes of members.  Investor members receive a share of profits based on their ownership while user members receive a share of profits based on patronage.  That creates a direct incentive for nonmember investment and addresses some of the limitations in raising nonmember equity. – Phil Kenkel, “Managing Capital Structure,” Cooperatives, 8-21-19

All successful businesses are built upon the productive marriage of capital and labor. Present day conceptualization of capital is largely financial. Money to buy the productive assets and to hire the workers at start-up and scale-up. There was a time when capital was more associated with an ownership claim to land. But the industrial transformation of the 1800s and the present-era digital transformation put the money version of capital at the forefront of critical business formation resources.

Beginning with the industrial revolution, agricultural workers and artisans were increasingly replaced with machines. Many moved into the factories to provide service to the machines and become employees, factors of production. Initially, being an employee was better than being an indentured servant to a landowner. Over time, the labor of workers was a cost to be minimized, an asset whose productivity was to be maximized with long hours and deplorable safety conditions. These conditions spurred the development of movements—labor unions, communes and cooperatives.

These conditions spurred the development of movements—labor unions, communes and cooperatives.

Many credit unions were started with the blessing and support of employers, but they were soon organizations of workers. They were structured to be that way. Organized on democratic governance principles, credit unions have long been heavily focused on the well-being of working people. Rural electric co-ops were enabled by the Rural Electrification Act of 1936, but they too were democratically governed and primarily focused on the people and small businesses left behind by return-seeking investors. Similar origin stories exist for farmer co-ops and others. But none are more born for labor than worker co-ops. These democratically structured institutions are directly focused on creating value for labor. The most recent manifestation of worker co-ops are the platform co-ops like the Drivers Cooperative in New York and Stocksy United in Canada. In most cases and in many ways, co-ops were born for labor.

All co-ops are pledged to democracy in governance. And democratic governance will almost always choose to distribute the profits of cooperatives to the members based on their usage of the organization’s products and services. The few memberships that have delegated authority to elected officials and hired guns who feel otherwise will be attracted to demutualization, where profits can be directed to investors or insiders. But for the rest, democratic governance and profit distribution according to usage sews the seeds for one of the biggest frustrations of the cooperative business model: access to affordable financial capital for growth and investment.

Democratic governance and profit distribution according to usage sews the seeds for one of the biggest frustrations of the cooperative business model: access to affordable financial capital for growth and investment.

As a result, cooperatives have been “dancing” with capital in several ways:

Requiring members to supply paid-in capital

The purest way to assemble paid-in capital is to get it from members. Purchasing co-ops, closed membership co-ops, secondary co-ops (corporate CUs in the credit union sector) and more capital-intensive start-ups typically require sign-up investments or capital shares that are a function of size. Corporate CUs have paid-in capital formulas based on the size of the member credit union and grocery co-ops often require a joining fee of a few hundred dollars.

Consumer co-ops don’t generally set high paid-in capital requirements. Competitive circumstances and the desire to expand membership make paid-in capital requirements unworkable. In some cases, annual membership fees augment member paid-in capital. Rarely is paid-in capital obtained from members sufficient to handle all (or even a significant part) of operational capital needs. A Virginia grocery co-op recently took more than four years to assemble enough member paid-in capital to get the doors open.

Growing slow and withholding profits from distribution

The most prevalent method of co-op capital accumulation is essentially profit retention in the business. It takes years to build scale to the stage where internal profit generation is sufficient to propel the business. As such, start-up expenses and early-stage scale-up costs cannot be covered by internal profit generation alone.

Co-ops create balance sheets from their operations. Assets are supported by debt (including deposits at credit unions) and equity. The suppliers of debt rely on the equity to protect them from losses during the tough times. They have limits to the amount they are willing to supply based on the ratio of debt to equity (leverage). And, as leverage increases the suppliers will generally expect higher returns (interest) as compensation. When the suppliers of debt (depositors at a credit union, for example) are protected from loss (by deposit insurance), government steps in with regulation and supervision to limit leverage.

Credit unions are limited to leverage of 10-12 times equity. Deposit growth is confined by annual earnings. If profit equates to, say, 1 percent of assets, credit union growth is effectively limited to about 10 percent per year. Other co-ops face similar growth limitations, usually imposed by private sector creditors. In many cases, co-ops can avoid taxes by declaring patronage dividends equal to total earnings. Since members have to pay taxes at the receiving end, co-ops typically pay out 30-40 percent in cash. The other portion is credited to non-voting stock. This is suboptimal because the co-op can only use 60-70 percent of its earnings for investment over time and the absence of a secondary market for the members’ stock creates pressure for eventual redemption.

Obtaining long-term (ideally subordinated) debt

Assuming there is a sufficient capital cushion or that there are patient, mission-driven investors (or likely both), it is possible to imagine attracting long-term debt to finance growth oriented investment at the co-op. This form of “capital” can be especially helpful if it is willing to be subordinated to the claims of all other debt. Normally, subordinated debt investors expect to receive a high rate of interest and have a say in decision-making if key performance ratios fall short (via covenants).

In the co-op world, sub-debt would be less likely to alter democratic governance than equity. And it is possible to envision long-term debt arrangements that are provided and/or supported by government, foundations, or mission-driven companies/individuals.

Obtaining non-member equity investment

There’s a basic principle that most institutional investors embrace—equity gets a voice. If a co-op attracts non-member equity or even proposes to attract disproportionate equity from members, structural or de-facto proportional voice will be difficult to avoid. And at least some of the profits will have to be apportioned based on equity investment stakes. To the Rochdale Pioneers and many present-day co-op leaders, this is the place where a co-op stops being a co-op.

Notwithstanding, the concept of a multi-stakeholder co-op has emerged onto the scene as co-ops struggle with ways to raise affordable and sufficient capital. For example, baby-boomers are nearing the stage in life where they would like to exit their businesses as they slide into retirement. Many would like to leave the business in the hands of the long-loyal employees. But they also desire to be paid out for the equity that has been created over the years. Worker co-ops would be a great transition destination for these businesses. But workers are rarely in a position to raise the necessary funds to make an acceptable offer. Enter the multi-stakeholder co-op.

Multi-stakeholder co-ops have been designed to combine the ability to have cooperative stakeholders and investor stakeholders.

Multi-stakeholder co-ops have been designed to combine the ability to have cooperative stakeholders and investor stakeholders. So far, governance has been tilted toward the cooperative element. Usually, the plan is to pay out the investors over time and return the co-op to full democratic governance. Others see this as a more permanent form of structure. In any case, attracting non-member paid-in equity is complicated, at best. With enough pressure from investors, it could end up being another path to demutualization.

Recirculating surplus co-op capital

All of the considerations above are within the realm of individual co-op decision-making. Another way to think about dancing with capital would be to view it as circulating capital within the co-op community, not sourcing it from the outside. This would require wide-spread collaboration. Many of the large co-ops have enough capital that they could allocate a small sliver to a common capital pool that could be used to provide patient debt (or equity) to co-ops that need it. Or perhaps they could collectively create a loan guaranty system that could be leveraged with affordable debt.

Another way to think about dancing with capital would be to view it as circulating capital within the co-op community, not sourcing it from the outside.

The borrowers would have to be vetted well. A poor business model doesn’t work—no matter the structure. Technical assistance would have to be a part of the deal. But it is plausible to imagine that the co-op system could create a capital facility that would dramatically improve the affordability and sustainability of capital resources. In northern Spain, co-ops have a complete entrepreneurial support system that includes affordable access to capital. In Italy, co-ops are required to set aside 3 percent of their profits to support co-op development (in return for tax preferences). In the U.S., wherewithal exists to create a capital recirculation capability that sufficiently and safely rewards the capital suppliers.

Never happen? A bridge too far? Entrepreneurs have already started to assemble the pieces. Today, co-op leaders are having dialogue about collaboration to enhance capital sourcing for co-ops. Literally, today.

Co-ops can dance with capital.

Stay tuned,
Mike

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