How to Invest in Cooperatives (Part Two)
Different ownership creates different incentives
As we talked about in Part 1, while the need for financing in a cooperatively owned business is very much the same as a traditional business, investment can look really different.
When investing in a cooperative, the biggest difference is that investor repayment generally has to happen out of company revenue or profit, not an increase in the share price. To understand why, we need to look more closely at what has to happen to make a share appreciate in price and why it often isn’t the right fit for cooperative ownership.
In any business, there are generally only three ways for investors or lenders earn a return on their investment:
- The company’s share price goes up
- The company pays back investors out of revenue
- The company pays back investors out of profit or dividends
(To keep things simple, we’re ignoring refinancing which can function as another source of investor repayment.)
People are generally most familiar with #1, because that’s how the stock market works and where gains in a typical retail investor’s portfolio come from. You buy a share of stock in a publicly listed company and then later sell that stock to someone else. In doing so, you are exiting your position, in what is called a secondary market, such as the New York Stock Exchange or NASDAQ.
Investors, like angel investors and venture capital funds, who typically invest in early-stage, non-public companies, also hope the value of their investment — the position they take in the company — will increase. However, very few secondary markets exist for companies that are not publicly traded. So these investors are looking to exit via slightly different strategies: a) the company goes public, b) the company is acquired, or c) the shares can be resold to another investor.
“Who can I sell this company to?”
Early-stage investors want to make sure they can get their money back by selling or liquidating their share. So right from the very start when they evaluate an investment opportunity, they are asking themselves “who can I sell my share of company ownership to?” And some of these investors — specifically equity funds — need to harvest returns within the 10-year period of most funds, in order to repay their investors within the agreed upon timeline. As a result, there is immense pressure on the companies backed by these investors to go fast, go big, and sell the company or IPO within 10 years of the initial investment.
Who benefits financially in this scenario? The small group of people who invested early (and who had the economic privilege to invest in the first place).
Now, consider, on the other hand, the very different financial incentives of cooperatives, who are explicitly trying to create long-term ownership and wealth within a much broader community, whether that community be workers, or Black farmers, or musicians.
Cooperatives Are Built for Long-Term Purpose and Profit
Perhaps that is why the first cooperative in the US, a consumer-owned mutual insurance company founded in 1752 by Benjamin Franklin, is still in operation today. And the second oldest continuously running cooperative in the country is the Associated Press, whose members are 6,000 radio, newspaper and TV stations.
Like most cooperatives, these organizations were built for long-term growth, which makes them poor investments for investors looking for a quick exit by acquisition or public offering. So it rarely makes sense for cooperative investors to expect their repayment to come from an appreciated share price via an exit.
(While co-op share prices generally don’t appreciate, there are always exceptions such as when a company sells, converts to non-cooperative ownership, or if a secondary market could be created.)
Cooperatives Pay Investors out of Company Revenue
If investors don’t expect to see returns on their investment via an increased share price at an exit, how do cooperatives pay back equity investors? In some respects, the answer is far less speculative: cooperatives pay back their investors from money generated by the business: either an allocation of revenue or profit. This approach aligns both investors and entrepreneurs around a focus on the growth of top line company revenue and bottom line profit.
The following three repayment options have all been used to invest in cooperatives and to generate returns to investors. (Co-op attorney Jason Weiner has published a more exhaustive list here.) Which repayment option makes the most sense for entrepreneurs and investors may vary based on the specific stage, business model, values, and state of each company.
- Revenue share: As investors buy shares in the company, the company allocates a small percentage of revenue to pay back those investors at a predetermined multiple, anywhere from say 1.2x to 4x of the initial investment. With this “structured exit” model, investors can receive regular payments without waiting years for an “exit” or “liquidity event”. (This repayment model is sometimes referred to as Revenue Based Financing, and can be done as either debt or equity.) For those worried about capturing additional upside, see the indie.vc term sheet for a creative solution that provides upside using revenue based financing.
- Profit share: As investors buy shares in the company, in return the company distributes an agreed upon allocation of profits among eligible investors on a proportional “pro rata” basis.
- Dividend share: As documented in our Equal Exchange case study, investors buy shares in each company. Each share purchased offers a pre-determined yearly 4–9% “target dividend” per share. Yearly dividend distributions are approved by the company’s board and are paid out of company profits.
(The main difference between profit share and a dividend share being that the profit share repayment is based on what percentage ownership each investor has out of the total investor share class, while the dividend share repayments are calculated based upon a pre-negotiated 4–9% target dividend percentage per share.)
Since both profits and dividends come out of top line company revenue, we would argue that in one form or another, ultimately all cooperatives repay investors out of revenue. Therefore it is incredibly important that if a cooperative does choose to take on outside investment, it should be tied to a plan to build revenue and sales that both the cooperative and investors can believe in.
What Percentage of Company Ownership Can Investors Hold?
As we discussed in Part 1, cooperatives can authorize an outside investor class that sits alongside their patron member class. Many people worry that by opening up a cooperative to outside investors, the cooperative might be giving up control of their business. But with just a tiny bit of creativity, we can also design co-op friendly terms.
The primary design consideration is that patron members always need to control the majority of the cooperative’s ownership. Unless otherwise approved by the members, investors in a cooperative can not receive the majority of financial gain, nor can investors occupy a majority of company board seats. Cooperatives can theoretically allocate up to 49% of the total company equity and still be considered a cooperative but that is an extreme. In order to avoid giving away too much, cooperatives often choose to start to allocate an initial 5–10% to investors in order to raise the smallest capital they need. And often the shares can be repurchased by the cooperative in order to make sure they still retain control.
What Kind of Stock? Common vs. Preferred
Common stock in cooperatives is reserved for patron class member-owners, so investors in cooperatives almost always receive preferred stock. Is this unusual? Many well known companies including Berkshire Hathaway and Google offer non-voting preferred stock, and they offer it for the exact same reason that cooperatives do: they want to provide a financial return to investors, while still retaining majority control of the company.
In a cooperative, much like any other typical business, if the business were sold, liquidated, or forced to close, the order of liquidation would generally be creditors and lenders first; then preferred stockholders, and finally common stockholders.
Voting and Governance Rights?
In terms of board representation and governance rights, in order to protect member interests and control, many cooperatives choose to have all investor shares be non-voting shares. However other cooperatives provide investors with board observer rights, or designate a small number of board seats which the investor class can elect.
Each cooperative can choose which of the following governance options to provide to their investor share class:
- Non-voting shares
- Non-voting shares with a designated board seat or board observer rights
- Voting shares that are represent a minority of the votes/board seats
In practice, a lot of investors we meet don’t ever want control or a board seat, frankly they don’t have the time. What they want is to invest in cooperative businesses that offer both a financial return and ESG impact.
Connecting Investors to Cooperatives
Modern cooperatives have the potential to bring in outside investment from the millions of people looking to create a more equitable economy. But there are still major challenges. Complicated securities laws can feel intimidating for entrepreneurs to create an offering to investors. And even if entrepreneurs make it through that steep and very expensive learning curve, they typically don’t have access to a strong community of like-minded investors. This is especially conspicuous for BIPOC entrepreneurs, whose access to connections and capital is consistently hindered by bias and systemic inequality.
At the same time, it’s often hard for investors, especially those new to the cooperative ecosystem, to find and screen the most promising cooperatives. There are a number of existing resources and new initiatives available for entrepreneurs and investors alike, and as interest in cooperatives grows (concurrent with increasing interest in impact investing more broadly) we expect to see more new vehicles and innovations emerge.
Co-op Investment Fund Options
- For people who want to lend to cooperatives via debt, we have seen recent growth at loan funds like Shared Capital, Seed Commons, Cooperative Fund of New England, and Local Enterprise Assistance Fund.
- Equity funds are also innovating in the shared ownership ecosystem: Kachuwa Impact Fund is an investment cooperative focused on owning and operating “impact real estate” and investing in privately held “Impact Companies” many of which are cooperatively owned. Apis & Heritage Capital Partners is currently raising a fund explicitly focused on helping companies with majority BIPOC workforces convert to employee ownership in an effort to address racial wealth gap.
- Regionally across the U.S. groups of people join together to invest in cooperatives and shared ownership through investment clubs. From the Colorado Solidarity Fund, to the Vermont Solidarity Investment Club and the Boston Cooperative Investment Club, there are a number of new place-based options for investors looking to invest in co-ops.
- At Start.coop we are experimenting with an investor-entrepreneur matching tool to help co-op curious investors access deal flow and help entrepreneurs find aligned investors. Investors can sign up for the private, double opt-in matching tool here and co-op entrepreneurs seeking funding can submit their business for consideration here.
To complement these options and build a truly dedicated community of co-op friendly investors, we also recently launched the Equitable Economy Fund, a $2 million dollar pilot equity fund. We’ve seen great momentum already: 22 committed investors have helped us reach and exceed our first year capital raise (as of April, 2021). We receive a handful of new inquiries each week and are still accepting new accredited investors and growing this investing community.
Where to from Here?
As wealth inequality skyrockets, the need to rethink capitalism and rethink investing is urgent and growing. Cooperatives — community-owned businesses designed for profit and purpose — are increasing in popularity among entrepreneurs and investors alike. Yet the cooperative investing landscape is nascent and today represents just a drop in the bucket of cooperatives’ capital needs.
If we truly wish to cultivate the next generation of cooperative businesses at scale, we need to invest in these businesses and help them access the capital they need to grow and thrive. Together, we need to introduce more investors to cooperative investing while also innovating new investment terms and new investment vehicles. Only then will we be able to unlock the power of cooperative ownership for a more robust, resilient, and equitable economy.Please note: This blog post is solely for educational purposes to help people better understand the kinds of options available for investing in cooperatives. Nothing in this post should be construed as investment advice, direction or solicitation. When considering any investment, it is critical to perform proper due diligence to evaluate each unique opportunity and you should always consult with your own attorney and financial advisor before making an investment.