Five Questions to Ask
Before Joining A New Processing Cooperative
EC-1108, July 1996
Frayne Olson, Assistant Director
Quentin Burdick Center for Cooperatives
New venture processing cooperatives are structured differently than traditional farm
supply and commodity marketing cooperatives. These new co-ops focus on processing and
marketing processed products rather than input supply and marketing of raw agricultural
commodities. They require members to deliver commodities through marketing contracts, tie
delivery rights to the purchase of equity stock in the co-op, and limit the amount of
equity stock to a level which is sufficient to ensure peak use of its facilities.
A combination of factors make a new venture processing co-op membership decision
complex. The following questions should help you make an informed decision.
I. What are the potential returns from cooperative membership?
This question is more difficult to answer than it first appears. New venture
cooperatives typically return financial benefits to members in the form of net returns
from operations (cash and retained refunds) and equity stock appreciation. These benefits
are received at different times in the future. The difference in time from the initial
investment until the receipt of returns should be accounted for by using a net present
value analysis. This process accounts for the time value of money which reduces the value
of future cash inflows because they are not available for use today. An example of a net
present value analysis is included.
The cooperative's prospectus, which is a summary of the business plan, should provide
most of the information needed for a net present value analysis. However, an appropriate
discount rate must be selected. There are two common approaches used to do this. The first
is to select a discount rate which is equal to the next best use of money, usually equal
to the highest interest rate that you are paying on debt capital. The second is to select
a discount rate which represents a desired rate of return. This second approach has
advantages because it allows you to include the risks surrounding the cooperative business
and your equity investment. The rule is, the greater the risk, the higher the discount
rate.
II. What risks are the cooperative business exposed to?
Risks are commonly divided into two broad categories. The first category is business
risks. These include construction and operating risk, market and price risk, technological
risk, legal and social risk, and human risk. Most of these business risks have
straight-forward explanations. However, human risk is commonly underemphasized. Human risk
relates to selecting and maintaining high quality labor, management and board of
directors. The people who are involved with the co-op are the ones who make it successful.
The second category is financial risk. Financial risk is the increase in business risk
caused by debt financing. These include the availability of borrowed capital, credit
terms, and changing interest rates. Financial risk may not seem as large as business risk,
but the ability to adjust to business risk by using borrowed capital can have a great
impact on the co-op's ability to succeed.
Both business and financial risks should be incorporated into the selection of an
appropriate discount rate, and be included in your co-op membership decision.
III. How will cooperative membership influence your farm/ranch operation?
Cooperative membership can influence your farm/ranch production, marketing and finance.
Many new venture co-ops develop recommended production practices for their members so that
the co-op will have a consistent, high quality supply of commodities. Some of these are
mandatory; while others are voluntary. Some practices are very simple to implement and
relatively low cost; others are more complex and costly. It is important to consider both
direct costs and indirect costs to your other farm/ranch enterprises before making changes
in production practices.
In most cases, the responsibility for profitably marketing the commodity is turned over
to the co-op though its processing activities. It is important to understand how and when
you will be paid for the commodity you deliver. It may be necessary to adjust the
marketing of your other commodities or short term borrowing to adapt to the co-op's
payment schedule. You should also understand what will happen if you cannot deliver the
quantity or quality of product which is listed in the co-op's marketing agreement. Some
co-ops have developed marketing pools which can be used to fill shortfalls. Other co-ops
require that you purchase the commodity from alternative sources.
There are both long-term and short-term financial impacts on your farm/ranch from co-op
membership. The long-term impacts can be captured by preparing two whole farm budgets. The
first budget should represent business as usual, without co-op membership. A second budget
should include co-op membership. A comparison of the two budgets will show the projected
long-term impact on net farm income, change in net worth, and long-term cash flow. These
are three of the most important measures of the farm/ranch financial health.
It is not unusual for a new venture co-op to take several years of operation before
positive net returns are realized and returned to its member/patrons. It is critical that
the farm/ranch be able to meet all of its financial obligations during this time. A
short-term cash flow projection will show if this is possible.
IV. How will my lender view the cooperative investment?
It is important to discuss co-op membership with your lender regardless of whether your
membership investment is self-financed or debt-financed. Any significant change in your
farm/ranch operation should be reviewed with your lender to maintain good working
relations.
Your lender will have many of the same questions about co-op membership that have
already been discussed. However, your lender may also want to know how possible co-op
losses will be distributed and how easily membership stock can be transferred. These
additional questions will help your lender determine the maximum loss potential and co-op
stock liquidity. The answers may influence loan terms, as well as collateral levels and
sources.
Some lenders have developed special loan programs which meet the unique needs of new
venture co-op membership, while others rely on traditional lending practices. In either
case, loan terms and collateral sources and amounts should be thoroughly discussed to
reduce the potential for future financial problems.
V. How will cooperative membership impact my personal and business goals?
One of the most commonly cited personal benefits of co-op membership is the ability to
have a voice in the operation of the business. Some farmers and ranchers list this as one
of the main reasons they became a member in a co-op.
Potential community economic benefits and increased job prospects are also reasons for
becoming a co-op member/investor. Even though these are important reasons, you should
consider whether the co-op will locate within your community. It is also important to
understand that not all of the economic impacts on a community are positive. Some
communities have found that increased populations have put a strain on existing water,
sewage, fire fighting, police, medical services, and schools. An expanded job market may
also increase competition for labor and put additional financial pressure on existing
businesses.
The desire to assist the next farming/ranching generation is another factor which is
commonly given for new venture co-op membership.
Summary
This has been a very brief review of some of the many issues which can play a role in a
new venture cooperative membership decision. An expanded discussion of these and other
related topics are available through Extension Bulletin #67, Should I Join A New Processing Cooperative?
A Net Present Value Example
A new venture processing co-op is requesting a $200 common stock, or membership fee,
plus a minimum purchase of 500 shares of preferred stock, at $20 per share. Each share of
stock allows for the delivery of one unit of commodity to the co-op for processing. This
results in a minimum total investment of $10,200.
Table 1 lists the projected per-unit net return and percent cash patronage refund for
the first five years of the cooperative's operation.
Table 1. Projected per-unit co-op net returns and cash
patronage refund.
---------------------------------------------------------------
Year 1 Year 2 Year 3 Year 4 Year 5
---------------------------------------------------------------
Per unit net return $-1.50 $-0.50 $1.00 $2.00 $3.25
Cash patronage
refund 20% 40% 60%
---------------------------------------------------------------
OTHER KEY ASSUMPTIONS:
Planned length of investment: 20 years
Retained refund redemption: 10 year revolving basis, with balance redeemed when
membership ends (death or stock transferred to another producer)
Estimated sales value of stock in year 20: $32,500
Marginal income tax rate: 30%
Discount Rate: 8%
The insert provides a net present value analysis of this
example. A brief discussion of the calculation process and results are included on the
back.
EC-1108, July 1996
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