The Mechanics of Cooperative Conversion

Four Cooperative Conversion Types

As described later in this handbook, there are two primary ways to sell a business, each with pros and cons: An asset sale and an entity sale. In an asset sale, a business sells its assets (including tangible assets, intellectual property, and goodwill) to another entity or person. In an entity sale, the owners/shareholders of the business sell their shares or memberships in the business to another entity or person.

To sell a business to workers and create a cooperative, there is an additional layer of consideration around the mechanics of how the business will transform its financial, governance, and entity structure to that of a worker cooperative.

In some cases, a new cooperative entity will be formed to acquire the assets or shares of the original business. In other cases, the original entity will simply amend its governing documents to restructure into a cooperative. Combining both layers of considerations, we have outlined four ways a cooperative conversion can play out:

Type A: Convert the Original Entity

The original entity converts to a cooperative by filing amended and restated Articles of Incorporation and adopting amended Bylaws (or an amended Operating Agreement, in the case of an LLC). The original owners redeem some or all of their shares and/or interests in exchange for cash, promissory notes, and/or preferred shares. Workers become members of the cooperative, usually by contributing capital.

Type B: Form a New Entity and Acquire the Business’ Assets

The workers form a new and separate cooperative entity, and then acquire the assets of the original business. This approach has the benefit of enabling workers to organize and operate as a cooperative, even before taking over the business. The new entity can act independently to raise money, negotiate with business owners, and begin practicing democratic governance.

Type C: Form a New Entity that Buys the Original Business Entity, then Merge the Two Entities

The workers form a new cooperative entity and acquire the shares and/or interest held by former business owners, then merge the entities. There are at least a couple scenarios where this might occur. One is where the sale of shares, as opposed to the sale of assets, offers a tax advantage to one of the parties. Another is where a shareholder of the original entity resists cooperative conversion and refuses to redeem his/her shares. In such a case, depending on the terms of the business’ Bylaws or stock plan, sometimes the only way to legally force redemption is to do a “reorganization.” Merging the entity with another entity generally counts as a reorganization under statutory definitions.

Type D: Form a New Entity that Buys the Original Business Entity, and Operate Both Entities

The workers form a new cooperative entity and acquire the shares and/or interests held by former business owners, then continue to operate the business under the original non-cooperative entity. There are at least a couple scenarios where this might take place. In multi-stage buy-outs, the worker cooperative entity can operate primarily as a shell that slowly acquires the interests of the owners of the primary business entity, until such time as it acquires a sufficient share of the interest and merges. In other cases, the operation of the business under the umbrella of a conventional corporation may be preferred by the lenders that finance the worker buyout. In this way, shares of the conventional corporation may be pledged as a security for the loans. In both cases, the two entities could eventually merge when the cooperative pays off its obligations to the sellers and lenders.

In a Type D conversion, although the business operates under a conventional corporation, the characteristics of a cooperative can be established by requiring that the cooperative entity appoint its own Board to act as the Board of the primary business entity, and that it allocate dividends on the basis of the cooperative members’ patronage of the primary business. This scenario, however, would require careful review to determine whether the cooperative is eligible for taxation under Subchapter T of the tax code. While a Type D conversion may offer benefits to the sellers and lenders, the workers and cooperative may be ineligible for the pass-through tax status they would receive in a straightforward cooperative. In addition, in order to receive the benefits of the 1042 capital gains rollover, the owners need to sell their business interests to a qualifying worker cooperative. More research is needed, but it is possible that the workers would actually need to be employed by the cooperative entity, which would act as an employee leasing company for the primary business entity. If that is the case, this adds significantly to the administrative burden of the entities, particularly with regard to compliance with employment laws.

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