From Nonprofit to Cooperative

Nonprofit (dues-based) corporate structures, used by many social, political, and charitable organizations, are relatively easy to understand and implement. But an equity (share-purchase) structure, used by most for-profit businesses, has important financial advantages for cooperatives, including a clearer basis for member investment. While most cooperatives founded prior to the 1960s have an equity structure, some "new wave" cooperatives were formed using a nonprofit structure. Over time, many of the latter are reorganizing as cooperatives with an equity base.

The joy of service

Sevananda Community-Owned Natural Foods Market has a somewhat unique history with regard to its structure. It was organized in 1974 as a Georgia nonprofit corporation in Atlanta by the Ananda Marga Yoga Society (sevananda is Sanskrit for "the joy of service"). The board of directors consisted of members of Ananda Marga, and it was self-perpetuating. In other ways, however, Sevananda acted like a cooperative, with members who joined by paying dues and who received a discount on purchases.

While Sevananda was founded as a service organization, one of its other purposes was only nominally "nonprofit": to generate funds for its parent religious organization. This practice was controversial amongst the members and local community, and in 1979, after a heated court battle, the board of directors broke its official ties with Ananda Marga.

The new board adopted bylaws to ensure that future boards were democratically elected by the members. It is doubtful that this board considered reorganizing on an equity basis. They had inherited a dues-based structure, a common practice among other cooperatives. In addition, the state of Georgia does not have statutes to govern stock-based consumer cooperatives; the only law is limited to agricultural cooperatives.

10 dollar dues and 10 percent discounts

The new Sevananda retained its membership structure, which fell into two classes: the "charter" members, who at one time had paid "lifetime" dues of between $10 and $25; and members who joined after 1978 and were required to pay annual dues of $10. Members received a 10 percent point-of-sale discount off shelf prices.

By 1990 Sevananda was losing money and could not afford to upgrade its facilities. The truth of the matter was that members were receiving advance distribution of profits (or net savings) which simply didn't exist. Inflation and growing member sales had more than doubled the dollar value of the discount. For every $1 of dues collected, $6.56 in discounts were given out.

Sevananda's new general manager, Alan Mathewson was unrelenting in challenging discount practices. At his urging, the board of directors took several steps. First, it halved the discount to 5 percent. Second, it raised the annual dues payment to $20. And third, it eliminated the "lifetime" privilege of the charter members and required them to also pay annual dues. By the end of 1992, these changes had the effect of reducing the discount-to-dues ratio to $2.91 to $1. Sevananda was back on a more firm financial foundation, allowing it to undertake a major renovation of the store that year, fund continued improvements, and pay off its debts.

While most members understood that these changes were necessary, many still grumbled that 5 percent was too small a discount. The removal of charter member privileges also resulted in lasting bad feelings among many of the charter members who were still around. But this step was required in the interest of fairness to the other members, who were being asked to make additional dues payments.

If a cooperative uses a dues system, it is too easy to interpret operational results by factoring in the dues income. For years, "other income" in the form of dues was allowed to subsidize operations, which gave a false reading of operational performance and discouraged adequate capital improvements.

Whither the co-op?

With the wolves beaten back from the door, the board and manager had a chance to sit back and think about "what next?" And what we saw was an explosion of interest in the natural foods market, both within Atlanta and across the country.

Unfortunately, because Sevananda had been inwardly focused and undercapitalized for so many years, it was in no position to take advantage of opportunities to serve a larger community. Furthermore, because of increasing competition in the market, the store's margins were expected to shrink. Although continued increased sales were expected, it was clear that the present storefront would not be able to sustain such growth indefinitely. Retained earnings would eventually suffer, and there was no other equity source to finance an expansion.

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It appeared that even if Sevananda did nothing but try to maintain its own corner of the market, sooner or later we would be forced to reduce the discount and/or raise member dues again. Since the discount is based on sales rather than on net income, increased competition and reduced margins would eventually take their toll. And, as we found when the discount was previously reduced, many members were extremely averse to dramatic changes in their membership requirements and benefits. A more flexible arrangement was therefore needed to protect Sevananda's long term interests.

In 1993 the board of directors began looking carefully at the idea of establishing a member equity system, using share purchases instead of dues and a patronage refund instead of a point-of-sale discount. Although some of us had experience with other equity-based cooperatives, we also studied many articles that had appeared in COOPERATIVE GROCER and elsewhere to understand the various approaches that were being used. Fortunately, Sevananda was not facing economic disaster; in fact we were in the middle of the most profitable year in its history. But we could see that this state of affairs would probably not continue, and we wanted to establish a foundation for expansion. Member equity looked like a better way to protect Sevananda's future.

If a cooperative uses a dues system, it is too easy to interpret operational results by factoring in the dues income. For years, "other income" in the form of dues was allowed to subsidize operations, which gave a false reading of operational performance and discouraged adequate capital improvements.

Discounts vs. rebates

While a discount is one method for fulfilling the requirement of the Rochdale Cooperative Principles that profits (net savings) be returned to the membership, in Sevananda's experience it is a rather blunt instrument for this purpose and is a risky practice financially. How much more prudent and even equitable it would be to allow the cooperative to retain any profit until an operating period has concluded, and only then distribute it to members, in proportion to their purchases. Such a patronage refund has the same effect as a discount, but it also has the important advantage that it is based on the cooperative's net income. As business conditions change, the amount returned to members can also easily change.

One disadvantage of a patronage refund is that it is not as obvious an enticement to membership as a discount. It is typically paid only once a year, and its uncertain size can make it a nebulous concept to new members, especially if they are making a nonrefundable dues payment. By replacing dues with a refundable share purchase, however, a patronage refund will seem less of a gamble. The members' up-front contributions then become investments in the cooperative, and they can compare their patronage refund to the return on other investments, for example savings accounts.

ABCs of capital

A primary reason for switching from dues to share purchase is that less of the store's income will go to the government and more to the members. Member dues are taxable because they are income to the store, whereas share investments are not because they are refundable. In addition, most of the store's net income from business with members can be sheltered in the same way, because federal tax law allows all of it to be declared as a patronage refund, and up to 80 percent of it can be retained in the members' names. These funds must eventually be returned to the members, but until that time they are an important additional investment in the cooperative which reflects the members' patronage.

Another important reason for having a share purchase system is that it helps to clearly distinguish between funds that should be used for capital improvement purposes and those used for store operations. Tax law requires that capital improvements be depreciated over many years, so expenditures for that purpose don't immediately show up on a business' income statement. It makes sense, then, that the funding source for those expenditures should also not appear on the income statement. Whether in the form of dues payments or equity shares, member payments are capital -- needed to leverage new equipment and future expansion.

Such non-operational income should be kept separate from operational profit or loss. However, only share investments (a liability of the co-op to the member) can be legally kept off the income statement. If a cooperative uses a member dues system, it is too easy for nonaccountants to interpret operational results by factoring in the dues revenue. For years of Sevananda's history, "other income in the form of dues was allowed to subsidize operations, which gave a false reading of operational performance and discouraged adequate capital improvements.

A final reason for switching to a member equity system lies in the simple truth that under a nonprofit structure the state is the real owner of the cooperative. If the cooperative for some reason were to liquidate its assets, any residual equity would have to go either to another nonprofit corporation or to the state. With a member equity system, the members are truly the owners of the cooperative.

Planning the transition

For all of these reasons, Sevananda's board of directors decided to implement a member equity system. One of the basic requirements, we realized, was a computerized cash register system to track member purchases for later determination of patronage refunds. Otherwise, member receipts would have to be tallied by hand, an expensive and time-consuming proposition. Since we were already planning to replace our 1970s era registers, this was not an impediment [see sidebar].

We also asked our accountant to research federal tax laws governing cooperatives. Although we could have tried to implement a share system under our nonprofit structure, a share system with the force of corporate law behind it would be much less susceptible to legal and tax difficulties. However, as previously mentioned, Georgia law does not allow for consumer cooperatives. Rather than try to change the law (a multi-year process), we decided instead to reincorporate in another state with favorable cooperative laws. Although the business is "foreign" to the state it operates in, the only essential difference is an annual registration and a small fee that must be paid.

We therefore retained the services of an attorney who specializes in cooperative law. He recommended three possibilities: Wisconsin, Oregon, and Minnesota. The laws of these states are relatively simple and flexible, with few unusual restrictions. Moreover, they all have a fair number of consumer cooperatives, which promised the likelihood of support. We decided on Wisconsin statutes as the basis for our "new" cooperative.

A critical step in our progression to an equity system was research on other cooperatives' methods. We contacted the UW Center for Cooperatives to get some guidance on specific approaches being used at other cooperatives. We also visited Outpost Natural Foods in Milwaukee, whose membership, store size, and volume are similar to Sevananda's. Outpost shared their experiences and provided us with a set of bylaws, consistent with Wisconsin law, which could form a basis for the necessary modifications to Sevananda's bylaws.

Designing the system

Finally, we pulled all our information together to design an equity system for Sevananda. A key requirement was to maintain a level of member "affordability" that paralleled the existing yearly dues of $20. We settled on a $100 requirement which could be paid either at the time of joining or over a five-year period.

The articles of incorporation establish a par value for shares of $20. The new bylaws require members to buy five shares each, which we call a "full share." This structure allows for the eventual increase in the full share requirement by modifying only the bylaws, and always by specifying an integral number of shares. Such an increase can occur either by direct member amendment to the bylaws or through a bylaw provision that allows for a cost-of-living adjustment no more than once every five years, on action by the board of directors. In this way the capital supplied by the members can rise along with the cost of capital improvements.

One of the problems at some cooperatives is that they have several different levels of share requirements, depending on when members had joined. Not only is this a bookkeeping nightmare, it is also inherently unfair to require newer members to have larger requirements. In the case of increases corresponding to inflation, it may be claimed that the actual value of the full share hasn't really changed. But from the point of view of the cooperative it has changed: the value of an investment is its face value, and generally speaking that value decreases with time. (This is true for any investment in any business; no bank or credit union pays interest plus cost of living increases.) Since the member has already been receiving the benefits of membership for some period of time, a small increase in share investment to the level paid by new members is a reasonable requirement.

POINT OF SALE SYSTEM:

In moving towards an equity program at Sevananda, one of our goals has been to replace our point of sale (P05) discount with a year-end dividend based upon patronage. But saying we wanted to track member/owner purchases was easy, while actually trying to perform the feat resulted in a major collective headache. We have just recently become able to perform such record-keeping, due to a lack of preparation and some turnover in the staff assigned to oversee the transition. Some surprising set-backs also resulted from an overestimation of the capabilities of our new POS system from Stores Automated Systems, Inc. (SASI).

What is involved in tracking member purchases? During a transaction, the customer must be identified as a co-op member to the computer. This is achieved with a scannable membership card, with a barcode unique to the member. The POS system must maintain a database of all current members and update the fields in the appropriate record to reflect previous purchases plus what was just bought. Our new POS system had pieces we needed to do the job, but no integrated package designed specifically with our needs in mind.

For the membership cards, we found an inexpensive software package (Avery Label Pro for Windows) that was able to produce the needed barcodes, import graphics for our logo, and work with a merge list produced by our front end department. When we moved to cards prepared by our database, we discovered errors such as missing entries, misspelled names, and wrong addresses.

Another aspect of implementing the new equity system involved the production of a contract that spells out the obligations between Sevananda and its member/owners and serves as a form for entry of member information into the database. We've been through several revisions of this form; the text remains basically the same. It is set up to encourage neatness (essential for accuracy) and ease of use for data entry. The current version has the contract on the . back, with the front devoted to a summary and a neatly~ structured area for gathering data. A similar form, lacking. the contract on the back, serves for annual installments of U equity payments, information updates, and applications for non-member courtesy cards (e.g., senior citizen).

Perhaps the most important lesson from our experience implementing a new equity system is the necessity of communicating with all the people who will be involved in using the system. It doesn't suffice for one or two people to make assumptions about what will or might work. Our. front end people gave us valuable input on the layout of membership cards and streamlining the signup process. The member services coordinator, who has primary responsibility for data entry, had a lot to say about the layout of the information section. As systems manager, I was involved in some of the nuts and bolts of implementation. Finally, we retained the services of a professional consultant to help us fine tune the whole operation.

If you are getting ready to implement a new equity system, bear in mind you don't have to go about the whole process alone. We have done a lot of networking over the last few months with several cooperatives that are converting to an equity system, especially those who have the SASI system. I encourage you to contact us if you are considering a new P05 system or would like more input on tracking member purchases.

- Paul Kelly, Sevananda systems manager

Our bylaws stipulate that when the full share requirement is increased, all members must purchase additional shares to come up to the new value. Of course, there will always be members who don't understand the reason for this requirement and who will complain. It is important, therefore, to minimize the impact of an increase on current members. In practice it is possible to avoid out-of-pocket payments on their part because, in addition to the full share, most of them will have some amount of retained patronage refunds invested as well. Sevananda's bylaws therefore allow the additional required share(s) to be paid for out of these retained funds (or future patronage refunds if necessary). This has the effect of shifting funds from one member account to another; increasing the required share investment while reducing the retained funds that eventually will be returned.

In planning the change from the old system to the new, the board also planned for a gradual transition from a point-of-sale discount to a patronage refund. Because Sevananda's financial health was good, we had the luxury of initially providing both, thereby defusing member complaints due to a sudden change in benefits.

The discount for 1995 was kept at 5 percent, althoug it will probably be reduced to 2 percent in 1996 and possibly eliminated some time thereafter. To prepare the membership for this reuction, we plan on providing them with individual information about the discount they have received in relation to the equity they have invested, and by continuing to emphasize that while the discount may be decreasing, the patronage refund should increase correspondingly.

Convincing the membership

The "marketing" of a major change such as reincorporation is every bit as important as the structure itself. Even while we were researching member equity and preparing the new bylaws, the board of directors began introducing the "why and how" to the membership. We wrote articles for our monthly newsletter, made presentations at the 1993 fall and 1994 winter membership meetings, and held a special meeting strictly to discuss the plan.

Throughout the information-sharing phase of the reincorporation we emphasized the probability of an eventual reduction or elimination of the point-of-sale discount in favor of a patronage discount. We illustrated the fundamental ideas with comparisons to credit unions and to Recreational Equipment Inc., which had recently opened a store in Atlanta. Members familiar with equity in other cooperatives also contributed.

The final design was sent to members in a special mailing, along with a detailed description of bylaw changes. The proposal was then put to a vote at the annual election in April 1994. the efforts we had put forth over the previous year bore fruit, with the membership voting overwhelmingly in favor of the reincorporation: 90 percent approval was registered!

With the force of the membership behind us, we proceeded with Sevananda's reincorporation. We established a new Wisconsin cooperative to which we could transfer the assets, liabilities, and responsibilities of the old Georgia nonprofit corporation. On December 31, 1994, when the last light was off and the door was locked, Sevanda Inc. was no more. We all rested on January 1, and when we reopened on January 2, our customers were lined up at the door. It proved to be the busiest day (at that point) in our history.

An era has passed; the genesis of Sevananda's future has been created. Member response to the equity system has been dynamic and supportive. So far we have outpaced previous member payments by 25 percent.

Our future plans are to build on the foundation we have established with our member share system. It is unlikely that this systtem will provide for more than gradual growth of Sevananda. If we are to open a second store, a much larger infusion of capital will be needed.  We therefore plan to ask our membership to approve the addition of "preferred" shares to our articles of incorporation and bylaws. Such shares, allowed by the flexibility of Wisconsin law, do not provide any membership rights, but earn a limited rate of interest. This will allow our members (and other) to invest additional capital in Sevananda, reducing the need for bank loans and benefiting both the cooperative and its members.

See other articles from this issue: #058 May - June - 1995