Perspectives on Cooperative Finance Cooperative Strategy, Structure and Finance

1. Perspectives on Cooperative Finance Cooperative Strategy, Structure and Finance Farmer Cooperatives Conference November 19, 2008 St. Paul, Minnesota

2. Session Agenda: Three Panels 8:00 a.m. Cooperative Finance: Principals versus Practice David Barton Chris Peterson 9:00 a.m. Equity and Capital Management Strategies Doug Derscheid Tom Houser 10:00 a.m. Break 10:15 a.m. Legal Challenges and Solutions Three Attorneys 11:00 a.m. Closing Session

3. Principles versus Practice: David Barton • Principles of cooperative finance: what (most) experts agree on • Practices of cooperative businesses: the good, the bad and the ugly • Point and counter-point: experts and practitioners will disagree • Your questions

4. Five General Recommendations: A Preview • Co-ops must be competitive • Co-ops should make as much profit as possible • Co-ops should use balance sheet management • Serving core customers comes first • Finance, strategy and risk management should be integrated

5. Five Specific Recommendations: A Logical Process • Make profitable asset investments • Finance assets with sufficient equity • Choose equity structure, equity investments and income distribution strategies most beneficial to patron-owners • Equity structure: source, ownership rights, permanency, classes • Purchased versus earned equity • Allocated versus unallocated • Qualified versus nonqualified • Calculate a redemption budget using balance sheet management • Divide redemption budget among owners using preferred redemption methods (programs)

6. Principles of Cooperative Finance: What (Most) Experts Agree On • Co-op business model • Finance decision framework • Income distribution • Strategic choices • Model and process • Equity management • Strategic choices • Model balance sheet management process

7. Cooperative Business Model: Focus on Benefits and Responsibilities A cooperative is a business operated primarily to provide benefits to members through marketing transactions and through a distribution of patronage earnings from these transactions; in return, members have a responsibility to provide ownership capital and exercise member control (governance).

8. Four Unique Roles RolesFunctionAction • Customer Marketing or Buy/Sell Profit Generation Transactions 2. PatronProfit Distribution Patronage Refunds Per Unit Retains 3. OwnerOwnershipInvestment &Redemption 4. MemberControlVote Which role is predominant in members’ minds? Most say the customer role is predominant. Serving customers is the end and the roles of patron, owner and member are means to the end. Challenge: Inherent conflict of interest between customer, patron and owner roles.

9. Finance Decision Framework Finance involves making three critically important and interrelated decisions: • Investment decision • Assets needed to support business strategy • Expected income and risk • Financing decision • Debt and equity to finance assets • Expected income, cost and risk • Income decision • Distribution of income to patrons and owners as cash or increased ownership • Expected investment and financing needs

10. Finance Decisions and Interrelationships 1. Investment • Assets 2. Financing Balance Sheet • Liabilities or debt • Equity • Investment • Redemption 3. Income • Generation Income Statement • Distribution Challenge: Access to equity capital - most co-ops get almost all equity investment by retaining some of the income generated by operations.

11. Balance Sheet Issues • Asset Investment • Total assets, intended growth rate • Asset type, profitability and risk • Regional Investment • Joint venture investment • “Local” current and fixed assets • Debt and Equity Financing • Liquidity: Working capital • Solvency: Equity to assets & debt to equity • Equity Structure • Allocated: three basic types (redemption expectation) • Permanent: NGC Stock or Preferred Stock • Semi-permanent: Common Stock • Revolving: Retained patronage refunds • Unallocated: permanent retained earnings • Non-permanent co-op equity is like debt! Owners expect redemption. Philosophy: (1) Use proactive Balance Sheet Management (2) Protect the co-op, then redeem excess equity

12. Income Statement Issues • Income Generation • Revenues – Expenses = Total Income • Income Distribution • Non-patronage income (“non-member”) • Dividends on stock • Retained earnings (unallocated) • Income taxes • Patronage income (“member”) • Qualified • Cash patronage refunds • Retained patronage refunds • Per unit retains • Nonqualified • Dividends on Stock • Retained earnings (P) • Retained patronage refunds (NQ) • Per unit retains (NQ) • Income taxes Philosophy and Challenge : (1) Be competitive, make as much profit as possible (2) Choose income distributionalternatives that maximize benefits to patron-owners

13. Model Co-op: Case 1 (S1) 2007 Income Statement (“annual flow”)

14. Income Distribution: Four Selected Strategic Choices • Patronage income allocation goal: high customer-patron ownership (high allocated) versus high retained earnings (high unallocated or low allocated). • Patronage income distribution by source: allocated versus unallocated • “Local” operating income • Regional (other) cooperative income • Other income (investment, etc.) • Patronage refund taxability to co-op: qualified versus nonqualified. • Qualified cash patronage refund rate

15. “Pure Co-op”

17. Equity Management:Six Selected Strategic Choices • Asset growth trend: high, low, none or negative • Liquidity target and resulting trend: high, moderate or low • Solvency target and resulting trend: high, moderate or low • Equity structure: • High allocated versus high unallocated • Many allocated equity classes versus few (especially applies to mergers)

18. Equity Management: Six Selected Strategic Choices • Redemption budget: First manage the balance sheet, then determine budget and redeem “surplus” equity versus first manage patron accounts with set targets like AP/O age or RF length to determine budget • Redemption program and methods: • High proportionality of investment (AP/P, RF, BC) versus other goals (AP/O, PP) • Simple program versus complex program for each equity class • Same program for all equity classes versus unique program for each class

20. Equity Capitalization Classes • Allocated: Permanent or Semi-Permanent • Common Stock • Preferred Stock • Allocated: Revolving • Retained Patronage Refunds/Per Unit Retains • Qualified • Nonqualified • Allocated co-op equity is like debt! It should be serviced through the redemption program. • Unallocated: Permanent • Retained Earnings

21. Equity Capitalization Alternatives Balance sheet management assumes all equity is permanent until authorized for redemption.

22. Capital Structure Factors: Debt versus Equity

23. Capital Structure Choice Matrix Risk Profitability If agricultural local co-op Conclusion: Risk has increased, implying need for higher working capital (liquidity) and equity (solvency), even though profitability has also increased.

24. Equity Management Process: Balance Sheet Management Equity management involves making five critically important and interrelated decisions: • Determine income generation and income distribution • Determine desired assets • Determine desired financial structure • Liquidity: Cash, Working capital, Current ratio • Solvency: Equity to assets, Debt to equity • Determine desired equity investment and structure • Determine desired equity redemption • First, manage balance sheet: Total redemption budget is “surplus” equity • Second, manage patron accounts: Redemption program distributes budget. • Don’t let the tail wag the dog! Philosophy: Protect the company; owners get what’s left over. Challenge: Implement balance sheet management philosophy.

29. Equity Redemption Methods • SP: Special (estate settlements, etc.) • AP/O: Age of patron - oldest first • AP/P: Age of patron - prorate • PP: Percentage pool • RF: Revolving fund • BC: Base capital Challenge: Select the combination of redemption methods for each equity class that provide the right balance between (1) simplicity, (2) highest proportionality of investment and (3) highest cash flow to patron-owners.

30. Implications of Model Co-op Analysis Biggest driver of equity management performance is profitability. Cash flow to patron-owners varies little with alternative patronage income allocation strategies. High, medium and low patronage income allocation strategies are all sustainable if growth rate is linked to profitability and cash flow. You can’t enjoy a champagne diet on a beer budget.

31. Four Cornerstones of Financial Success • Be a profitable business • Manage income generation • Return profits to patrons • Manage income distribution • Provide sufficient equity financing • Manage balance sheet • Require patron equity investment proportional to use • Manage patron equity accounts

32. Practices of Cooperative Businesses: the Good, the Bad and the Ugly • Top three good innovative practices • Top four bad innovative practices • Top three ugly traditional practices

33. Top Three Good Innovative Practices Less than one percent of co-ops do any of these. Maybe 1 in 1,000 do all three. • Drop traditional qualified patronage refund distributions and replace with nonqualified distributions. • Practice strict balance sheet management on the finance side by (a) setting liquidity solvency targets to derive a total redemption budget first; (b) then choose a redemption program to divide up the budget of the individual patron-owner equity accounts. • Divide up the equity redemption budget among patron-owner accounts by using a base capital redemption program.

34. Top Four Bad Innovative Ideas • Distribute regional patronage refund income to a separate nonqualified “regional” equity class and classify it not eligible for redemptions except upon company dissolution. • Distribute regional patronage refund income to a separate qualified “regional” equity class and tie redemption to redemption of regional investment. • Distribute all patronage income to unallocated retained earnings except for a small 100% cash patronage refund; tied to patron-owners having only one share of common stock (e.g., $100) • Sell large volume product transactions to patrons on a non-patronage basis and use volume discount pricing at lower net margins than patronage sales.

35. Top Three Ugly Traditional Practices • Pursuing a high growth, low profit, low solvency, high risk strategy. • Redeeming equity using the age of patron, oldest first method. • Redeeming equity using the percentage pool method especially to natural persons.

36. “Destiny is no matter of chance… it is a matter of choice.” -William Jennings Bryan

37. Questions and Discussion