In addition to institutional and member capital, modern cooperatives increasingly tap external sources to fund their operations or to finance investments. Nonmember sources of capital may include cooperative or commercial banks, suppliers, government or donor agencies, and even investor-owed companies and capital markets.
External funding may be obtained in different ways. Commercial providers of funds such as banks generally provide credit that is legally secured by collateral consisting of cooperative assets (which then become bank property in the event that the loan is not repaid). These lenders are motivated by profit and seek to minimize risk. Non-commercial providers, such as governments or donors, provide grants or credit on more generous terms below market rates of interest. Their motivations may be social, political or economic, or a mixture of all three.
Short-term loans are the most common type of funding obtained by cooperatives. Well run cooperatives have commercial borrowing power that can be tapped on a seasonal basis to finance members through production loans, and to finance storage and processing of commodities that will be sold before the next season. The season’s sales proceeds are used to repay the commercial loan.
Medium or long-term loans may be more difficult to obtain. The confidence that lenders have in the cooperative’s operations, market niche and management, determine its ability to attract longer-term loans. The conditions that create confidence usually include a loyal membership base. The matching principle in finance suggests that longer-term funds are usually best used for assets that have longer lives. Exceptions may include special situations and opportunities, such as exceptionally low market rates of interest.
Suppliers often offer credit in order to gain business. These loans may be short term, against grain in storage, for example, or longer term, based on the economically useful life of equipment bought from the supplier. This form of finance is convenient and common, but cooperatives should also look at other sources of financing. The real cost of interest in the supplier’s proposition may be hidden, making it difficult to compare the combined offer with separate costs of cash purchase from the supplier and financing from another source.
As with member capital (as explored in Box 2) outside funding has advantages and disadvantages. These are summed up briefly in Box 5. In addition to the pros and cons that characterize equity funding, borrowing money involves certain tradeoffs between risks and returns. The added risks are those of not being able to repay and as a result losing control of the business. The returns, on the other hand, are those created by having more capital to finance activities so that operating efficiency is increased, or to expand the cooperative’s range of services.
Advantages and disadvantages of external borrowing are based on the perspectives of the involved stakeholders - member-users of the cooperative’s services, member-suppliers of capital, and management - which may coincide or may differ significantly.
Box 5 Advantages and disadvantages of external borrowing by commercial cooperatives
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Member - Users |
Member - investers |
Cooperative Management |
|
Advantages |
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|
Source of growth and productivity in order to supplement and increase member capital |
Source of growth and productivity supplementing member investment and returns |
Source of productivity and growth, creating opportunities for
more economic operations and flexibility in business strategy; |
|
Disadvantages |
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|
Repayment risk; creates claims having priority over members’ claims |
Repayment risk; creates claims having priority over members’ claims |
Risk that loan conditions or covenants restrict managerial
flexibility; |
Equity is defined as funds that do not have to be repaid. Equity is permanent capital, in contrast to debt that has to be repaid and therefore has a limited life. Equity capital belongs to owners, and may be liquidated only if the enterprise itself is liquidated, as in bankruptcy. Institutional capital, discussed earlier, is a form of cooperative equity, as are grants and some commercial forms of capitalization. (Incidentally, where cooperative practice includes share redemption when a member leaves the cooperative, this should not be considered as equity but rather a form of long-term debt without a specific repayment date.)
Grants are a source of traditional cooperative equity held collectively, that is not allocated to members’ accounts, as is the case with institutional capital. Grants may come from a variety of sources including government subsidies, foundations or foreign assistance. As noted previously, this source of support can create dependency, may encourage inefficiencies, and is diminishing. For all practical purposes, grants should no longer be counted on as a way of gaining access to long-term funds.
Grants and subsidies that are obtained are often most usefully employed in ways that diminish dependence and set the stage for higher levels of commercial operation, keeping pace with increasingly competitive markets.
Equity is also provided by outside investors seeking a return on their investment and ownership control. Investors are attracted to cooperatives through new forms of collaboration. The investment vehicles that are used may attract equity capital directly into a cooperative or provide access to funding linked with other forms of enterprise, often investor-owned firms. In addition to access to capital, cooperatives are motivated to establish these links by faster decision-making and lower transaction costs, control of marketing channels, and efforts to retain features of the cooperative promise where competition is intense.
Equity investors do not take collateral because they have some degree of direct control over business decisions through their voting power. They may also use contracts to define control and decision-making powers in those cases in which there are different classes of shares or in joint ventures.
Where cooperatives have difficulty attracting outside capital, the reasons may include:
inefficiencies that are unlikely to be overcome simply by access to capital,
flawed governance, as when managers’ or owners’ personal motives are not consistent with sound business operation,
lack of transparency through incomplete or faulty record-keeping and disclosure, which makes it difficult to value the business and determine its debt capacity, and
small size, which means that outsiders’ transaction costs may be high relative to the amount of the loan or equity that they might provide.
Those controlling capital and its flows want to earn a return. They are willing to bear risk if they think they understand it and can to some degree manage it. They may have to meet certain standards that are required by regulators, or expected by society, or self-imposed in efforts to specialize, or to assert their business values.
As outlined below, those working with cooperatives have devised two specific types of arrangements to engage outside capital. Each type has several variants, which respond to the flexibility of private capital markets. Examples are provided in Annexes 1 and 2.
Investor-share cooperatives: attracting investment not related to patronage
Investor-share cooperatives are hybrids. They issue traditional cooperative shares to members, but also sell equity shares to investors who are not members. In some cases, non-voting equity shares are issued, which keeps decision-making within the cooperative.
Cooperatives with capital-seeking entities: access to outside equity that remains outside the cooperative
Cooperatives that want to retain member control while obtaining additional equity capital may establish a separate legal entity for this purpose. This may be a strategic alliance, a trust company or a subsidiary organized as a joint stock company. The use of outside entities may be directed at gaining control of upstream or downstream parts of the food chain. (In addition to these two structures that attract outside capital, some New Generation Cooperatives have also allowed non-member investors to own stock.)
