Distributing Returns to Owners - Director Handbook

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Marketing the Value of Our Board Design

Nothing could be more important as a Board contribution than making sure that our cooperative model creates a competitive advantage for our firm and its owners. Beyond that, they must make sure the owners' best interests are embedded in our design and guarded by the Board's actions in everything we do.

When the Board is challenged, it is important that we do not defend people, but rather defend the design and the collective action of our Board. Defending people is defending a candidate, not the institution of our Board of Directors. Like building a succession plan vision for our employees, where we say our design is sustainable no matter who is executing it, we need to say that the importance of our Board is also sustainable based on its design.

Our Design for Managing Ownership Returns

The Board needs to maximize the current-year distributions to owners whenever possible. This happens through two distributions:
- Patronage Dividends: Pre-tax dividends. (The major concern here is the marketing effect of Patronage Dividends and the appearance of Patronage Dividends trending up, down, or staying the same. What does that mean to the market and the confidence of our clients and owners?)
- Stock Dividends: Post-tax dividends which reduce the equity effect of net income from the current year.
The Board needs to maximize the current stockholder value so that credit unions who bought in and paid an ownership delta to participate as owners can eventually cover that delta with equity growth. Equity growth comes from two sources:
- The sales of ownership positions to credit unions who pay the book value plus an opportunity cost through the Board setting the purchase price.
- The net income after Patronage Dividends and taxes, less stock owner dividend distributions, that is added to retained earnings.

Other Considerations in Representing Our Ownership: Maximizing Their Returns

The Board must also be diligent in helping us maximize the value of our cooperative model. They do this based on a deep understanding of the basic tenets of our CUSO. When working properly, these tenets benefit our customer/owners through expected ownership returns that give us a competitive advantage over for-profit firms. These tenets include:

Our pricing and our value exchange with our customers are designed to be ownership dividends themselves. There is no advantage in our cooperative model to overcharging our customer/owners in order to transfer income to third-party stockholders. We lower prices whenever possible to distribute ownership value. Therefore, we charge when we have to, not just when we can.
Owners are part of our innovative process and are rewarded for this. First, owner customers should have a greater input into and response from our firm in developing solutions. This should be embedded in our design. Second, owner customers can choose to fund the investment and, based on our pricing; we can distribute an ownership dividend that is pre-tax and consistent with the operational intent of our credit union owners.
The Board guards owner returns through the tenet that we are more focused on our current customer owners and their needs versus the at-risk investment and promises for potential clients through our cost-of-sales investment. Third-party firms are typically more worried about marketplace expansion first, given that they redistribute income from clients to themselves.

Defending our Cooperative Customer/Ownership Model

In the perfect cooperative, where every single customer is an owner, at every level of design, you are ensuring that all owners are represented. There is no model of distribution of income from one client to another: all clients enjoy the same pricing, all clients enjoy the same interactions, and all clients share the returns evenly. Effectively, this model is exactly what you have when you consolidate everyone into one firm. Based on the fact that our CUSO grows both from customers and owners, how do we get as close to this model as possible?

In Figure 1, the value recognized and the returns generated are equally distributed to all, since all owners are customers; everyone has an equitable distribution of all that is available.
In Figure 2, when there is an option to be an owner or a design that limits the number of owners, there is potential for a less-than-equitable distribution of all that it is available. It is the Board's oversight that balances these distributions and ensures the success of both the customers and the owners.
In Figure 3, where the earned returns are all focused on a single owner, there is a greater potential for the owner not to be as concerned about customer value exchanges that are equitable to the amount the owner receives in yield. In other words, "who cares what we charge them, as long as we get what we want?"

Our model, and the way the Board governs the decisions we make in regards to our customers/owners, should maximize the returns for all stakeholders in the most equitable way possible.

This not to say that for-profit firms with different ownership models don't have to balance their returns against their desire to expand their market, keep customers, and see themselves as ethical business people. We just run a different kind of business, and hopefully our customers see the value in the protection of our design and having a Board with parallel interests as customers and owners themselves.

The very idea that we chose this business charter (a cooperative) sets the stage for a very important Board responsibility: maximize the return from our charter. This highlights another responsibility of the Board: maintaining a proper balance between the revenues generated from customers in relationship to the number of owners. The Board is responsible for working with all of the owners to set a number for the maximum number of owners, and to set the ownership price in a way that protects current owner equity and allows the firm to add new owners on goal.

NOTE: Figure 1 is one of the greatest advantages credit unions have. By design, all customers are owners, and all customers are supposed to have an equal share of distributed returns, pushed forward to future owners. The model is perverted whenever the management team or Board assumes an ownership perspective and starts to focus the returns more on themselves than the customers/owners as large. Every credit union Board needs to understand the responsibility not to do that.

Using Ownership Distribution Targets Throughout the Year

When it comes to planning and executing on the distribution of net income to its owners, CU*Answers has three key annual events:

August – Approving the Budget and Business Plan for the next year (August 2010: set 2011 budget)

At this time of year, the Board evaluates the targets against the projected net income of the next year's budget and uses the targets as a gut-check to make sure the owners' priorities for income distributions are considered.
April – Approving the Mid-Year Budget Recast (April 2011: assess mid-year performance for the 2011 business year)

At this time of year, the Board evaluates the progress towards the ownership distribution targets and directs management to adjust its operations or budget accordingly. For example, the Board might anticipate that targets will be easily met and allow management to move forward to additional investments, or direct management to increase the targeted levels. Based on our rolling 18-month budget process, the Board can see all the way to end of the next year and how targets might be unfolding based on the projections.
June – Thinking about the current budget work for the next calendar year (June 2011: set targets for the 2012 budget)

As part of the June Board meeting, and in preparation for Management creating the budget for the next business year, the Board will undergo a discussion with Management as to the targets that are the foundation for the upcoming year's budget and business plan. One more review before the team gets busy on the budget.
October – Evaluating targets and our performance for the previous year and setting the final distribution of income (October 2011: set 2011 distribution amounts based on Sept. 30 year-end closing financials)

At this time of year, the Board evaluates its ability to distribute income against its targets, and may actually declare additional distributions to either current-year payments or improvements in equity. In some years, it may actually say it missed the targets and would distribute income that was lower than the original intent. One additional action at this time is to consider whether the current target formulas are still relevant or whether they should be changed and documented as to why. For example, in a year where you paid well in excess of your targeted Patronage Dividends, should you continue on with the plan for a similar annual increase every year?

The ultimate goal here is a system that always has the owner in mind and that is well balanced against the other needs of the firm. The Board has a design for doing so, the Board documents how it is using the design, and the Board evolves the design every year to maintain a healthy firm, confident owners and a positive marketplace persona.

Proposed Target Formulas

Maximizing Current-Year Distributions

Target 1: Patronage Dividend
Set a target for the change in Patronage Dividends. For example, if the previous year Patronage Dividends were $500,000, what is the goal for the next year – increase, decrease, or stay the same? Remember our marketing concerns: what do Patronage Dividends mean to the market and to the confidence of our clients and owners? NOTE: Keep in mind that a bonus Patronage Dividend can also be paid on top of the core based on a positive variance in our execution to budget.
Target 2: Stock Dividend
Set a target for the change in Stock dividend distributions. For example, if we paid out xx.xx% in stock dividends in the previous year, what should the trend be, moving forward? Do we want an ever-increasing stock dividend percentage, a consistent percentage, or should it start trending downward? If we set a goal of 0.05% growth for 2010 over the 2009 value, we could calculate a number and the effect it would have on equity?

Maximizing Stockholder Value

Target 3: New Owners
Set a goal for attracting new owners and increasing equity through additional paid-in capital. For example, in 2010, we may have set a goal to add 4 new owners, representing roughly 25% of the proposed new clients that are anticipated to convert during that fiscal year. Using $99,000 as the share price paid, the CFO would be able to anticipate the effect of 4 new owners on the equity for 2010.
Target 4: Per-Share Value
Increase the value per share by a growth percentage over the previous year-end, yielding a targeted net equity increase at the end of the upcoming year. For example, in 2010, we might have set the goal for per-share value to increase by 10%. This would allow the CFO to calculate the actual net increase for the end of the year. The budget could get to this number via two tactics: selling new owners, or earning net income. Therefore the formula is new equity equals additional paid-in capital plus retained earnings from the year.

Sample Illustration