Bill Fitzwater Cooperative Chair
Oklahoma State University
In my last newsletter I commented on increasing portion of cooperative equity held as unallocated reserves. The cooperative financial model has many moving parts and unallocated equity has numerous roles and implications. Cooperatives need unallocated reserves because they redeem equity at face value. In the absence of unallocated reserves, a cooperative would be forced to write down stock value in any year they sustained a loss. That leads to the recommendation that a cooperative should have sufficient unallocated reserves to cover one or two years of loss. Another thumb rule for “adequate” unallocated reserves is an amount equal to regional equity. The rationale for that criterion is that bankruptcy or stock write downs from the regional cooperatives would not force the local cooperative to write down stock. Most regional cooperatives are currently in very strong financial condition. Maintaining unallocated reserves for regional stock write downs looks a little bit like eternally preparing to re-fight the last war.
While there is unarguably a role for unallocated reserves there are numerous myths or misconceptions surrounding this topic. One rationale for retaining member profits as unallocated reserves is to create permanent capital. Cooperative firms constantly create (retain) and destroy (redeem) equity, and this structure is unique to the cooperative business model. That structure creates the need for cooperatives to actively manage their balance sheet. Balance sheet management involves discipline to establish targets for debt/equity levels, working capital and cash flow and then adjust cash patronage and equity retirement within those constraints. The rationale for permanent equity is that the board and managers do not have the discipline for balance sheet management and may allow equity redemption to override balance sheet targets. In reality, allocated equity can be as permanent as necessary. The issue is not the characteristic of the equity class but rather the discipline in managing the balance sheet. There are also other strategies to create permanent or at least semi-permanent equity including increasing the cost of membership stock, selling preferred stock or redeeming equity in the form preferred stock.
It is the permanent characteristic of unallocated reserves that creates the incentive for liquidation and the decrease in the member’s rate of return. Cooperatives need appropriate levels of equity and working capital. Creating permanent capital or managing revolving capital are both tools to maintain the target balance sheet structure. If the choice criteria is maximizing the return to the member and preventing the liquidation of the cooperative, managing revolving capital is the better choice.
In my next newsletter I will discuss the interactions of unallocated reserves and the revolving cycle of allocated equity.