Because cooperatives are focused on benefiting their members, rather than producing profits for investors, cooperatives often face unique challenges when it comes to raising capital. Traditional funding methods, such as member equity contributions or reinvested earnings, might not be sufficient for expanding operations through capital purchases, offering new products, or hiring employees. For cooperatives organized on a stock basis, members are typically limited to purchasing one share of common stock that gives voting rights but does not appreciate in value or provide dividends. Cooperatives thus cannot use common stock as a tool for attracting outside investors.
For cooperatives seeking external capital without diluting member control, issuing preferred stock is a potential option. Selling preferred stock allows cooperatives to attract outside investment while maintaining their cooperative identity. Preferred stock also gives supporters in the community an opportunity to support the cooperative through their investments without becoming members. However, the issuance of preferred stock requires an analysis of federal and state legal and regulatory considerations. This post explores how cooperatives can use preferred stock to secure outside funding and highlights the key legal factors under federal and state laws. Methods
1. What Is Preferred Stock?
Preferred stock represents a class of equity that provides its holders with certain advantages over common stockholders. These advantages typically include:
- Priority in Dividends: Preferred shareholders often receive dividends before any distributions are made to common shareholders. Because common shareholders in cooperatives do not receive dividends, issuing preferred stock allows cooperatives to provide investors with a return on investment.
- Preference in Liquidation: In the event of company liquidation, preferred stockholders are paid out before common shareholders. This preference gives investors an incentive to invest even when a cooperative is not yet financially mature.
Preferred stock also has certain limitations that are useful for cooperatives:
- Non-Voting Rights: Preferred shares typically do not carry voting rights, making them appealing for cooperatives concerned about preserving member control.
- Delayed Return: Preferred stock can be structured so that the cooperative’s board of directors can delay paying dividends until the cooperative is financially secure.
- Repurchase: Preferred stock can be structured so that the cooperative has the right to repurchase such stock after a certain period (and thus end dividend payouts).
2. The Role of Preferred Stock in Cooperatives
For cooperatives, preferred stock offers a compelling way to raise funds from external investors who are willing to forgo voting rights in exchange for financial returns. Preferred stock provides a middle ground by allowing cooperatives to access external capital without granting investors decision-making power.
Even if a cooperative is not in a financial position to attract outside investors, it can still use preferred stock as a vehicle to obtain financial support from its community. Because cooperatives typically have strong ties to their communities through their members, cooperatives can offer preferred stock to non-members in the community and give them an opportunity to invest in the cooperative’s growth. In this scenario, investors are less concerned about the potential financial return and are more focused on helping a local business grow that will directly support their community.
3. Legal Considerations for Issuing Preferred Stock
Issuing preferred stock is not a straightforward process. Cooperatives must navigate complex federal and state regulations to ensure compliance. Below are the primary legal considerations:
- Federal Regulations: SEC Requirements
Under federal law, any sale of securities, including preferred stock, must comply with the Securities Act of 1933. (Exceptions apply for the common stock described above that is issued by cooperatives to their members). This law mandates that securities be registered with the Securities and Exchange Commission (SEC) unless an exemption applies. Key considerations include:
- Registration Requirements: Registering securities with the SEC involves extensive disclosure obligations, including providing detailed financial statements and risk factors. This process can be costly and time-consuming for cooperatives.
- Exemptions to Registration: Many cooperatives seek exemptions to avoid the burdens of full SEC registration. Common exemptions include:
- Regulation D (Rule 506): Allows for the sale of securities to accredited investors (e.g., high-net-worth individuals or institutions) without SEC registration. Rule 506(b) permits a limited number of unaccredited investors, while Rule 506(c) allows for general solicitation but restricts sales to accredited investors only.
- Regulation A+: Permits small to medium-sized offerings (up to $75 million annually) with less stringent disclosure requirements than full registration.
- Intrastate Offering Exemption: If the offering is limited to investors within a single state, cooperatives might qualify for this exemption under Rule 147 or Rule 147A.
Cooperatives must carefully assess which exemption aligns with their goals, investor base, and budget for compliance, and should obtain guidance from legal counsel familiar with cooperative stock offerings.
- State Securities Laws: Blue Sky Laws
In addition to federal regulations, cooperatives must adhere to state securities laws, often referred to as blue sky laws. These laws vary significantly by state and govern the offering and sale of securities within each jurisdiction.
Key state-level considerations include:
- Filing Requirements: States may require cooperatives to file disclosures or register their offerings, even if an SEC exemption applies.
- Crowdfunding Exemptions: Some states have specific exemptions for small offerings conducted through intrastate crowdfunding platforms, which can be advantageous for cooperatives targeting local investors.
- Cooperative-Specific Exemptions: Certain states have tailored exemptions for cooperatives issuing preferred stock to members or community investors.
State regulations often involve additional costs and legal complexities, so cooperatives must work closely with legal counsel familiar with securities laws in their state to ensure compliance.
- Bylaws and Cooperative Statutes
Before issuing preferred stock, cooperatives must ensure their organizational documents and governing statutes permit such an action. Key considerations include:
- Amending Bylaws: Many cooperatives will need to amend their bylaws to authorize the issuance of preferred stock. This process typically requires approval from the board of directors and the members.
- Compliance with Cooperative Principles: Some state cooperative statutes limit the extent to which non-members can hold equity. Cooperatives must ensure that issuing preferred stock does not compromise their status under state law.
- Dividend Restrictions: Cooperative statutes in some states may restrict the rate or amount of dividends payable to preferred shareholders to ensure the cooperative’s margins primarily benefit its members.
4. Best Practices for Issuing Preferred Stock
To successfully navigate the complexities of issuing preferred stock, cooperatives should consider the following best practices:
- Define the Purpose of the Offering
Clearly articulate the purpose of the capital that will be raised and how it will align with the cooperative’s mission. Investors are more likely to participate if they understand how their funds will be used. Also, such information will be necessary in preparing the offering document that will be provided to potential investors.
- Engage Legal and Financial Experts
Work with attorneys who specialize in both cooperative and securities law to structure the offering in compliance with federal and state requirements. Financial advisors can help design attractive terms for the preferred stock in collaboration with legal counsel and cooperative management.
- Choose the Right Exemption
Select a registration exemption that aligns with your cooperative’s size, investor base, and fundraising goals. Be prepared to meet the disclosure and filing requirements associated with your chosen exemption. Also, be prepared for the possibility that using a relatively low-cost exemption (such as the intrastate exemption) may limit the cooperative’s potential pool of investors.
- Educate Investors
Provide clear and transparent information to prospective investors, including the risks associated with preferred stock, the conditions attached to preferred stock, and the cooperative’s financial position. For example, if the cooperative’s board will have the ability to delay paying dividends, such flexibility should be highlighted in the offering document.
- Preserve Cooperative Principles
Ensure that the issuance of preferred stock does not undermine member control or the cooperative’s democratic governance.
5. Conclusion
Preferred stock is a powerful tool for cooperatives looking to raise outside capital while preserving their cooperative structure. By carefully navigating the legal and regulatory requirements, cooperatives can design offerings that attract investors without compromising member control. Even for newer cooperatives that may not be in a position to attract the typical outside investor, preferred stock can be used to obtain financial support from the community in which the cooperative and its members are based.
For more information about this post’s content, please contact Roland Hall at [email protected]