Cooperatives have three areas of accounting that need to be understood by their members as the cooperatives are formed and as they are operated. Cooperatives obtain and track equity capital, usually through the members. As a business entity, the cooperative generates income through the products its sells or the services it provides to clients and customers. Depending on the type of cooperative, the members are the ones who provide the services, produce and sell the products, or in some cases, purchase the services or products from or through the cooperative. Very simply the income, less expenses, generates profits and those are distributed to the members based on their patronage of the cooperative. This blog post will explain how income, patronage and equity capital are defined and interrelated in different types of cooperatives.
Generally, when a cooperative is formed, the people who are going to be the initial or founding members come together and decide how much money they need to get the business started. This is called the “initial capital contribution”. The amount of money needed will depend on the type of industry is involved. If the coop is in a service industry, with little to no funds needed to purchase manufacturing equipment or vehicles, or other expensive start-up costs, then the capital contribution may be small. Other cooperatives within more capital-intensive industries may require their members to make much larger initial capital contributions.
These capital contributions are generally recorded on the books of the cooperative when a new member purchases a share of membership stock, or perhaps a membership unit if it is a nonstock cooperative. The contributions will show up as “equity capital” on one side of the balance sheet of the cooperative and as cash on the other side. The cash can be used by the cooperative to operate its business, with the knowledge that at some point in the future, that equity capital will need to be returned to the member making the contribution. The initial capital contribution, sometimes called a “membership fee”, or “member buy-in” is considered personal property of the member and will need to be redeemed if the member leaves the cooperative.
Then the initial members need to think about the future and what new members may be asked to contribute to the cooperative as their share of the capital of the cooperative. Again, depending on the type of cooperative and industry, the purchase price for an ownership stake in a cooperative can be as little as $3, going into the hundreds of thousands of dollars. In the worker cooperatives I helped, I have seen membership fees or the fee for a share of membership stock or a membership unit range in price from $25 to $10,000. This blog post won’t go into cooperatives that have multiple types or classes of membership, but it should be kept in mind that different classes can have different requirements for capital contributions.
Some cooperatives have other forms of generating capital, other than through the initial capital contribution. These capital raising mechanisms are called retained earnings and retained allocations. Of course these two mechanisms do not include raising capital through investments but more information can be found about those methods in our blog post titled “Capital Basics: 5 Categories of Financing”. Retained earnings are a portion of the cooperative’s profits that are retained by the cooperative to use in the future for capital expenditures. With respect to retained allocations, when a cooperative has annual profits, it can allocate those profits to its members in either cash or by depositing the profits in a separate equity capital account held in the member’s name in the cooperative. There is more discussion about this in the Patronage section below.
The cooperative now has members and is starting to operate its business. Income is being generated by selling products or services to the public or to its own members. An example is an agricultural cooperative what sells seed and fertilizer to its farmer members who turn around and sell their crops through the cooperative. In a worker cooperative, the workers generate income by operating the business, whether that is in production, services, sales, management, or administration. In a purchasing cooperative, the members obtain favorable rates from vendors by buying in bulk. The farmer cooperative pays its farmers for their crops. The worker cooperative pays its worker-owners wages or distributions based on their work product. The purchasing cooperative will usually give rebates to its members. These costs are expenses to the cooperative and are deducted from income through the year, along with other general expenses of operating the cooperative.
When thinking about a worker cooperative, or a cooperative with independent contractors who provide services to the cooperative, the members can be compensated in different ways. In some worker cooperatives, the owners are also employees and receive standard W-2 wages where they receive a paycheck for their work and payroll taxes are deducted on their behalf. In other worker cooperatives, especially those taxed as partnerships, the owners do not get W-2 wages but are instead compensated by draws or distributions. In still other worker cooperatives, the owners are paid based on their production. For example, an artist coop might pay its members by the dollar value of work produced and sold to cooperative clients. A cooperative where the members are compensated based on their work product will often have a separate agreement between the cooperative and the member, detailing how and when the member will be paid for their work product.
It is important for cooperative owners to separate what they are paid as producers, workers, suppliers of the cooperative, and what they receive as a benefit of cooperative ownership – the patronage dividend or patronage refund.
In other types of business entities, the owners share profits based on their percentage of ownership in the company. In cooperatives, profits are not shared based on equity ownership but are allocated based on patronage. As producers, workers, or suppliers, the amount members “use” the cooperative is tracked by the cooperative, forming the basis to determine both patronage and patronage allocations which are two separate issues. “Patronage” is sometimes a difficult concept to understand but basically, patronage is the term used to describe how a member uses the cooperative. As a producer, how much a member sells through the cooperative (artwork, tech coding for a client, etc.). As a worker, how many hours worked or the value of projects completed. As a farmer, how much is purchased from the cooperative. All of these are examples of ways that a member patronizes or uses the cooperative. One of the first processes a new cooperative creates is how to define patronage and how it should be calculated for each of its members. Should it be the value of work completed, the number of hours worked, the amount of sales made to clients of the cooperative, or some other method. There is no one way to calculate patronage but there is one rule – patronage calculations must be equitable among all the members of a single class in the cooperative. A cooperative with multiple classes or types of membership can have different methods for determining how patronage is calculated in each class. These calculations and methods form the basis for determining how much each member has used the cooperative, which in turn form the basis for calculating what share of the cooperative’s net margins (“profits”) are allocated to each member.
“Patronage allocations”, also called patronage dividends or refunds, are payments for the member’s share of the profits, usually done on an annual basis. They are called “allocations” because the cooperative allocates to each member a share of the net margins, based on their patronage of the cooperative, not based on any equity capital contributions. The allocations can be in the form of cash or an entry on the cooperative’s books in the name of the member. For purposes of this blog post, I am using the Internal Revenue Code provisions for Subchapter T cooperatives (“Sub T”) in discussing patronage allocations. A cooperative can use partnership accounting, but that is the subject of another posting. The simple explanation for Sub T, is that a cooperative tracks all of its income and expenses throughout the year, just like any other business entity. The cooperative also tracks all of its members’ patronage contributions (work, services, purchasing, etc.) and then it looks at how to allocate profits to its members. In standard Sub T cooperatives, the share of profits allocated to each member is based on that member’s share or value of patronage in relation to all the other members’ share or value of patronage. For example, in a worker cooperative of 10 owners, if patronage is determined by the amount of hours worked and all the owner-workers work the same number of hours, then the patronage allocations (dividends) will be equal among all of the members. If one member only works part time through the year, or takes a sabbatical, then that member will receive a smaller patronage dividend that the other members. The same formula is used in other Sub T cooperatives in other industries. Patronage of the members are turned into percentages in comparison to all the other members. One member may have contributed 30 percent of the entire patronage (again, the value of the members’ use of the cooperative) generated by the members of the cooperative and will therefore receive 30 percent of any patronage dividends.
Equity capital (member or other contributions), income (member generated revenue), patronage (member use of the cooperative), and patronage allocations (member share of profits) are all interrelated and when a new cooperative is being formed, these interrelationships need to be considered. How does capital affect revenue? How does patronage affect income? How do all of these affect the bottom line and therefore patronage allocations and dividends to the members?
All part of the fun of becoming cooperative owners.