- Financing a Cooperative
- Alternative Ways to Raise Capital for a Cooperative
- Best Practices for Cooperative Owners Interested in Traditional Sources of Funding
- Securities Law and Cooperatives
- Ways to Raise Capital Without Securities Registration
- Ways to Raise Capital With Securities
- Government Funding
- Outside Investors and New Generation Cooperative Statutes
Financing a Cooperative
Due to their unique ownership structure, cooperatives often have a difficult time finding money to start and operate their enterprise. Traditionally, businesses look to three sources of capital: contributions from the owners of the business (internal equity), loans (debt), and outside investors (outside equity).
The initial source of funding for a cooperative is often capital contributions provided by the founding members (e.g., each founding member contributes an amount as a membership share). Membership share is a term used to refer to the contribution required for a person to become a member of the cooperative. The initial funding provided by founding members is also known as equity capital. Equity capital reflects the member’s ownership stake in the cooperative.
Equity capital is one of the measures by which financial institutions will gauge a business’ potential for receiving loans. Equity financing is typically received in exchange for an ownership share in the business. By contrast, debt financing is borrowing money that the business will have to pay back. The lender, such as a bank, does not receive an ownership share in the business. When analyzing the creditworthiness of a business, lenders like to see that the members of the business have invested their own money in the business first, before seeking outside funding. Lenders are also more comfortable giving loans if they feel that a business has its own resources to pay the loan back. Banks are not in business to lose money, so you need to convince them that lending to your cooperative is a worthwhile investment. Thus, in the eyes of banks and other lenders, the more equity capital the cooperative holds in the form of membership shares and other capital contributions, the more deserving of the loan it is.
It is important to note that cooperatives come in multiple forms and have unique, and sometimes complex accounting, tax, and financing issues. This website does not substitute for the advice of a qualified attorney, business advisor, or financial advisor.
Outside Equity: Issues Specific To Cooperative Corporations
Outside equity is more complicated for a cooperative business than a traditional for-profit business. First, in California, cooperatives are not permitted to have “outside” or non-member investors. Thus these investors need to become members of the cooperative most likely as a separate class of “investor” members. Second, cooperative businesses follow the principle that voting rights are based on one’s membership in the cooperative, not on one’s investment of capital. This is different from a traditional capitalist enterprise in which ownership and voting are based on the number of shares an individual owns. In a cooperative, ownership and voting are based on your membership. Thus, no one member should have more votes than another.
This is a problem when a cooperative tries to attract capital investors, because such investors typically would like to have increased ownership and voting rights based on their capital investment. They may not be familiar with the concept of cooperative ownership and may not be interested in giving up the rights they would otherwise have in a conventional corporation.
Cooperative businesses have sought ways around these obstacles to raising capital by issuing memberships to a separate class of “investor members” who do not work in the business. These memberships may allow the outside investors limited additional voting protections related to transformative events, such as mergers, acquisitions, or the dissolution of the cooperative. In addition these shares can offer dividends, which may incentivize people to invest. However, dividend distributions (i.e., returns that are not based on patronage) from a cooperative corporation are often limited by statute (e.g., in California, they are limited to 15% of the capital contribution per year). As a result of obstacles to obtaining equity capital, most cooperatives are debt financed, as opposed to outside-equity financed.
Alternative Ways to Raise Capital for a Cooperative
Here are examples of ways to raise capital that are well suited to cooperatives:
(1) Member Capital Contributions
If cooperative member will be participating in the management of the business, the members’ capital contributions are generally not considered a security.
When people give money without the expectation of receiving anything in return, they are donating. Many entrepreneurs are using so-called crowdfunding websites such as Kickstarter.com and Indiegogo.com to raise money for various enterprises. Entrepreneurs that solicit donations often provide non-monetary rewards to donors.
For example, the Isla Vista Food Co-op launched Project We Own It in 2012 as an effort to purchase its property. The National Cooperative Bank lent them $1.2 million for the purchase and they successfully raised $200,000 for the down payment through crowdfunding.
(3) Micro Loans
While traditional banking loans are sometimes difficult for cooperatives to obtain, an alternative is a micro loan. A micro loan is a small, low interest rate loan, supplied through various sources. . Typically, the organizations that provide micro loans are socially conscious about the difficulties that community entrepreneurs face when trying to secure financing.
Two examples of micro lenders are Kiva Zip and Working Solutions. Team Works, a cooperative home cleaners based in San Jose, had two successful Kiva Zip campaigns in 2012. They were lent $10,000, enough working capital to be able to provide health care for their members and expand their membership. This article from Grassroots Economic Organizing gives a good overview of the process they went through to find a trustee and promoting the loan. Though these loans can be very demanding, Kiva Zip requires the first repayment within one month of disbursement, they are zero interest and can work well for coops that have outside support.
If you’re an existing business and want to expand your business, one possible way to raise funds is to pre-sell gift certificates. For example, you might sell a $150 gift certificate that a customer can redeem at your business, but only charge $100 for the gift certificate. Charging less than the value of the certificate gives the buyer an extra incentive to purchase the gift certificate.
(5) Loans with Return of Principle Only
Return of principle only means giving back the money that the funder gave, and not offering a return on the investment. Not offering a return means that the business will not offer anything more than the original investment amount, such as an additional dividend, interest, or appreciation in value. It is important to note that, in California, this is likely considered to be a security, so you should proceed with caution and consult with a lawyer if you choose to utilize this funding method.
(6) Product Discounts
Another way to raise capital for your business is to charge a membership fee and offer product discounts in exchange. REI provides an interesting model for product discounts funding. REI is a consumer cooperative that sells memberships to its customers. At the end of the year, REI members receive a “dividend” based on the amount spent at REI during the year. This “dividend” can then be used to shop at REI.
One unique and often overlooked way to gain needed resources is to avoid money altogether for certain goods or services your business needs. Bartering, or exchanging services or goods directly, is a means of obtaining resources. If you need to raise money to pay for something such as web design or compostable cups, consider whether you might be able to barter your goods or services to get what you need. This is not a traditional means utilized by businesses when financing their business; however, it can be utilized as an alternative way to obtain much needed resources for your business. However, you should note that bartering may be subject to taxation.
Best Practices for Cooperative Owners Interested in Traditional Sources of Funding
Thus far you have been presented with an overview of financing available for your cooperative business and some alternative means for financing that business. You may still be interested in attempting to secure a bank loan or other traditional financing methods. The following page outlines best practices when approaching a bank for financing. The goal of this section is to help you understand the difficulties that cooperatives face when approaching a lender, more importantly, preparing you to overcome, to the best of your abilities, these challenges. Here are some best practices:
Preparation is a key step in both business development and obtaining funding for your business. Very few people can simply walk into the bank without preparation and obtain a significant loan. To prepare for your interactions with financial institutions start by evaluating your financial situation and the financial situation of your fellow founding co-op members. You will want to collect documents from all founding members and evaluate personal income, credit scores, debts etc. You will then want to decide whether it is in the best interest of your cooperative to obtain funding individually (e.g., one member has outstanding credit and is willing to try and obtain a loan) or collectively (e.g., you all pool your resources and sign together for a loan). You can receive one free credit score per year at the government sponsored site www.annualcreditreport.com, beware of credit report scams at other websites. You will want to bring all financial documents with you when speaking to financial officers. Be sure to cast a wide net, bringing more documents is better than bringing less. Do not neglect any information that is less favorable to you (e.g., a bad credit score or default on loans). You need to realistically consider the pros and cons of your financial situation, individually or as a group, and be prepared to discuss these pros and address the cons where necessary.
(2) Understanding The Bank’s Perspective
A bank is a business. They want to reduce their risk and increase their returns. It is important to understand that bankers, loan officers, or whomever you are dealing with at a financial institution has to follow institutionally determined standards. These standards are not all the same and some are less difficult to overcome than others. Ultimately, a financial institution will be interested in knowing how much money you want, what you plan on doing with it, and how you are going to pay the money back (on time!).
(3) Pay Attention to Detail
Details are key! Neglecting a negative financial history or failing to point out the strengths of your business are just two important details that might get skipped in the process of obtaining a loan. A financial institution should not have to search for necessary and persuasive information about you or the business. Present all the details of your unique financial circumstances to the bank clearly. Also, being detailed and thorough will only make the process run more smoothly.
(4) Follow-Up/Be Creative/Keep At It!
Receiving financial assistance in the form of a loan is undoubtedly a difficult and time-consuming process; however, persistence is the key. Many small businesses face hurdles when they are just beginning. Do not let a few undesired events get in the way of your business’ success. Be creative when preparing for and communicating with financial institutions and potential investors. Remember not to burn bridges and do not stop trying when one door closes.
Securities Law and Cooperatives
How to Comply With Security Laws
Don’t just ask for loans and investments! Make sure you follow the law. Even asking a potential investor for money can be considered a violation of securities law, unless you’re just applying for a regular business loan from your bank as described above. This section of the manual does not substitute consultation with a qualified lawyer in the field of securities law. Securities law is highly complex and failure to comply with securities regulations may lead to civil and criminal sanctions. Consult an attorney before trying to raise money. This section of the manual will attempt to provide you with a basic overview of securities law as it relates to finding funding for your cooperative business.
What Is A Security?
A security is a financial instrument representing ownership, a debt agreement, or the rights to ownership. Examples include stocks, bonds, derivatives, and many other types of financial assets. You create a security when you ask people to put money into your business or venture, and you offer them a return. For example, a security could be:
- Selling stock in your business
- Asking people to lend money to your business
- Offering a share of your business’ profits
- Interests in limited liability companies
Most financing and fundraising options require compliance with securities laws. This is true when the funders are looking for a “return” on their investment.
It is important to know what is or is not a security because when you sell or even offer to sell a security, it needs to either: 1) be registered with the U.S. Securities and Exchange Commission and with the state agency where you want to raise money (in California, state registration is called “qualification”); or 2) qualify for an exemption from registration. Registration/qualification is an expensive, time-consuming process. If possible, your business should try to find an exemption, which is simpler and less expensive.
Ways to Raise Capital Without Securities Registration
The seven alternative methods to funding your cooperative, mentioned above, are examples of ways that you can raise capital without triggering securities law.
Ways to Raise Capital With Securities
California Limited Offering Exemption
California Corporations Code Section 25102(f) offers a special securities law exemption to certain kinds of private securities offerings, if they meet the following criteria:
First, you must be exempt from federal securities filing requirements:
- Your company must be formed under California law (i.e., if you are a corporation you filed your articles of incorporation in California, etc.)
- You plan only to offer securities to California residents
- Your contract with your investors includes that they will not resell the security to anyone outside the state for nine months
- Your business is very California-focused – here is a test for this:
- You get at least 80% of your revenues from California
- At least 80% of your assets are in California
- You plan to use at least 80% of the money you raise within California
Then, you must meet the requirements for 25102(f)
- You can sell your securities to up to 35 investors that are not wealthy as long as they meet one or more of the following criteria:
- The investors have a preexisting personal or business relationship with you “consisting of personal or business contacts of a nature and duration such as would enable a reasonably prudent purchaser to be aware of the character, business acumen, and general business and financial circumstances of the person with whom such relationship exists.” These investors can be friends or family;
- The investors have enough financial experience to protect their interests; or
- The investors have experienced professional financial advisors.
- You can sell an unlimited number of securities to officers and directors of the company and accredited investors. Accredited investors are 1) people with $1 million in net worth (excluding their home) or $200,000 in annual income, or 2) entities with more than $5 million in assets.
- Your securities offering cannot be advertised to the public.
- The investors must sign something saying that they are not investing for the purpose of reselling the securities to someone else.
- You have to file a simple form with the California Department of Corporations.
California Cooperative Equity Exemption
Under California Corporations Code Section 25100(r), a California cooperative can raise up to $1,000 from each member without qualifying the securities. For example, a cooperative might set its initial capital contribution requirement at $1,000. However, any person who purchases a security under this exemption becomes a member and must have voting rights in the cooperative. Also, you cannot use a “promoter” to sell these securities. As with the California Limited Offering Exemption above, you could use the federal intrastate offering exemption to satisfy the federal securities regulations.
Note that if a cooperative member will be participating in the management of the business, the members’ capital contributions are generally not considered a security, which means each member can contribute more than $1,000 to the cooperative. It is primarily for non-managing cooperative members that you would need to use the 25100(r) exemption.
Worker cooperatives in California may sell shares to community investors for up to $1,000 per person, with minimal voting rights, and avoid securities registration. Read more about this financing strategy here.
Direct Public Offering (DPO)
Registering a DPO is not simple and it may require assistance from a lawyer, but it’s a nice option if you need to raise a lot of money and you want to offer shares of your business to local community members. A DPO is a securities offering that is registered at the state level and allows a business to publicly advertise investment opportunities to both accredited and non-accredited investors.Unlike an initial public offering (IPO), which requires an investment bank to underwrite the security, or the anticipated Crowdfunding exemption, which will require the online funding portal to be registered as an intermediary, a DPO allows an entity to sell securities directly to the public without a third party intermediary. Upon the state’s approval of your DPO plan, you can begin offering securities directly to the public.
The formation of a cooperative waste management company called CERO in the Boston area provides a great case study of a cooperative successfully raising money through different financing options. They have used crowdfunding, CDFI loans and a DPO to raise the money needed to purchase their trucks and enter into waste removal contracts. CERO hired Cutting Edge Capital, one of the leading consultants in the field of community capital development, to help them with launch their DPO. CERO reached its goal, raising $340,250 by early June 2015. All investments came from Massachusetts residents and ranged from $2,500-$25,00. Cutting Edge recently launched CuttingEdgeX, a marketplace which has provided a centralized place for investors to find social enterprises with open DPOs.
Angel Investors and Venture Capital
Finding an angel investor or venture capitalist to invest in your business can be competitive and challenging. At the same time, angel and venture capital funds have helped to launch and grow many successful businesses.
Socially Responsible Investing or Community Investment
Socially responsible investment organizations have grown rapidly over the past 30 years and continue to expand, even in the down economy. Many of them are located in the Bay Area.
Crowdfunding Exemption (2012 JOBS Act)
In April 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act. Among other things, the JOBS Act includes a provision that would exempt certain small investments from securities registration requirements. More info here. Crowdfunded investing occurs when many members of the general public invest smaller amounts of money in a business. Instead of relying on a small pool of wealthy “accredited” investors, crowdfunded investing allows a business to gather support from their customers, neighbors, friends, family, and other community members, most of whom might be non-wealthy people who otherwise want to support your business. Although this new exemption is not specific to cooperatives, some cooperatives might consider using this exemption at some point, after considering related issues such as how crowdfunded investing might affect a cooperative’s governance or control by its members.Cutting Edge Capital is also a good resource for information on crowdfunding.
There are also some decent government financing options, the most notable of which is the Small Business Administration (SBA) Loan.
- Most relevantly, the SBA offers the CDC/504 Loan Program
- A Certified Development Company (CDC) is a private, nonprofit corporation which is set up to contribute to economic development within its community. CDCs work with SBA and private sector lenders to provide financing to small businesses, which accomplishes the goal of community economic development.
- Must be used for fixed-asset projects:
- The purchase of land, including existing buildings;
- The purchase of improvements, including grading, street improvements, utilities, parking lots and landscaping;
- The construction of new facilities or modernizing, renovating or converting existing facilities; and
- The purchase of long-term machinery and equipment.
- Cannot be used for working capital or inventory, consolidating or repaying debt, or refinancing.
- There is also the California Small Business Loan Guarantee.
- It allows a business to not only acquire a loan it could not otherwise obtain, but to establish a favorable credit history with a lender so that the business may obtain future financing on its own.
- Eligible Applicants: Any small business as defined by the SBA (typically businesses that employ 100 people or less).
- Eligible Uses: Proceeds must be used primarily in California and for any standard business purpose beneficial to the applicant’s business, such as expansion into new facilities or purchase of new equipment.
Outside Investors and New Generation Cooperative Statutes
The issue of “outside investors” in cooperatives is the subject of a great deal of debate. Cooperatives must serve the interests of their members and must not subordinate member interests to outside investors. Most cooperatives avoid taking investments from non-members to avoid the potential for conflict between those two interests. However, it is becoming increasingly difficult for cooperatives to rely exclusively on member capital and bank loans, since bank loans for cooperatives are very scarce. Capital-intensive cooperatives such as agricultural processors or restaurants may find it impossible to start up and operate without outside capital. While most cooperative statutes permit outside investors, they do not allow outside investors to have any voting rights and they cap their returns. This is consistent with the principles laid out in Puget Sound Plywood, 44 T.C. 305 (1965). Unfortunately, it is very difficult to attract outside investors without offering them any voting rights to protect their investment. Some cooperatives, like Organic Valley and Equal Exchange, have successfully sold non-voting preferred stock have successfully sold non-voting preferred stock, but most cooperatives would have a hard time selling an investment like that because most investors would not feel comfortable making a large investment unless they have some right to influence major decisions, at least.
Because of this problem, some states, including Iowa, Wyoming, Wisconsin, Minnesota, and Tennessee, have adopted a statute called the Limited Cooperative Association (also known as “new generation cooperatives”). (The National Conference of Commissioners on Uniform State Laws adopted a Uniform Limited Cooperative Association Act that is the model legislation for the new generation cooperative statute.) This is a hybrid between a traditional cooperative corporation and an LLC. These statutes allow outside investors to have limited voting rights while still ensuring that members retain control and majority ownership. For example, Wisconsin’s Chapter 193 authorizes the formation of Cooperative Associations. Investor-members’ voting rights may not exceed 49 percent, but the bylaws may provide such members with the power to veto certain unusual decisions, such as merger or dissolution. In addition, the investors’ may not receive more than 70 percent of the profit allocations and distributions of the cooperative.
Because these cooperatives essentially are LLCs, they can elect to be taxed under Subchapter K which has many of the same advantages as Subchapter T. It remains to be seen whether a cooperative that has a significant amount of outside investment and that provides limited voting rights to these investors would be deemed by the IRS as not “operating on a cooperative basis.”