Legal Case Study: Select Machine
Select Machine is an Ohio-based firm that manufactures, sells, and distributes custom parts for demolition and construction equipment. It was founded in 1994 by Doug Beavers and Bill Sagaser. They chose to convert their business when they were ready to retire to avoid laying off their employees.
Exploring Cooperative Conversion
Background
In 2006 Beavers and Sagaser began considering retirement, the company had 11 employees and sales of $2.5 million in 2006. Beavers and Sagaser began seeking out buyers, and though several offers materialized, prospective buyers seemed primarily interested in getting their hands on Select Machine’s client list. A new owner would likely shut down the plant and cherry-pick through the equipment for use at facilities elsewhere. This spelled out layoffs for Select Machine’s current employees. Beavers and Sagaser considered the employees of Select Machine – which is located in a rural, close-knit community – to be family. They did not want to see the plant closed and their friends out of work. As Sagaser put it, “[t]hese are our guys, our family, and we wanted them to keep on working.”
Considering Cooperative Conversion
In 2005, Beavers’ and Sagaser’s banker suggested they contact the Ohio Employee Ownership Center (OEOC) for guidance. OEOC is a non-profit organization that provides outreach, information, and technical assistance to employees and business owners interested in employee ownership. OEOC director, John Logue, knew that an Employee Stock Ownership Plan (ESOP), would be too costly for a small operation like Select Machine. Logue suggested that instead, Select Machine explore conversion to a worker cooperative as an exit strategy. OEOC mediated the conversion, helped fund a feasibility study, and financed part of the initial stock redemption.
Preparing to Convert to a Worker Cooperative
Initial Steps
- The OEOC staff conducted several meetings with the owners, reviewed the company’s financials, and toured the facility to get a better understanding of the business and to start charting out what the transaction would entail.
- Beavers and Sagaser discussed the idea of converting to a worker-owned business with the employees, and were met with enthusiasm.
- OEOC then met with the employees to explain the basics of worker cooperatives and how such a conversion could be structured for Select Machine.
- The employees then voted to investigate the possibility of setting up a cooperative, and elected a “buyout committee” to undertake that task.
- Local accounting firm Brott Mardis conducted the feasibility assessment to estimate the value of the business and to determine if the sale was possible. The study was paid for by the Ohio Department of Job & Family Services’ Prefeasibility Study Grant Program, administered by OEOC. The valuation exceeded the founders’ predetermined selling price, but the owners stuck with their original sale price nevertheless.
Vote to Convert
At the completion of the feasibility study, Mark Stewart prepared an offering statement for the employees. The prospective worker-owners then took time to review the offering statement, the feasibility study, the valuation, and the financial statements of the company. The employees then held a vote and agreed to set up an employee-owned cooperative.
Governance
They then moved into deliberations about how to structure the cooperative:
- qualifications for membership,
- membership fees,
- and how to allocate patronage.
They set the cooperative membership fee at $1,000. They developed a weighted patronage formula to use for allocating profits amongst the worker-owners. The formula assigns 50% of patronage to W-2 earnings (rewarding current market value of their skills), 25% to hours worked (rewarding diligence and equality), and 25% to seniority capped at 120 months (long-term contribution to the business). Until the debt is paid off, the worker-owners’ patronage allocations will go to pay down the note used to acquire their stock.
Financing the Buy-Out
Multi-stage Buy-out plan
To finance the deal, Logue and attorney Mark Stewart developed a multi-stage buy-out plan meaning the cooperative initially took out $324,000 in loans from a local bank and revolving loan fund, all personally guaranteed by Beavers and Sagaser, to finance the redemption of an initial 40% of Beavers’ and Sagaser’s stock. The monthly loan payment of $6,000 would come out of the company’s cash flow. Once the loans were repaid, Beavers and Sagaser would sell the remaining shares to the cooperative. They would then retire from the business. In the intervening period, they would train the other worker-owners to run the business successfully.
Executing the Conversion and Partial Buy-Out
The sale and conversion happened at the same time. Select Machine’s articles of incorporation were amended and restated to restructure the company into an employee cooperative. New Bylaws were drafted to replace the old Bylaws, reflecting the new cooperative structure. All of the nine employees at Select Machine (including the two owners) became worker-owners. The worker-owners elected a board of five comprised of the two selling owners and three new worker-owners. The new board then voted to authorize the redemption of 40% of Beavers’ and Sagaser’s stock, and to authorize the cooperative’s borrowing of the money to fund it. From the initial conversation between Select Machine and OEOC to completion, the deal took six months.
Ongoing Involvement of Original Owners
As noted above, Beavers and Sagaser became members of the cooperative as well. To do so, they each put up a portion of their unredeemed stock holdings as their membership stock (their portions being equivalent to the average membership stock the other members hold). Whereas the patronage allocations distributed to the other worker-owners goes toward paying down the debt used to purchase the worker-owners’ stock, Beavers’ and Sagaser’s patronage allocations went directly into their capital accounts. After all, their membership stock is not debt-financed – as it came from their unredeemed stock holdings, they already own it. To be clear, however, while Beavers and Sagaser will build their capital accounts, they will not acquire additional stock in the process. Additionally, Beavers, Sagaser, and the cooperative executed an owners’ employment agreement that provided Beavers and Sagaser with certain reserved rights as “protected shareholders” until their stock is fully redeemed.
Completing the Gradual Buy-Out
While the cooperative planned on purchasing 60% of stock by 2010, the dismal economy led the workers vote to to delay the transaction. Due to a decrease in revenues, the company reduced its workforce on a voluntary basis in 2009. During the recession, the cooperative redeemed a 5% block and then a 10% block. As the economy began to recover in 2010, however, Select Machine, Inc. returned to pre-recession revenues, and the worker-owners resumed the process to complete the full acquisition. Finally, in 2011, the cooperative redeemed the remaining stock from the founders, financed by a loan from the founders themselves. Although the parties agreed from the beginning to revalue the company for each stock redemption agreement, the company was revalued only for the final stock redemption. The cooperative continues to repay the loan from the founders.
Timeframe
The conversion, from the first discussion with OEOC to first stock redemption, took six months, and the stock redemptions took six years to complete.
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