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

2 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 Session Agenda: Three Panels

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 3

Five General Recommendations: A Preview 1.Co-ops must be competitive 2.Co-ops should make as much profit as possible 3.Co-ops should use balance sheet management 4.Serving core customers comes first 5.Finance, strategy and risk management should be integrated 4

Five Specific Recommendations: A Logical Process 1.Make profitable asset investments 2.Finance assets with sufficient equity 3.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 4.Calculate a redemption budget using balance sheet management 5.Divide redemption budget among owners using preferred redemption methods (programs) 5

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 6

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). 7

Four Unique Roles RolesFunctionAction 1.CustomerMarketing orBuy/Sell Profit GenerationTransactions 8 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. Which role is predominant in members’ minds? 4. MemberControlVote 3. OwnerOwnershipInvestment & Redemption 2. PatronProfit DistributionPatronage Refunds Per Unit Retains Challenge: Inherent conflict of interest between customer, patron and owner roles.

Finance Decision Framework 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 9 Finance involves making three critically important and interrelated decisions:

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

Balance Sheet Issues 1.Asset Investment Total assets, intended growth rate Asset type, profitability and risk –Regional Investment –Joint venture investment –“Local” current and fixed assets 11 2.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

Income Statement Issues 1. 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 distribution alternatives that maximize benefits to patron-owners

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

Income Distribution: Four Selected Strategic Choices 1.Patronage income allocation goal: high customer-patron ownership (high allocated) versus high retained earnings (high unallocated or low allocated). 2.Patronage income distribution by source: allocated versus unallocated a.“Local” operating income b.Regional (other) cooperative income c.Other income (investment, etc.) 3.Patronage refund taxability to co-op: qualified versus nonqualified. 4.Qualified cash patronage refund rate 14

15 “Pure Co-op”

16

17 Equity structure, measured by retained earnings to total equity, varies widely from state to state and co-op to co-op. It is highest in CO, IL, IN and OH.

18 Solvency varies widely from state to state and between co-ops.

19 Solvency, as measured by adjusted equity to assets (total equity divided by (total assets minus current liabilities)) varies widely from state to state and co-op to co-op.

20 Profitability varies widely from state to state and co-op to co-op. Profitability is highest in MI and WA and lowest in MO and OK. We expect profitability to be highest in high risk environments. We expect solvency to be highest in low profit, high risk environments. Are they?

Equity Management: Six Selected Strategic Choices 1.Asset growth trend: high, low, none or negative 2.Liquidity target and resulting trend: high, moderate or low 3.Solvency target and resulting trend: high, moderate or low 4.Equity structure: a.High allocated versus high unallocated b.Many allocated equity classes versus few (especially applies to mergers) 21

Equity Management: Six Selected Strategic Choices 5.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 6.Redemption program and methods: a.High proportionality of investment (AP/P, RF, BC) versus other goals (AP/O, PP) b.Simple program versus complex program for each equity class c.Same program for all equity classes versus unique program for each class 22

23

24 Equity Capitalization Classes 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 Allocated: Permanent or Semi-Permanent –Common Stock –Preferred Stock

Equity Capitalization Alternatives 25 Balance sheet management assumes all equity is permanent until authorized for redemption.

Capital Structure Factors: Debt versus Equity Factor Amount of Equity 1.Least cost financing - equity costs more than debt Higher cost, lower equity 2.Risk - ag co-ops have high risk Higher risk, higher equity 3.Profitability - ag co-ops have low profitability Higher profit, lower equity Conclusion: Minimize equity, given risk and profitability because of opportunity cost of equity 26

Capital Structure Choice Matrix LowHigh Low Moderate Solvency ETA: 50-60% High Solvency ETA: 60-75% High Low Solvency ETA: 35-50% Moderate Solvency ETA: 50-60% 27 Profitability Risk 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.

Equity Management Process: Balance Sheet Management 28 1.Determine income generation and income distribution 2.Determine desired assets 3.Determine desired financial structure –Liquidity: Cash, Working capital, Current ratio –Solvency: Equity to assets, Debt to equity 4.Determine desired equity investment and structure 5.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! Equity management involves making five critically important and interrelated decisions: Philosophy: Protect the company; owners get what’s left over. Challenge: Implement balance sheet management philosophy.

29

30

31

32

33 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.

34 Implications of Model Co-op Analysis 1.Biggest driver of equity management performance is profitability. 2.Cash flow to patron-owners varies little with alternative patronage income allocation strategies. 3.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.

Four Cornerstones of Financial Success 35 1.Be a profitable business – Manage income generation 2.Return profits to patrons – Manage income distribution 3.Provide sufficient equity financing – Manage balance sheet 4.Require patron equity investment proportional to use – Manage patron equity accounts

36 Challenges and Conclusions 1.The biggest financial challenges are: a.Inherent conflict of interest between roles of customer, patron and owner. b.Access to equity capital – most co-ops get almost all equity investment by retaining some of the income generated by operations. c.Non-permanent co-op equity is like debt! d.Be competitive for customers’ business and make as much profit as possible. e.Choose income distribution alternatives that maximize benefits to patron-owners.

37 Challenges and Conclusions 2.The biggest financial challenges are: a.Implement balance sheet management philosophy by protecting co-op solvency and liquidity and calculating a redemption budget. b.Select a redemption program that balances simplicity, proportionality of investment and cash flow to patron- owners.

38 Challenges and Conclusions 3.A co-op should practice balance sheet management by setting liquidity and solvency objectives to protect the company. This implies the derivation of a redemption budget to redeem the “surplus” equity. This provides a discipline and guideline for equity management easily defendable by the board and management. This is an element in the value proposition. 4.The biggest driver in equity management performance is profitability. Performance can be measured by revolving fund length or cash flow to patrons. When co-ops perform poorly in equity management measures or getting cash to patrons, it is primarily due to poor profitability, not income distribution and equity structure choices.

Top three good innovative practices Top four bad innovative practices Top three ugly traditional practices 39 Practices of Cooperative Businesses: the Good, the Bad and the Ugly

Less than one percent of co-ops do any of these. Maybe 1 in 1,000 do all three. 1.Drop traditional qualified patronage refund distributions and replace with nonqualified distributions. 2.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. 3.Divide up the equity redemption budget among patron-owner accounts by using a base capital redemption program. 40 Top Three Good Innovative Practices

1.Distribute regional patronage refund income to a separate nonqualified “regional” equity class and classify it not eligible for redemptions except upon company dissolution. 2.Distribute regional patronage refund income to a separate qualified “regional” equity class and tie redemption to redemption of regional investment. 3.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) 4.Sell large volume product transactions to patrons on a non-patronage basis and use volume discount pricing at lower net margins than patronage sales. 41 Top Four Bad Innovative Ideas

1.Pursuing a high growth, low profit, low solvency, high risk strategy. 2.Redeeming equity using the age of patron, oldest first method. 3.Redeeming equity using the percentage pool method especially to natural persons. 42 Top Three Ugly Traditional Practices

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

44QuestionsandDiscussion