Exchanging membership interests for stock can be quite rewarding. Image source: Getty Images.

Investors are most familiar with businesses that are set up as corporations, but there are other forms that businesses can take. Some organizations are customer-owned, and these are usually referred to as mutual organizations or cooperatives. When a mutual organization converts to a business form that has shareholders, the process is called demutualization. Businesses in the insurance industry most commonly go through demutualization, and in such cases, policyholders end up owning valuable shares of stock in the insurance company. As shareholders, they can then profit even more in the future.

What types of businesses have demutualized in the past?

Several different types of member-owned organizations have gone through demutualization, but the life insurance industry is where the practice has been most prevalent. Hundreds of insurance companies have demutualized over the decades, and even some of the largest publicly traded life-insurers started out as mutual organizations. Now, there are still some insurers that are organized as mutual, but they have become the exception, rather than the rule.

Many securities exchanges have demutualized, awarding shares to their members. Among them are the New York Stock Exchange, as well as two major Chicago-based commodities exchanges and several exchanges around the world.

Other examples include various agricultural and consumer-oriented cooperatives. Another well-known demutualization occurred with the credit card payment network companies Visa and MasterCard, which demutualized in their initial public offerings in the mid-2000s.

Pros and cons of demutualization

The immediate benefit of demutualization is that members get a windfall. Because members get a liquid, tradable security in exchange for their membership interest in a demutualization, the transaction can make it easier to cash out of what was formerly an illiquid asset or diversify part of their holdings.

Whether demutualization is beneficial for investors, customers, and the business in the long run is less clear. In the insurance company context, policyholders have received tens of billions of dollars through demutualizations, effectively realizing the profits that the member-owned insurance businesses had generated over time. Yet going forward, demutualized companies have less interest in building the connection with new customers than they did with their former member-owners.

Finally, keep in mind that demutualization has tax implications. Typically, the shares you get are treated as though they were received in a tax-free reorganization, so there won't necessarily be any gain or loss when the demutualization happens. However, if you take cash in a demutualization instead of shares, then you can end up having to pay tax.

Demutualization has led many people to receive stock or money that they never expected to get. Keeping the potential of demutualization in mind can make buying into a cooperative or mutual organization even more rewarding in the long run.

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