How to Invest in Cooperatives (Part 1)

This post is the first in a two-part series on investing in cooperatively-owned businesses.

• Part 1: Provides context on why cooperatives need financing, the role of co-op loan funds, how undercapitalization slows cooperative ownership, and recent innovations in co-op financing.
• Part 2: Provides a more hands-on look at the specific terms of what investing in cooperatives looks like, how investors are repaid, what co-op friendly term sheets look like, and how investors can connect to emerging investment funds.

The #1 inquiry we get at Start.coop is about investment in coops.

Every week we hear from entrepreneurs asking, “How can I raise needed funding for our cooperative?” and we hear from investors asking “What does investing in cooperatives even look like and how would I go about it?”.

Many of these entrepreneurs are struggling to grow and scale their businesses because the pool of available funding is much smaller than for traditionally-owned businesses. They often have a great concept and early customers eager to use their product or service but many lack the resources needed to move from prototype to full-scale development and bring their solution to market. Meanwhile, there is a growing community of investors who care deeply about wealth inequality, and for whom investments in cooperatives could be a great fit.

These entrepreneurs and investors both deeply want to participate in the cooperative economy. Yet, often neither side has a clear picture of what investing in cooperatives actually looks like. We spend a lot of time trying to help entrepreneurs and investors better understand the potential of the cooperative economy and ease their entry into it.

This two part series shares our best thinking to-date on the unique questions and challenges of investing in cooperatives.

Let’s start with the need for capital, ie “where’s the money?”

The need for capital and the realities of startup financing

As documented by the Kauffman Foundation, between 90% and 95% of entrepreneurs require some amount of financing to start their businesses. But existing capital markets barely scratch the surface of the capital needed. While there’s a prevailing narrative in the entrepreneurship and investor communities that the majority of companies are funded by venture capital, in fact less than 1% of companies in the U.S. ever raise venture capital. For women entrepreneurs and people of color, the financing landscape is even bleaker, as only 2% of venture capital goes to women entrepreneurs, and only 1% to Black, Indigenous and People of Color (BIPOC). While bank loans are a great option for later stage companies, they only provide financing for around 18% of companies in the U.S., and again because of implicit bias, women- and BIPOC-led businesses have a harder time securing bank loans. Most notably, 81% of businesses never receive outside funding at all.

Some businesses may not need any outside funding either because their business model has low startup costs or because of the founder’s ability to draw on personal wealth and/or the wealth of friends and family. But for those who fall in neither of these two categories, options for outside capital are few and far between. The result? The vast majority of startup businesses get stuck, unfunded, in capital purgatory in what Kauffman has called the “debt-equity chasm”, where businesses are too early for debt, but often can’t find outside equity investors.

But we are getting ahead of ourselves, so let’s take a step back to understand how cooperative financing has developed.

A brief history of the cooperative funding landscape

In the past, cooperatives were limited to only one ownership class, for example:

• In a worker-owned company, such as Equal Exchange, the workers are the owners.
• In a consumer-owned company, such as REI, the consumers are the owners.
• In a farmer owned company, such as Ocean Spray, the farmers are the owners.

In these cooperatives, there was no outside ownership for investors. In fact it was often a point of pride to be 100% member-owned. However 100% member ownership means that any capital needed for expansion or growth has to be raised either internally from cash generated by the business, the members themselves, or taking on debt from an outside bank or loan fund.

To meet the need for friendly outside capital, a small handful of co-op friendly loan funds emerged in the late 70’s, and early 80’s. These loan funds were, and continue to be, critical in helping cooperatives access the capital needed to purchase new assets. They provide values aligned capital with a fixed interest rate and have clearly defined lending criteria. As you might imagine, the ideal borrower for a loan fund would be an established company with a credit history and/or assets such as a building, equipment, or inventory which the cooperative can borrow against. We’ve listed those co-op friendly loan funds on our website and in part two of this blog post.

The limitations of debt & the startup valley of death

We observe two huge problems of why existing the financing landscape can not solve all the needs of the startup cooperatives we meet.

#1: Startups are riskier and require different financing: In reaction to the extreme wealth inequality all around us, we are seeing a new generation of entrepreneurs who want to share the wealth created by business. However every successful company has a start-up phase, with limited credit history, which is inherently riskier. Their lack of history makes these companies poor candidates for the criteria of many loan funds. This drives many startup entrepreneurs to fall into the debt-equity chasm”where they haven’t been around long enough to qualify for debt and don’t have the personal or network financial support to establish a credit history while bootstrapping.

We also need to acknowledge the stark differences in the personal wealth of our start-up entrepreneurs. Many entrepreneurs, but particularly entrepreneurs of color, often do not have the personal networks to tap into, and don’t have the luxury to wait around to build the corporate credit history many loan funds would like to see. (Ironically, if they had the history, they might not need the loan anymore!)

#2: Modern businesses accumulate fewer physical assets: Just as our economy has evolved to be more service and technology based, new types of cooperatives have emerged: platform coops in particular. These cooperatives generally lack physical assets, they often do not have a building, or inventory to borrow against. Like other tech companies, their assets are their technology and their network.

Through our accelerator, we are meeting platform cooperatives who are aspiring to compete against venture backed companies such as Uber, Lyft, Door Dash, Patreon, etc. However these virtual assets fall less easily into the lending framework of loan funds. And even when loan funds can provide a small start-up loan, the cooperatives are still far undercapitalized to compete against such massive venture backed companies. We are expecting entrepreneurs to achieve scale on a non-scale budget. Is it any wonder then why we see smaller success and scale of impact?

Many of these cooperatives need to raise a higher initial investment to build out their platforms and to gain traction, and as such these businesses could dramatically benefit from equity-based financing, the sort that has fueled the growth of technology companies over the last 20 years. Without outside equity investment, there would likely be no Google, Apple, Tesla, or Moderna. We may never know how many cooperatively owned start-ups failed to launch because they couldn’t find outside equity.

This phenomenon, sometimes referred to as the startup valley of death, is not entirely unique to cooperatives, however it feels even more challenging because of the gap in equity financing.

The lack of outside equity has limited cooperative growth generally

What is unique to cooperatives is the lack of outside equity. And this is why many cooperatives do not make it past the startup valley of death.

In fact, the trend we observe more broadly is the cooperatives who make it big are either those who have been able to self-finance out of their own company revenue, such as REI, Ocean Spray, and Ace Hardware, or companies who were able to gain traction in eras before the highly competitive landscapes see today. (Or at least were able to survive long enough to then access outside debt as needed)

And then there is a long tail of thousands of other cooperatives who remain small because there are so few outside equity options available. When we get asked why we don’t see a greater number of large cooperatives, one of the core reasons is the mismatch of available financing, the higher risk equity that startups need to grow and scale — vs the low-risk debt that is often available.

There are exceptions of course, but even some of the recent exceptions of coop success stories illustrate the rule. Stocksy United launched using founder wealth to provide many of the benefits of early equity. Equal Exchange used outside investor shares to finance their fair trade business. ROC-USA (a 501c3) had to create their own national financing network to scale the housing co-ops they create. And cooperatives such as Real Pickles have turned to crowdfunding for outside equity to solve this financing challenge.

The scarcity of outside financing options has caused many cooperatives to remain undercapitalized. And that undercapitalization directly impedes business growth. Our theory is that without access to outside financing, fewer cooperative startups succeed, cooperatives are less able to compete well in their respective verticals, and expansion plans can go unfunded.

Having access to only outside debt, is like if we limited each carpenter to only one tool in their tool belt. Maybe the carpenter might make it work, but tremendous efficiency is lost, and some projects never get finished at all. The reality is that we need different tools for different projects, and more often than not we need more than one tool on the same project! Is it any wonder then that we don’t see more cooperatives at scale, when they don’t have access to the same robust financial tools as other entrepreneurs?

Unlocking outside equity

Over the past few decades, two major changes to the cooperative funding landscape have unlocked access to outside equity: (1) the creation of investor shares and (2) the emergence of multi-stakeholder cooperatives.

In 1989, Equal Exchange, a worker-owned fair trade coffee & chocolate business, created an investor share class. This was the first time in the U.S. that outside investors held ownership in a cooperative and opened the door to a new source of financing for Equal Exchange, and numerous cooperatives to follow. As detailed in our Case Study, Equal Exchange created a preferred share class in which equity investors would receive annual dividends paid back out of company profits.

The major second change to the cooperative funding landscape was the 2003 Minnesota 308(B) Cooperative Statute which opened up the possibility for cooperatives to have multiple share classes (often called“ multi stakeholder ownership”). While well intentioned, the Minnesota law capped investor returns and therefore saw limited adoption. An even more flexible 2012 Colorado statute authorizing Limited Cooperative Associations really opened up the doors to create a flexible minority investor class that can sit alongside a majority member-owner class. Using the work done by Equal Exchange, and friendlier incorporation options such as Colorado, most modern cooperatives can now easily create an investor class.

With these tools in place, entrepreneurs can now look at the full spectrum of both debt and equity, to build out their businesses faster AND increase their impact. The majority of the cooperatives we meet looking to scale now anticipate needing an investor class. However they are still being held back by the lack of clarity over what co-op investment terms might look like and the scarcity of cooperative investors or investment funds. In Part Two, we look into the mechanics of how investing in a cooperative actually works.