Financing the conversion of a worker cooperative can be tricky even if it brings tremendous benefits to workers, businesses, and society. To purchase the business they work for, workers generally need to get capital from multiple sources. Here we explore the general considerations, strategies, and sources of financing a cooperative conversion. Each type of financing may come with legal considerations related to securities and tax law, which, if violated, can be both personally and professionally damaging to the cooperative’s members. Aka, talk to an attorney before moving down any of these paths!
General Considerations in Financing a Cooperative Conversion
Financing a cooperative is different in a few ways from financing a conventional business. In a conventional business, investment capital comes with the expectation that the lender will get some control over the business and that profits will be maximized for the benefit of these outside investors and lenders. Worker cooperatives, by definition, put control in the hands of their workers and distribute earnings primarily on the value and quantity of the workers’ labor contribution. This type of distribution is also known as patronage-based distribution of earnings. With this cooperative type of earnings distribution, what should you be aware of when it comes to financing your conversion? We’ve identified three general considerations to be aware of when financing your cooperative conversion: legal limitations, multi-stage buy-outs, and rewarding the cooperative’s founders.
(1) Rewarding cooperative founders for founding the cooperative!
Oftentimes, the first few years after a cooperative has been founded are very lean and members don’t receive much, if any, patronage distributions. For example, in the years following a cooperative conversion, the cooperative may need to commit a substantial portion of its earnings towards making payments on any loans it received to support the conversion process. This means that the workers who took the risk to convert the business to a cooperative will receive fewer financial rewards than workers who join in the years after the loans are paid down. As a result, it’s good practice to offer additional financial or other incentives to the workers who take part in the conversion process.
There are many different ways worker cooperatives change the patronage-based distribution of earnings to reward workers who took risks in founding the cooperative and stuck with it during those initial “lean” years. Some cooperatives do this by allowing the members’ capital contributions to accumulate interest. In cooperatives where the workers provide very little in the way of monetary capital contributions, they still “capitalize” the business with their labor. In light of this, some cooperatives pay a “bonus” later on based on the estimate of what workers would have made had the financing payments been distributed more evenly over a longer period. There are more ways to reward the cooperative’s founders, so be creative, seek support, and find what feels best for your specific conversion!
(2) Spreading out the business purchase into multiple payments, aka Multi-Stage Buy-Outs
When converting to a cooperative, it may be difficult to obtain all financing necessary to purchase the business in a single loan or transaction. Spreading out the purchase of the business into multiple payments, also known as a multi-staged buy-out (which we go into further depth here), can be helpful in obtaining financing sources to complete the conversion.
(3) Legal limitations on the type of financing
Legal limitations are another important consideration. The type of financing the business chooses when converting to a cooperative has implications for the cooperative’s eligibility for Subchapter T taxation (a beneficial tax category the IRS created for cooperatives) and may have implications under the state’s cooperative statute.
For example, part of being eligible for pass-through taxation under Subchapter T is that a cooperative 1) must distribute its earnings based on patronage and 2) earnings sourced from non-members or which are not distributed based on patronage are subject to taxation at the entity level, creating double taxation for that income. If a cooperative creates a class of preferred shares that pay out fixed dividends, both the cooperative and the shareholder will pay tax on that income.
Regarding state specific limitations that could impact your ability to attract certain investors, some cooperative statutes explicitly limit the size of the return that can be distributed each year based on capital contributions. In California, for example, this limit is 15%. Thus, any financing provided to a cooperative should be limited in its rate of return depending on the tax category and the legal entity your cooperative chooses. How a business entity impacts your tax rate in a cooperative conversion sale can be found here and more about how a business’ tax status determines how much income tax it pays and how that tax is calculated can be found here.
Considerations Related to Different Sources of Financing
Above, we covered general considerations in financing a cooperative conversion. Below, we explore the specific considerations when financing your cooperative with worker-sourced capital, seller financing, and loans.
(1) Worker-Sourced Financing
The workers, themselves, are often a key source of capital for a cooperative conversion. Many cooperatives choose to have each member contribute equally to the capital of the cooperative. However, in practice, in industries such as food service, where employees generally receive fairly low wages, it is quite likely that workers will not have any savings that could be used to finance a buy-out. In addition, the economic status of cooperative members could vary widely. Regardless of the amount of capital contributed by each member, everyone should have equal voting power.
In general, it’s important for the workers to contribute at least some capital. When analyzing the creditworthiness of a business, lenders like to see that the owners of the business have invested their own money in the business before seeking outside funding.
- How much will an ownership share cost? We have seen worker cooperatives set member share prices anywhere from $10 to $15,000. When deciding on the member share cost, consider members’ ability to pay, the need for capital, access to other financings, the value of membership, and the legal limitations for capital contributions (if any) set by your State.
- Will there be one or multiple classes of shares? As described elsewhere, some cooperatives create a category of preferred shares to incentivize both members and non-members to contribute additional capital that may have very limited or no governance rights over the decisions of the cooperative.
Will the cooperative pay interest on member shares? Many cooperatives we know of do not pay interest on member shares, which enables the cooperative to distribute earnings primarily on the basis of patronage. However, to give some members incentives to contribute more capital, a cooperative could offer to pay a small amount of interest on amounts contributed.
May a member receive a membership share in exchange for goods or services? Some cooperatives allow members to “pay for” their membership share in exchange for agreed upon goods or services. The value of the membership share may be taxable income to the member, so it is important to consider whether a member would be prepared to pay taxes on the value of that share. Note, also, that provision of services in order to purchase a membership share may create an employment relationship, which you can read more about on our employment law page for more details.
Does the share structure comply with securities law? Securities laws are designed to protect people from fraudulent or overly risky investment schemes, and may apply when workers finance the development of their own cooperative. The decisions about the structure and size of member contributions may be influenced by securities law considerations.
May members purchase preferred shares? As described elsewhere, preferred shares are generally structured to pay a fixed return, making them similar to loans. However, repayment of the preferred shares are generally paid after the repayment of loans (though they may or may not be “subordinate” to, that is “paid after,” the repayment of membership shares). In addition, preferred shares are generally recorded as equity on the books, rather than debt, which looks better to prospective lenders reviewing the books.
May members lend money to the cooperative, and at what interest rate? Generally, if a member loans money to the cooperative, that loan pays interest and has priority for repayment over the member shares. For a cooperative member, it may feel advantageous to provide capital in the form of a loan. For the cooperative and other members, however, it may create a burden that would not be present if the same capital were provided in the form of a membership share.
Can the contribution be made through a regular withholding of wages or through the withholding of patronage dividends? It is very common for cooperatives to receive at least some portion of a worker’s capital contribution through the regular withholding of wages. Note that the amount withheld from the paycheck is still taxable income, because the member is receiving something of value in exchange for his or her labor. Generally, withholding of wages for this purpose requires the written and informed consent of the employee. Alternatively, if the cooperative foresees that it will make patronage dividends in the near future, it can allow a member to finance buy-in through an agreement to have the cooperative withhold a portion of that patronage dividend until the buy-in amount is paid in full.
If a share is expensive, can the worker purchase it over time or find personal financing? Although somewhat rare, there may be sources of loans to help individual cooperative members finance the purchase of their membership share.
May cooperative members contribute unequally? If so, how can the cooperative prevent tensions from arising from the fact that some members have more money at risk than others? Should the cooperative make a plan to pay members back in order to equalize financing?
(2) Seller Financing
In cooperative conversions, it is very common for the former owner to finance at least part of the buy-out. Often, a seller does this by accepting a promissory note which is a legal document that outlines the cooperative’s promise to pay the seller over time. It can be a difficult balancing act to ensure that both the sellers and the workers are adequately protected in this scenario. By that, we mean that it may be difficult to ensure that the seller is paid over the specified amount of time and that the workers are not so burdened with debt that they can barely scrape by. Generally, the best scenario for everyone is to take additional steps to ensure that the business will continue to thrive, such as having the seller agree to provide ongoing technical assistance, gaining commitments from customers, ensuring that workers are adequately trained to manage the business, and so on.
When thinking about ways to protect the seller, safeguards can also be written into the governance documents, such as supermajority voting requirements for major decisions or requiring consent from the seller for major decisions until the seller has been fully repaid.
There are also some possible tax advantages to seller financing. When a business owner sells to workers in exchange for a promissory note, as opposed to receiving cash, it is possible that the seller cannot be taxed as if it were cash. This allows the seller to stretch their payments of capital gains taxes over a longer period. This may be especially helpful to an owner (such as a sole proprietor) who is not readily eligible for the 1042 rollover.
(3) Obtaining Loans
It can be difficult to convince any lender, especially a conventional commercial lender, to debt-finance 100% of a transaction. Lenders are reluctant to do this even for common transactions (like mortgages) and are even more reluctant to do this for more “exotic” transactions (like a cooperative buy-out). In such a situation, there are a handful of ways to “sweeten the deal” for a prospective lender. Some of those include doing one or more of the following:
- Have an individual, a guaranty fund, or another organization guarantee the loan by signing an agreement to pay the loan in the event that the borrower is unable to pay the loan. A seller is often in a good position to guarantee a loan from a third party, since the majority of the loaned funds are presumably paid to the seller to begin with.
- Secure the loan with assets, by pledging business inventory, equipment, real estate, stock, or other valuable assets.
- Have the prior owner secure the loan with “replacement property” from the 1042 rollover. In circumstances where a prior owner takes advantage of the 1042 capital gains tax deferral by rolling the gains over into “replacement property” in the form of stocks or other securities, the replacement property could be pledged to secure the loan.
- Create two entities and pledge stock of one entity as a security. An example of this is the Island Employee Cooperative, which created two entities during their conversion – a cooperative and a conventional corporation called Burnt Cove. The cooperative owned all stock of Burnt Cove but also pledged some of that stock to secure the loans that the cooperative received. Administratively and for tax purposes, it may not be ideal to maintain two entities, but it was necessary in that case to satisfy the concerns of lenders.
- Commit to obtaining technical assistance to ensure the business will be a success. Island Employee Cooperative, for example, committed to contract with technical assistance providers for at least five years to ensure that the businesses would thrive and be positioned to pay off the loans.
- Give a lender priority for repayment. In the event that the cooperative receives loans from multiple sources, one or more lenders may demand that its loan be in first position for repayment. In this case, an Intercreditor agreement can be made between lenders to specify the priority and timeline for the repayment of each lender.
- Give the lender the right to approve major decisions. Although lenders are not given a vote in the bylaws of a cooperative, a loan agreement may nevertheless specify that a cooperative must seek a lender’s permission prior to making certain major decisions, such as expenditure over a certain dollar threshold, or any other decision that could substantially undermine the cooperative’s ability to pay back the loan.
The conversion of the Island Employee Cooperative is particularly instructive with regard to the variety of safeguards that can be built into lending transactions, and with regard to the use of Inter-Creditor Agreements.
In general, it is a good idea to engage in conversation with financing institutions to understand what they look for when deciding to finance a worker cooperative. What does the financing institution need to see on the books of the cooperative? What risks is it concerned about and how can those be mitigated? What does it need to know and understand about cooperatives?
(4) Pre-selling goods and services
Another way to get funding for your conversion is to receive support from enthusiastic customers. Find out more about pre-selling here.
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