How Co-ops Raise Capital

How Co-ops Raise Capital

An overview of funding sources for cooperative start-up and development

If you are starting or developing a cooperative, you have probably noticed that cooperatives do not use the same approach to capital-raising that standard businesses do. The standard approach–selling a slice of a profitable business to investors–is not easily available for cooperatives. But, there are also capital-raising strategies available to cooperatives that are not available to standard profit corporations.

Cooperatives are democratically owned and governed by their members, and exist to serve their members by providing goods or services, helping members sell their goods or services, or providing a workplace for worker-members to provide service and receive wages. Cooperatives are a social business form. The cooperative form has more potential to heal social relationships and ecosystems than investor-owned business forms, because of the incentive structure and the way decisions are made. We will all benefit from the presence of more and bigger cooperatives. To create this growth, it is important that cooperatives receive adequate funding. 

When any enterprise is getting started, it usually must raise start-up funding from multiple sources. Amounts from different sources add up to what is called a “capital stack.” 

In a cooperative, the capital stack often looks like this:

*CDFI – community development financial institution.

Q: Where does capital for cooperatives come from?

Potential sources of capital for cooperatives include:

We often see some non-member investment in a capital stack. (The term “member” has a technical legal meaning, but in this blog post, “non-member” just means someone who does not use the cooperative’s services.) Non-member investors often provide a layer of funding that serves as the bridge between the initial member investment and an institutional loan. In certain cases, cooperatives have done larger private or public capital raises to meet their full funding needs.

Q: Why do cooperatives seek funding from non-member investors?

Members often cannot provide all of the necessary start-up capital themselves. They must rely on other sources before they can get a CDFI or bank loan. Sometimes these institutional lenders require a co-op to raise other capital first. Some types of cooperatives are small by nature, including most worker cooperatives. For this reason, members need help from outside capital that is friendly and patient.

Q: What can a cooperative offer to outside investors?

This is a difficult question for cooperatives because of the nature of doing business on a cooperative basis. Cooperatives exist to benefit members by doing business with those members. The goal in organizing a cooperative is to provide goods that were not already available in the market, or to help producers sell their goods and have more market access collectively than they would separately, or to operate a business through which members can provide services and receive wages. In general, the goal of a cooperative is to operate at cost, maintaining only a necessary reserve, and return all surplus to members. A cooperative’s goal is not to accumulate profit for itself or for investors. It is typically not seeking to be acquired by another company. This means cooperatives cannot approach capital-raising the same way that founder-owned businesses do.

However, many cooperatives can and do provide reasonable, non-extractive returns to investors. Cooperatives can be a meaningful way for “impact investors” to put their investment dollars to good use, and potentially receive a reasonable return on their investment.

At Cutting Edge, we regularly help cooperatives prepare capital campaigns. Here are a few types of investments that a cooperative can offer:

  1. Redeemable, non-voting preferred stock with a dividend that is a percentage of the original amount invested. Generally the investor will have to hold the stock until the cooperative has cash available to buy it back.
  2. Revenue-share debt or equity. In a revenue-share instrument, the cooperative will set a total repayment price, which is a multiple of the original investment amount (such as 1.5x–it generally does not need to be a high multiple for impact focused opportunities). Then the cooperative uses a specified portion of its top-line revenue to make payments to the investors over time. If the instrument is debt, those payments will be part interest and part repayment of principal. If the instrument is equity (stock), those payments will be part dividend, and part repurchase of the stock. When the full repayment amount is reached, the debt is repaid, or the stock is repurchased. The variable that affects investor returns is the speed at which the enterprise can increase its revenue.
  3. Debt. Asking investors to lend, and promising repayment of principal with simple interest, is a good option for cooperatives who want to keep it simple. Before planning to take on debt, though, cooperatives should plan ahead and determine what later investments they will need. Debt on the balance sheet can deter later investors, especially institutional lenders, so we want to make sure the cooperative will have adequate equity before adding debt.

Q: If we have “outside investors,” is it still a cooperative?

Yes, as long as the members democratically govern the cooperative, and as long as the total design of the cooperative’s finances will primarily return surplus to members, in proportion to their use of the cooperative’s services. 

All enterprises, including cooperatives, have to pay the cost of capital. For example, cooperatives can borrow from a bank and pay interest. The cost of interest takes away from the surplus that would otherwise be available for members as patronage dividends. However, the bank loan does not make the organization any less cooperative.

We can think of non-voting shareholders in a similar way. They may have approval rights over certain decisions that would affect them, such as dissolving the cooperative. But we always give preferred stock minimal or no voting rights–outside investors do not play any meaningful role in governance during normal operation. Preferred shareholders receive a dividend (when cash is available), but after that dividend is paid, the rest of the cooperative’s surplus can be returned to members. Some cooperative purists say that cooperatives should not have outside investors, but if a cooperative needs equity capital in order to succeed, we would like to see that equity capital come in, from supportive, non-voting investors.

Successful Examples:

Food Shed Co-op, a start-up food cooperative in Illinois, is in the middle of a capital raise now, and has reached over $1 Million of its $1.75 Million goal, in a combination of debt and non-voting equity. This raise will allow this cooperative to open a community-owned grocery store featuring local products.

Bay Area Ranchers’ Cooperative raised over $300,000 on WeFunder to build a mobile, rancher-owned, responsible meat harvesting facility, so that Northern California ranchers will no longer have to drive to the few, far-away processing facilities.

Switchgrass Spirits is a worker-owned distillery in St. Louis, Missouri. Early private investors supported the start-up phase by investing in non-voting equity and debt. Thanks in part to these early investors, spirits sales are now growing quickly.

If you would like help designing a capital raise for a cooperative, or if you have questions about cooperative formation, feel free to get in touch for a free consultation


Lower Your Taxes with Economic Democracy

Lower Your Taxes with Economic Democracy

Many business people know that S corporations and limited liability companies (LLCs) are tools to skip tax on a business’s income. But did you know that Subchapter T allows certain enterprises to benefit from the corporate form AND pass profits through to members tax-free?

Subchapter T of the Internal Revenue Code[1] allows qualifying corporations to subtract “patronage dividends” from the corporation’s taxable income. Patronage dividends are NOT dividends on stock, despite the confusing use of the same word. Patronage dividends work like this:

The enterprise does business with patrons: selling to them, buying from them, and/or employing them and making profit through their labor. Then the profit is shared among the patrons in proportion to the quantity or value of business each patron did with the enterprise.

This arrangement is appropriate for worker-owned business, and potentially any type of enterprise that shares its profits with its customers, users, or suppliers in a meaningful way. This arrangement will NOT work for any business that wants to return profits only to investors.

How to qualify:

First, the business must be “operating on a cooperative basis.”[2] This means:

  • Most transactions are with “patrons.” Patrons are people with whom there is a pre-existing, legally binding agreement to share profit. Patrons could be customers, suppliers, and/or workers.
  • Most profits are returned to the patrons. The profits of investors, if any, cannot take precedence. The business may have loans and outside investors, and it may pay its investors first, but benefiting patrons must be the primary goal.
  • The corporation must be democratically controlled by its members. This generally means one member, one vote. Members cannot give control away to investors. The business can be run by a board and managed by managers, but they are ultimately accountable to members.
  • Profits must be shared with patrons on the basis of patronage, which means in proportion to the quantity or value of business each patron does with the enterprise.

Next, the patronage dividend must meet all of the tax code’s requirements. Here’s a summary of how to do that:

  • Patronage dividends must come from “patronage net income,” which derives from business done with or for patrons. Patronage dividends cannot come from “profit” from business with non-patrons.
  • Patronage dividends must be allocated on the basis of relative patronage – again, in proportion to the quantity or value of business each patron transacted with the co-op.
  • The patronage dividend must be paid in cash, or a specific type of written notice of the patronage dividend must be given within 8 ½ months after the close of the fiscal year, and at least 20% of the dividend must be paid in cash no matter what.[3]

If all of these requirements are met, the business can subtract all of the patronage dividends from its own taxable income.

How this is the best of both worlds:

Corporations offer certain advantages. When members come and go from an LLC, the accounting can be complex and thus expensive. Corporations make it much simpler.

A member’s income from an LLC might be business income, and might be self-employment income. The member might need to do quarterly estimated tax payments, and complete Schedule C on their tax return. The member might need to file a tax return in another state, if the LLC operates in one state and the member lives in another. On the other hand, receiving a 1099-PATR from a corporation, and a W-2 in the case of a worker, are much easier to deal with on the member’s personal tax return.

The income of an LLC or an S corp “passes through” to members and becomes part of the members’ taxable income … even if the business needs to build a reserve. This is the “phantom income” problem; LLC and S corp owners must pay tax on money held in reserve, even if they do not receive the income in cash. Members must pay tax out of pocket, or the business must carefully pay out to each member just enough for the members to pay their taxes. In a corporation using Subchapter T, only the corporation pays tax on income that is kept in reserve.

A democratic corporation enjoys these conveniences, AND it is a pass-through entity to the extent that its income comes from transactions with “patrons” and it shares that income with the patrons on the basis of the relative value each patron contributed.

Please note that there are some reasons that a worker-owned business, particularly a startup, would not want to organize as a corporation right away; I would be happy to explain those reasons via email or over the phone.

If you read to the end, you may have noticed that this article is about the tax advantage for cooperatives. I love Subchapter T and can talk about it all day.

Cutting Edge also supports cooperatives by helping to design structures that meet their goals, providing legal documents, and consulting and legal documentation for raising capital. We also help retiring business owners sell businesses to their workers. If you have a legal or funding question about a cooperative, let us know about it by clicking here or emailing us at info@cuttingedgecapital.com.

 

[1] I.R.C. §§ 1381 – 1388.

[2] I.R.C. § 1381(a)(2).

[3] I.R.C. §§ 1382(b)(1) , I.R.C. § 1388(a)(3).

WEBINAR REPLAY: Capital Raising Strategies for Cooperatives

WEBINAR REPLAY: Capital Raising Strategies for Cooperatives

Cutting Edge Capital is partnering with Project Equity to provide a free webinar outlining the creative ways that cooperatives can raise capital. Kim Arnone & Sarah Kaplan will discuss how cooperatives can utilize Direct Public Offerings (DPOs), California Cooperative Corporation Law, and Title III JOBS Act crowdfunding to fund their cooperative venture.

 

Memberships as Securities

Memberships as Securities

In 1959, some enterprising developers bought land in Marin County to develop a country club.  To pay for some of the costs of building the club, they sold charter memberships in the club.  The members would not share in the profits or ownership of the club but would have the right to use club facilities.

Under the federal definition, these memberships would not be securities because the members joined the club to get the benefits of membership, not for a financial return.

But the California Supreme Court, in a landmark case called Silver Hills Country Club v. Sobieski (1961), found that these memberships are securities.

The court formulated a new test for whether something is a security, called the “risk capital test” which considers

(1) whether funds are being raised for a business venture or enterprise;

(2) whether the transaction is offered indiscriminately to the public at large;

(3) whether the investors are substantially powerless to effect the success of the enterprise; and

(4) whether the investor’s money is substantially at risk because it is inadequately secured.

This test is used by many states.

What does this mean for coop memberships?

Memberships in an existing coop that is adequately capitalized would not be a security under the risk capital test because the funds are not “being raised for a business venture.”  However, memberships in a start-up coop where memberships are needed to pay for start up-costs would likely be considered securities.

California has an exemption for the sale of coop memberships for less than $300.  It would be risky to offer memberships in a coop in California for more than $300 if the membership revenue us going to be used for the development of the business.

Worker coops in which the workers are actively involved in management should be able to avoid this problem because the members are not “substantially powerless to effect the success of the enterprise.”

In People v. Syde, the court said the California securities law “was not intended to afford supervision and regulation of instruments which constitute agreements with persons who expect to reap a profit from their own services or other active participation in a business venture.”