legal guide to cooperative conversions

legal guide to cooperative conversions
LEGAL GUIDE TO COOPERATIVE CONVERSIONS
A Business Owner's Legal Guide to Cooperative Conversion
Including Conversion Models, Case Studies and Sample Documents
Created by:
Janelle Orsi | William Lisa
Sushil Jacob
DISCLAIMER: The research that provided the basis for this publication was supported by
funding under an award to the Metropolitan Transportation Commission (MTC) from the U.S.
Department of Housing and Urban Development. The substance and findings of the work are
dedicated to the public. The author and publisher are solely responsible for the accuracy of the
statements and interpretations contained in this publication. Such interpretations do not
necessarily reflect the views of the federal government or MTC. For a copy of the specific
research findings and the methodology underlying that research, please go
to http://www.theselc.org/cooperatives.
i
TABLE OF CONTENTS
The Purpose of this Guide ................................................................................................................... 1
Important Disclaimers: ........................................................................................................................ 1
Introduction to Employee-Owned Cooperatives................................................................................. 2
The Benefits of the Cooperative Form .................................................................................................................... 2
The Legal Definition and Structure of Cooperatives ............................................................................................. 3
Voting and Governance ......................................................................................................................................... 3
Patronage Distributions and Capital Distributions ............................................................................................ 3
Capital Structure, Capital Accounts ...................................................................................................................... 4
Types of Legal Entities ........................................................................................................................................... 4
Deciding to Convert into a Cooperative .................................................................................................................. 5
The Mechanics of Cooperative Conversion......................................................................................... 6
Four Cooperative Conversion Types........................................................................................................................ 6
Type A: Convert the Original Entity .................................................................................................................... 6
Type B: Form a New Entity and Acquire the Business’ Assets ....................................................................... 6
Type C: Form a New Entity that Buys the Original Entity, Merge the Two Entities ................................. 6
Type D: Form a New Entity that Buys the Original Entity, Operate Both Entities .................................... 6
Deciding Between an Asset Sale or Entity Sale ................................................................................... 7
Outstanding Liabilities and Method of Sale Choice ............................................................................................... 7
Tax Considerations in Method of Sale Choice........................................................................................................ 8
Noncapital Assets, Capital Assets and Capital Losses ........................................................................................... 8
Noncapital Assets .................................................................................................................................................... 8
Capital Assets ........................................................................................................................................................... 8
Capital Losses........................................................................................................................................................... 9
Depreciation Recapture............................................................................................................................................... 9
Effects of Entity Form................................................................................................................................................ 9
Pass- Through and Taxable Entities..................................................................................................................... 9
Sole Proprietorships and Single Member LLC's............................................................................................... 10
Partnership and Multi Member LLCs ................................................................................................................ 10
Corporations........................................................................................................................................................... 10
S Corporations ....................................................................................................................................................... 11
C Corporations ...................................................................................................................................................... 12
Section 1042 ................................................................................................................................................................ 12
Eligible Worker Cooperative ............................................................................................................................... 13
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Qualified Replacement Property ......................................................................................................................... 13
1042 for Entities Other than C Corporations................................................................................................... 13
Allocating the Purchase Price in an Asset Sale...................................................................................................... 14
The IRS Categories of Allocation ....................................................................................................................... 14
Conflicting Interests .............................................................................................................................................. 15
Valuing the Business and Determining a Sales Price ....................................................................... 17
Overview of Factors Affecting Business Valuation ............................................................................................. 17
Appraisal and Valuation Approaches ..................................................................................................................... 17
Income Valuation Methods ................................................................................................................................. 17
Discounted Cash Flow Method .......................................................................................................................... 18
Capitalization Method........................................................................................................................................... 18
Market Methods..................................................................................................................................................... 18
Asset Based Methods ............................................................................................................................................ 19
Working with Professionals...................................................................................................................................... 19
Documents Required in a Cooperative Conversion .......................................................................... 21
A Rough Timeline and Summary of Documents ................................................................................................. 21
Step 1 - Letter of Intent + Employee MOU – the “Ok, Let’s Do This” Documents ................................... 21
The Letter of Intent .............................................................................................................................................. 21
Memorandum of Understanding (MOU) among Workers ............................................................................ 21
Step 2 – The Conversion Agreement + Cooperative Governance Documents – the “Here is Exactly
What Everyone is Going to Do” Documents....................................................................................................... 22
The Conversion Agreement................................................................................................................................. 22
Cooperative Formation and Governance Documents .................................................................................... 23
Step 3 – Executory Documents – the “Now Everything is Final and Official” Documents........................ 23
Step 4 – A Few Final Formalities ............................................................................................................................ 25
Financing Cooperative Conversion ................................................................................................... 27
Legal Considerations Related to Financing Cooperative Conversion ............................................................... 27
General Considerations in Financing a Cooperative Conversion ...................................................................... 27
Rewarding Cooperative Founders ...................................................................................................................... 27
Multi-Stage Buy-Outs ........................................................................................................................................... 28
Legal Limitations on the Form of Financing .................................................................................................... 28
Considerations Related to Different Sources of Financing................................................................................. 28
Worker-Sourced Financing .................................................................................................................................. 28
Preferred Share Financing .................................................................................................................................... 30
Seller Financing .......................................................................................................................................................... 30
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Tax Advantages to Seller Financing ................................................................................................................... 31
Obtaining Loans ......................................................................................................................................................... 31
Pre-Selling Goods and Services to Finance the Buy-Out or Guaranty the Financing.................................... 32
Crowdfunding ........................................................................................................................................................ 32
Securities Law Considerations ................................................................................................................................. 32
Governance During and After Cooperative Conversion .................................................................... 36
Introduction ................................................................................................................................................................ 36
A Few Basic, But Powerful, Governance Rights.............................................................................................. 36
The Transition to Workplace Democracy ......................................................................................................... 36
How Much Will Governance and Management Change? ................................................................................... 36
Legal Governance Requirements............................................................................................................................. 37
Laws Governing Cooperative Corporations ..................................................................................................... 37
Laws Governing Cooperatives Taxed Under Subchapter T .......................................................................... 38
Laws Governing Partnerships and LLCs Operating as Cooperatives .......................................................... 38
The Critical Importance of Understanding and Adhering to Governance Documents ............................ 38
Some Basic Components of Governance .............................................................................................................. 38
Governance Transition Scenarios ........................................................................................................................... 39
1. Simple Transition: Transfer Ownership / Retain Management ................................................................ 39
2. When Former Owner Becomes Worker Owner.......................................................................................... 40
3. Transitioning to Collective Governance........................................................................................................ 40
4. Transitioning to Distributed Governance ..................................................................................................... 40
When Departing Owners Maintain Some Control ............................................................................................... 41
Reasons Former Owners Might Retain Some Control ................................................................................... 41
Retaining Control to Protect Financial Stake.................................................................................................... 41
Retaining Control to Protect Mission ................................................................................................................ 41
Specific Strategies for Giving Control to Former Owners ............................................................................. 42
Employment Law and Worker Cooperative Conversions ................................................................. 44
When are Worker-Owners Employees? ................................................................................................................. 44
How much control must each cooperative member have in order to be considered a “partner” rather
than an employee? ................................................................................................................................................. 46
Does it make a difference if you form a partnership, LLC, or cooperative corporation? ......................... 47
Workers Compensation Insurance and Cooperative Conversion...................................................................... 48
Could conversion affect union status of workers? ............................................................................................... 48
The Role of Lawyers in Cooperative Conversions ............................................................................. 50
The Need for Lawyers to Support Cooperative Conversions ............................................................................ 50
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Roles of Lawyers ........................................................................................................................................................ 50
Why Multiple Lawyers Will Likely Be Involved.................................................................................................... 51
In The Ideal Scenario: Everyone Would Get Independent Advice .............................................................. 51
Second Best Option: Involve at Least Two Lawyers ...................................................................................... 52
For Simple Conversions: When One Lawyer Might Suffice .......................................................................... 52
Legal Case Study: Island Employee Cooperative .............................................................................. 53
Exploring Cooperative Conversion ........................................................................................................................ 53
Forming the Steering Committee ............................................................................................................................ 53
Forming the Cooperative.......................................................................................................................................... 53
Financing the Purchase and Structuring Agreements with Lenders .................................................................. 53
Worker Buy-In............................................................................................................................................................ 54
The Purchase Agreement and Conversion Process.............................................................................................. 54
Additional Steps and Documents Required in the IEC Conversion ................................................................. 55
Legal Case Study: Select Machine ..................................................................................................... 56
Exploring Cooperative Conversion ........................................................................................................................ 56
Selecting a Buyout Committee and Assessing Feasibility .................................................................................... 56
Preparation of Offering Statement and Vote to Convert.................................................................................... 57
Deciding on Cooperative Financial and Patronage Structure ............................................................................. 57
Financing the Buy-Out .............................................................................................................................................. 57
Executing the Conversion and Partial Buy-Out.................................................................................................... 57
Ongoing Involvement of Original Owners ........................................................................................................... 57
Completing the Gradual Buy-Out ........................................................................................................................... 58
Legal Case Study: Loconomics Conversion to a Freelancer-Owned Cooperative ............................ 59
Background ................................................................................................................................................................. 59
A Freelancer-Owned Cooperative .......................................................................................................................... 59
Loconomics as a Conventional Shareholder-Owned Corporation .................................................................... 59
Documents Required in the Conversion................................................................................................................ 59
Redemption of Stock and Stock Options .............................................................................................................. 60
Valuation and Promissory Notes............................................................................................................................. 60
Amending Articles and Bylaws ................................................................................................................................ 60
Membership Structure ............................................................................................................................................... 60
Legal Case Study: Real Pickles .......................................................................................................... 61
Background ................................................................................................................................................................. 61
The Deal ...................................................................................................................................................................... 61
The Financing Strategy.............................................................................................................................................. 61
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Preferred share terms ................................................................................................................................................ 62
Legal Case Study: Colorado Recovery ............................................................................................... 63
Background ................................................................................................................................................................. 63
Key Personnel............................................................................................................................................................. 63
Determining the Sales Price and Incorporating .................................................................................................... 63
Sample Documents ............................................................................................................................ 65
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The Purpose of this Guide
This Guide has been prepared as a publication under an award to the Metropolitan Transportation
Commission, as part of a project to increase worker-ownership for low- to moderate-income workers.
We aim to provide an overview of the legal steps involved for you, a selling owner, to convert your
business to employee-ownership. We provide a few models of how to convert your business, the issues
raised in valuing your business, and related financing, governance and employment law considerations.
Finally, we close with a few case studies that illustrate the points we raised in the guide. We hope you
find this guide useful and please submit any comments or feedback to us at
[email protected]
Important Disclaimers:
The contents of this handbook should not be relied on as legal advice. Some of this information
could become outdated, and laws vary from place-to-place. Furthermore, although we tried to collect
accurate information and give the laws our best interpretation, some information in this booklet could
even turn out to be incorrect or subject to other interpretations by courts or regulators! We sure hope
that’s not the case, but, what can we say? Law is complicated stuff! That's why we strongly
recommend that you consult with an attorney before using this information to form or operate a
cooperative.
This handbook was written by lawyers knowledgeable primarily about California law. Although
we tried to write in general terms that could be applicable across states, and although some legal matters
are governed by federal tax law, anyone using this book should be aware of the necessity to research
your own state’s laws.
1
Introduction to Employee-Owned Cooperatives
The Benefits of the Cooperative Form
Cooperatives are member-owned and democratically controlled businesses that distribute profits based
on an equitable patronage system. 1 Cooperative membership is typically restricted to suppliers,
customers, workers, or some combination thereof. 2 In addition to ownership, control, and patronagebased profit sharing, most cooperatives adhere to the seven internationally-recognized cooperative
principles: (1) voluntary membership, (2) democratic member control, (3) member economic
participation, (4) autonomy and independence, (5) education, training and information, (6) cooperation
among cooperatives, and (7) concern for the community. 3
Currently worker cooperatives represent a relatively small portion of the annual $500 billion dollar U.S.
cooperative sector, 4 and a similarly small portion of employee-owned businesses in the U.S. 5
Nonetheless a myriad of studies have demonstrated the distinct advantages that employee ownership
presents when compared with the traditional investor-owned businesses, 6 and worker cooperatives often
present significant long-term advantages when compared with other forms of employee ownership. 7
Considering the advantages of employee ownership, it is no surprise that the number of employee
owned businesses have grown in recent years, both in the U.S. and abroad, 8 and cooperatives have
performed particularly well when compared with other firms during the recent recession. 9
Given the advantages of worker cooperatives compared with investor-owned and other employee-owned
forms of business, the relative rarity of worker co-ops is surprising, and is often attributed to workers'
lack of capital and expertise. 10 But in light of the rapidly changing nature of the economy, the growing
interest in worker cooperatives, the constant growth of employee ownership, and the structural
advantages presented by worker cooperatives, the worker cooperative sector is only likely to expand in
coming years. Given this trend, business and legal professionals should become familiar with the
cooperative structure, and legal rules that govern cooperative enterprise.
1
Think Outside the Boss, at 1-2 East Bay Community Law Center and Sustainable Economies Law Center (5th ed.
2014) available at
https://d3n8a8pro7vhmx.cloudfront.net/theselc/pages/146/attachments/original/1417036445/TOTB5_Manual_FIN
AL.pdf?1417036445.
2
See Peter Molk, The Puzzling Lack of Cooperatives, 88:899 Tulane L.J. 899, 901 (2014).
3
Sushil Jacob, Representing Worker Cooperatives in the 21st Century, California Law Practitioner, Winter 2014 at
26-27.
4
See Molk, supra note 2 at 917.
5
Jaques Kaswan, Projecting the Long-Term Consequences of ESOP Vs. Co-op Conversion of a Firm on Employee
Benefits and Company Cash at 1 (Democratic Bus. Ass'n of N. Cal. ed. 1992).
6
See e.g. Key Studies on Employee Ownership and Corporate Performance, nceo.org,
http://www.nceo.org/articles/studies-employee-ownership-corporate-performance (last visited March 20, 2015).
7
See id. at 11-16 (arguing that for low-growth employee-owned firms, Co-op members should experience
increasingly higher benefits when compared with ESOP members, while in high-growth firms ESOP members
experience higher benefits during the initial years, followed by a reversal where Co-op members experience higher
benefits for the duration of the business' life).
8
See e.g. Delivering Responsible Capitalism - The Growth of Employee Ownership, Forbes Opinion (September
25, 2014, 7:32 AM) http://www.forbes.com/sites/jonathanrefoy/2014/09/25/delivering-responsible-capitalism-thegrowth-of-employee-ownership/.
9
See Bruno Roelants et al., The Resilience of the Cooperative Model (CECOP-CICOPA Europe, June 2012)
available at http://cecop.coop/IMG/pdf/report_cecop_2012_en_web.pdf.
10
Jacob supra note 3 at 27.
2
The Legal Definition and Structure of Cooperatives
The legal definition of cooperative may vary based upon state or federal law. For instance, a cooperative
may refer to a particular type of legal entity - the Cooperative Corporation - whose legal requirements
vary from state to state. 11 On the other hand, in some states cooperatives may operate under a number of
legal forms, such as cooperative corporations, LLCs, nonprofit mutual benefits corporations, general
corporations or general partnerships. 12 And for certain federal tax provisions, only C Corporations,
including cooperative corporations, may be considered cooperatives. 13
Although the legal definition of cooperative may vary, cooperatives generally share a common set of
operational characteristics: (1) each member has substantially equal control and ownership; (2) members
have a functional role in the business; (3) transfer of ownership interest is prohibited or limited; (4) there
are strict limits to return on capital investments; (5) economic benefits pass to members on the basis of
their patronage; (6) members are not liable for the cooperative’s obligations; (7) businesses services are
primarily used by the members. 14 Nonetheless, businesses that do not exhibit all of these features may
still be considered cooperatives for federal tax purposes. 15
Voting and Governance
Unlike investor-owned businesses - in which major business decisions and board elections are made by
shareholders with voting power in proportion with the number of shares they own - in cooperatives
members exercise control of the enterprise on a one-member one-vote basis. Cooperatives generally
have boards of directors that exercise and oversee corporate duties and owe the company fiduciary
duties of care and loyalty. Most worker cooperatives utilize such a representative governance structure,
in which a class of employee-members elect the board of directors. A minority of worker cooperatives
are organized as collectives, in which all employee-members serve on the board, and all members vote
on key decisions. 16
Patronage Distributions and Capital Distributions
Unlike traditional investor-owned firms, the primary purpose of cooperatives is to benefit their members
as patrons, rather than to maximize profits for capital investors. As such, whenever a cooperative earns a
surplus of net revenue, the cooperative can retain it as working capital or distribute it to the members on
the basis of their patronage. In the worker cooperative context, a workers patronage is typically
determined on the basis of the number of hours the member worked or on the basis of how much he or
she earned in wages. A minority of cooperatives also choose to distribute their net earnings on the basis
of capital contributions. Unlike capital distributions, however, patronage distributions are tax-deductible
to the cooperative. 17
11
Think Outside the Boss supra note 1 at 3.
See Jacob supra note 3 at 28.
13
See 26 U.S.C. 1042.
14
Jacob supra note 3 at 28.
15
See 26 U.S.C. 1042 (c)(2)(E) (allowing some members to have greater ownership interests); see also infra p. 13.
16
Jacob supra note 3 at 31.
17
Id.
12
3
Capital Structure, Capital Accounts
In order to facilitate the payment of patronage dividends, most cooperatives have a capital structure
consisting of individual member capital accounts. 18 The member capital account system is similar to a
partnership's capital structure. Unlike a partnership, however, rather than all of the surplus passing
through to the cooperative members, cooperative corporations may retain their surplus in an unallocated
capital account for general business and administrative use. 19 In addition to the unallocated capital
account, which is subject to corporate tax rates, the cooperative can draw from the undistributed portion
of member capital accounts as an internal source of financing. The unallocated capital account combined
with member capital accounts comprises the book value of the company. 20
Types of Legal Entities
While worker cooperatives can operate under a number of different entities, worker cooperatives are
most commonly organized as cooperative corporations and LLCs. The precise requirements for
cooperative corporations may vary from state to state, but the cooperative corporation is often
considered the entity that best incorporates the cooperative principles of democratic ownership and
control. 21 That is because most cooperative statutes provide for direct worker participation in
governance, and provide for distribution on the basis of member patronage. On the other hand, LLCs are
also great vehicles for creating cooperative enterprise since they are quite flexible contract-based
structures, and LLC members can easily ensure the cooperative principles are codified in the LLC
Operating agreement. While both LLCs and cooperative corporations present great potential vehicles for
cooperative enterprise, there are important differences between the two business forms. Because of the
contractual basis for LLC operating structures, LLCs are more flexible when it comes to permitting
variations in governance structure. They are also more flexible when it comes to member employment
status, because members can be classified as employees or partners.
Governance Structure
LLCs have incredibly flexible governance structures, which can present great options for small
cooperatives, especially those that wish to operate informally in a collective fashion, since LLCs do not
require a board of directors. A risk with LLCs is that, while the Operating Agreement can be crafted to
include the cooperative principles of one-member one-vote, it can also be easy for future LLC members
to change to a non-cooperative governance structure by simply amending the Operating Agreement.
Cooperative corporations often do not present the same risk of future abandonment of the cooperative
principles, since many cooperative statutes have democratic member participation as a permanent
governance feature.
Employment Status
In cooperative corporations the worker members are often presumed to be employees. Thus most
businesses organized as cooperative corporations must ensure adherence to employment law, including
payment of minimum wage, deduction of payroll taxes, provision of workers' compensation insurance
and payment of overtime. The presumption that members are employees also means that all cooperative
18
Id. at 33.
Id.
20
Id.
21
See Think Outside the Boss supra note 1 at 14.
19
4
members should have legal authorization to work in the United States. By contrast, LLC members are
generally not considered employees, but are treated as partners. This means that members of LLCs are
often not required to be paid minimum wage, pay payroll tax, or have workers' compensation insurance.
It also means that the LLC may provide a vehicle of cooperative ownership for workers that are
precluded from becoming employees.
Deciding to Convert into a Cooperative
While worker cooperatives may present economic advantages, the decision to form or convert an
existing business into a cooperative typically involves additional concerns beyond competitive
advantage. Cooperatives help keep money circulating locally, thus providing communities with a greater
degree of economic autonomy, they afford members with greater job security, foster community and
worker happiness, and are conducive to environmental responsibility, since they are so rooted in local
communities. 22 Thus businesses that are trying to foster these values should consider the cooperative
form. Business owners considering converting into a cooperative should also consider whether the
business' workers are open and committed to cooperative principles and prepared to assume a more
active role in business management. 23 Additionally they should assess whether the appropriate financial
circumstances exist to enable conversion. In assessing whether and how to convert into a cooperative,
professional assistance from legal, financial and accounting professionals can prove essential.
The next section covers the mechanics of conversion, highlighting four possible ways for you to sell
your business to your employees and form an employee-owned cooperative.
22
23
See Id. at 4.
See id. at 7.
5
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 the former, a business sells all of its assets to another entity or
person. In the latter, the owners/shareholders of the business sell their interests/shares to another entity
or person.
In selling a business to workers to create a cooperative, there is an added 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 restructure into a
cooperative. Combining both layers of considerations, we have outlined four scenarios for how a
cooperative conversion might 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/interests in exchange for cash, promissory notes,
and/or preferred shares. Workers become members of the cooperative, usually by contributing capital. In
many ways, this may be the simplest way to complete a cooperative conversion, but it may not be ideal
in all cases, as described below.
Type B: Form a New Entity and Acquire the Business’ Assets
The workers form a new cooperative entity, and acquire 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 Entity, Merge the Two Entities
The workers form a new cooperative entity and acquire the shares/interests 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 Entity, Operate Both Entities
The workers form a new cooperative entity and acquire the shares/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.
6
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.
Deciding Between an Asset Sale or Entity Sale24
Businesses can be sold, and their assets transferred, either through an asset sale or an entity sale. In an
asset sale, the entity sells its tangible and intangible assets to the buyer, while the entity's owners retain
equity in the entity. On the other hand, in an entity sale, the seller transfers his or her equity to the buyer,
who acquires the entity with all of its assets. Where the business is a sole proprietorship, the sale by
default will be a sale of assets, because there is no entity apart from the owner. Where the entity is a
partnership, LLC or corporation, the buyer and seller will generally have some choice over how the
business should be sold.
Whether a business sale should be structured as a sale of assets or as an entity sale depends on a number
of factors, not the least important of which is what the buyer is willing to accept. Other crucial factors
that will weigh on both buyer's and seller's choice will be (1) the existence of outstanding liabilities; and
(2) the disparate tax effects that would result from the sale of assets when compared with the sale of the
business entity. The tax implications are especially important where the seller's business is a C
Corporation because a sale of assets might result in double taxation. Where the business is converting
from an investor owned or closely held C Corporation to an employee owned business, the incentive to
sell the business' equity to the employees is increased, because Section 1042 of the Tax Code provides
significant tax benefits to qualifying companies that transfer equity into employees' hands.
Unfortunately, tax and liability considerations often pit seller and buyer against one another. Typically,
the seller would prefer to transfer equity, while the buyer would prefer to buy a pool of assets.
Moreover, where both parties have agreed to an asset sale, the parties' interests often conflict as to how
the sales price should be allocated across assets. In the cooperative context, these concerns will
undoubtedly exist, but may be less pronounced, especially where the seller intends to stay on as a
worker-owner, employee or consultant. For attorneys intending to represent the seller, the buyer, or both
in a conversion project, please see [§ 41 of this guide], Legal Representation During Conversion.
Outstanding Liabilities and Method of Sale Choice
24
This section draws heavily from Fred S. Steingold, Sell Your Business, The Step by Step Legal Guide, 4/2-4/13
and 9/2-9/19 (Marcia Stewart and Jake Warner eds., 1st ed. 2004).
7
As a general rule, any outstanding liabilities will follow the business entity, but will not follow the
business' assets. Thus where a buyer purchases a business entity, he or she will be stuck with the
business' outstanding liabilities. On the other hand, in the vast majority of cases, if the buyer opts to
purchase the business in an asset sale, he or she can buy them free and clear of outstanding liabilities.
The only exception to the "free and clear rule" is a doctrine known as successor liability, which applies
in the some states, but only in the manufacturing context. For these states, if the buyer purchases a
manufacturing business through an asset sale, and continues engaging in substantially the same type of
production, he or she may be held liable for tort claims stemming from the seller's manufactures. In any
case, because outstanding liabilities and debts follow the business entity, where such liabilities exist, the
buyer will likely be much less inclined to purchase the business through an entity sale.
Tax Considerations in Method of Sale Choice
When a business owner decides to sell his or her business he or she must carefully consider the various
tax rates that might apply, for the applicable tax rates will have significant bearing on what transactional
structure the seller should seek, and might even affect the final sales price and business valuation. The
potentially applicable tax rates include (1) ordinary income tax rates, which max out at 39.6%; (2)
corporate income tax rates, which range from 15% to 35%; (3) long-term capital gains tax, which range
from 0-15%; and (4) the real estate recapture tax rate of 25% for all non-accelerated depreciation.
What tax rates apply will depend upon a number of factors including the ultimate form of the transaction
(i.e. whether the sale is an entity or asset sale), the terms of sale, whether the value of the business'
capital assets has been written off, what entities are involved, the business' income, and the seller's
present and future personal income, among others.
Noncapital Assets, Capital Assets and Capital Losses
Noncapital Assets
Noncapital assets consist of any asset that the IRS does not categorize as a capital asset.25 Noncapital
assets include: inventory, promissory notes given to the business, accounts receivable and real estate or
other depreciable trade or business property held for less than a year. Proceeds from the sale of
noncapital assets are treated as ordinary income or loss.
Capital Assets
Capital assets include equipment, real estate, good will and some intellectual property. Some capital
assets, known as Section 1231 assets, can be depreciated. These typically consist of business real estate,
furniture, fixtures and equipment held by the business for over a year, and intangible property that can
be amortized under Section 197.
When a business acquires a Section 1231 capital asset it is permitted to depreciate, or "write off," the
value of the asset over the period of its anticipated useful life, by allocating the asset's depreciation as an
expense on the company balance sheet, in accordance with the General Accepted Accounting
Principles. 26 If the business opts to depreciate the asset using a straight-line method, it will allocate the
same dollar amount of depreciation as an expense each year of the asset's anticipated useful life. 27 The
business may also use some accelerated method of depreciation, in which a greater portion of the asset's
25
IRS Publication 544, available at http://taxmap.ntis.gov/taxmap/pubs/p544-012.htm#TXMP6d1fb63b
See 7: Property, Plant, and Equipment, 2002 WL 31118534
27
Jerry J. Weygandt et al., Basic Accounting 430 (Christopher DeJohn and Brian Kamins eds. 8th ed. 2007).
26
8
value is written off in the early years of its anticipated useful life.28 Intangible personal property outlined
in Section 197 has a minimum authorized useful life of 15 years. 29 Other properties may be depreciated
in 3, 5, 7, 10, 20 or 25 years, as set forth in the tax code. 30
Whichever method is used, at the end of the asset's anticipated useful life, its entire value will have been
written off, and its book value will be zero. Of course, this does not actually mean that the asset is
without value, so long as it can be sold for some price.
Where a capital asset is sold that has been held for over a year, and is not eligible for depreciation, or
has not been depreciated, all proceeds resulting from its sale will be taxed at the long-term capital gains
rate - typically 15%.
Capital Losses
Where the sale of capital assets leads to net capital losses, sellers may subtract the loss from their
ordinary income for up to $3000 a year ($1500 if married and filing separately) until the capital loss is
used up.
Depreciation Recapture
Capital assets that have been depreciated, and are sold for an amount that exceeds their book value are
subject to deprecation recapture taxation. Depreciation recapture taxation enables the IRS to tax the full
value of capital assets whose book value has been depreciated below the sales price. Recapture taxation
is thus inapplicable in sales of capital assets that (1) cannot be depreciated, (2) have been held for less
than a year by the current owner, or (3) have been sold for an amount equal to or less than the asset's
book value.
Where some portion of a capital asset has been depreciated and the asset is sold for more than its book
value, it is subject to a recapture tax on the amount of the sales proceeds, exceeding the book value.
With the exception of real estate, where a Section 1231 asset is sold, any sales proceeds that exceed its
book value will be taxed at the ordinary income rate. For real estate, any accelerated depreciation must
be recaptured at ordinary income rates, while non-accelerated depreciation is taxed at a 25% capital gain
rate.
Effects of Entity Form
Pass- Through and Taxable Entities
Whether or not the business being sold is some type of pass-through entity - such as a sole
proprietorship, a partnership, an LLC that has not elected to be taxed as a C Corporation, or an S
corporation - can greatly affect the amount of the sale proceeds that will be taken from the proceeds
resulting from an asset sale. Whether or not the business has been organized as a pass-through entity
will thus influence the sellers' willingness and/or motivation to agree to sell the business as a collection
of assets.
A pass-through entity is one that does not pay income tax. Rather, the tax burden is passed through to
the shareholders or interest holders, who are taxed on the portion of the business income they receive at
28
Id. at 432.
See 26 U.S.C. § 197 (a) ("The amount of such deduction shall be determined by amortizing the adjusted basis
(for purposes of determining gain) of such intangible ratably over the 15-year period beginning with the month in
which such intangible was acquired").
30
See IRS Publication 946, 32 - 33, available at http://www.irs.gov/pub/irs-pdf/p946.pdf.
29
9
the applicable personal income tax rate. Because of this structure, when a business organized as a passthrough entity sells its assets, the amount of proceeds attributable to each interest or shareholder will be
subtracted from the sales price, paid to that interest or shareholder, and taxed at his or her personal
income tax rate.
Where the business is not a pass-through entity, i.e. an LLC or Corporation that has elected C tax status,
the proceeds resulting from an asset sale will be subject to double taxation. This is so because non-passthrough entities are subject to direct taxation on their income stream at the applicable corporate income
tax rate. And, if the business is profitable, and distributes some portion of its profits to shareholders or
interest holders, the shareholder or interest holder pays additional taxes at the dividends tax rate, usually
15%.
This form of double taxation may benefit businesses, if the corporation distributes all annual profits as
employee compensation, or if it invests back into the business and takes advantage of favorable retained
earnings tax rates for earnings under $100,000. On the other hand, where a corporate taxed entity
engages in the sale of capital assets, it is subject to the same double taxation, but without the
corresponding benefits. Proceeds from the sale will be taxed first as corporate income at the applicable
corporate income tax rate, then the owners will be taxed for the share of proceeds distributed to them
individually, at the dividends tax rate.
Sole Proprietorships and Single Member LLC's
Where the business entity is a sole-proprietorship or single member LLC, the business will be sold as a
collection of assets, and proceeds from the sale will be treated as the seller's personal income. However
this does not mean that all of the sale's proceeds will be taxed at the personal income rate. For some
assets, the seller will pay long-term capital gains tax (if those assets have been held for over a year),
while for others the seller will pay the ordinary income rate. Thus, the seller of a sole proprietorship or
single member LLC will pay long-term capital gains tax rates - most often 15% - for gains stemming
from the sale of inventory and equipment held for over a year, for which no depreciation has been taken.
On the other hand, on equipment for which a depreciation has been taken, the recapture rule applies. In
such an instance, where the asset is sold for a price that exceeds the asset's depreciated value all gains
above the depreciated value will be recaptured and treated as ordinary income.
Partnership and Multi Member LLCs
Entity Sale
In the sale of a partnership or LLC, each partner or member's ownership interest that has been held for
more than one year is treated as a capital asset. As such, the portion of sales proceeds that a partner is
due, based upon his or her interest, is generally subject only to the long-term capital gains rate, typically
15%. On the other hand, if the partner held his or her interest for less than one year, it will be taxed at
the ordinary income rate.
Asset Sale
Where a partnership or Multi Member LLC is sold in an asset sale, the entity itself will not be taxed.
The portion of the proceeds due each partner or member, based upon his or her interest, will passthrough and be subject to either the long term capital gains tax rate, or to the applicable income tax rate,
depending on how the sale price is allocated among the different classes of assets. [See §4].
Corporations
Entity Sale
10
The sale of corporate equity is treated as the sale of a capital asset. Thus, in an entity sale, where the
equity holder owned the stock for over a year, proceeds from the sale are taxed at the long-term capital
gains tax rate. Where the shareholder held the equity for less than a year, on the other hand, proceeds
are taxed at the applicable individual income tax rate.
Where the sale of a corporate entity results in a net loss for the seller, the loss will be treated as a capital
loss, an ordinary loss, or both. An ordinary loss is a loss that directly lowers one's taxable income. Thus,
if the seller of a business suffered a net loss of $75,000 and earned $100,000 the same year, an ordinary
loss would reduce the seller's taxable income to $25,000. This would have the corresponding benefit of
reducing the seller's overall tax rate.
While most losses will be treated as capital losses, Section 1244 of the Tax Code enables certain small
business shareholders to treat the first $50,000, or the first $100,000 if filing jointly with a spouse, as an
ordinary loss. To treat loss as ordinary (1) the seller must have been the first purchaser of the stock; (2)
the stock must have first been issued by a small business corporation in exchange for cash or other
property, excluding securities or stock; (3) the stock must have been issued to the seller as an individual;
(4) no more than half of the corporation's gross receipts from the past five years may have come from
passive income; (5) the total amount the corporation received for all Section 1244 stock may not have
exceed $1 million; (6) the corporation must be a U.S. Company. 31
Where the six conditions required for proper designation as Section 1244 stock are not present, the
seller's losses will be treated as a capital loss. In such an instance, the seller may only subtract $3000 a
year, or $1500 if married and filing separately, from his or her ordinary income, until the capital loss is
used up.
Asset Sale
While both S and C corporations are subject to the same types of taxation if sold as entities, where a
business organized as a corporation is sold in an asset sale, whether it is an S or C corporation can have
a big difference on the tax rate that will be applied to proceeds of the sale.
S Corporations
Because an S Corporation is a pass-through entity, selling an S corporation through an asset sale will not
result in double taxation at the federal level. Rather, each shareholder will pay taxes on his or her share
of the proceeds at the long-term capital gains rate and/or the applicable individual income tax rate,
depending on how the sales price is allocated.
Nonetheless, S Corporations may be subject to additional taxation that other pass-through entities are
not. Thus some states will tax the entity itself on the proceeds resulting from an asset sale, leading to
double taxation at the state level. Additionally, if the S corporation has been converted from a C
corporation within the past decade, it might be subject to a "built-in gains tax," which is computed at the
highest corporate rate of 39%.
An S corporation that converted from a C corporation within the last ten years, and which held assets
whose fair-market value exceeded their tax basis, would be subject to built-in gains tax of 39% for those
assets.
31
26 U.S.C. 1244.
11
C Corporations
Because C Corporations are not pass-through entities, proceeds from the sale of assets held by a C
corporation will generally be subject to double taxation: the proceeds will first be taxed at the long term
capital gain, depreciation, or corporate income tax rate, depending upon how the sales price is allocated.
If most of the corporation's assets are noncapital assets, they will be taxed as ordinary income, and any
proceeds distributed to shareholders will be taxed at the dividends tax rate, typically 15%. Thus, where a
business organized as a C Corporation is sold in an asset sale, the shareholders could potentially receive
less than half of the proceeds earmarked for them if the assets are noncapital assets.
Section 1042
As discussed above, when a business is organized as a C Corporation the seller would do better to sell
the business by transferring equity to the buyer, rather than transferring the corporation's assets.
Structuring the sale of the business as an equity sale as opposed to an asset sale will enable the seller to
avoid double taxation. The incentive for structuring the sale of a C Corporation as an entity sale is all the
more pronounced when the business is being sold to its employees, because Section 1042 of the tax code
enables business owners to reduce the amount of taxable proceeds resulting from the sale of equity to
employees.
Section 1042 enables some business owners that sell their company to employees to defer capital gains
taxation, and potentially avoid it altogether. In order to qualify for Section 1042 deferral the seller must
(1) have owned the stock for more than three years prior to transfer; (2) have transferred at least 30% of
the company's overall equity, and at least 30% of each class of outstanding stock, to his or her
employees; and (3) issue a written statement to the IRS consenting to certain tax rates and
requirements. 32 Two or more shareholders can combine their sales in order to meet the 30%
requirement, so long as the sales are part of a "single, integrated transaction." 33 Moreover, the 30%
requirement may be met over a series of multiple transactions - but only the transaction that facilitates
employee ownership of 30% or more of the company will qualify for Section 1042 treatment. 34 After the
initial 30% threshold is reached, all subsequent transfers to the ESOP or eligible worker cooperative will
qualify for Section 1042 treatment.
In addition to the seller requirements, Section 1042 is only applicable where (1) the selling business is a
C Corporation at the time of the sale (although some businesses other than C Corporations may be able
to take advantage of Section 1042 by converting to C Corporations), (2) the equity is transferred to an
ESOP or an "eligible worker-owned cooperative," and (3) the seller reinvests the proceeds of the sale in
"qualified replacement property.”
The seller has a 15-month period within which he or she can reinvest the proceeds or the equivalent
amount in qualifying property: a three-month period before the sale, and a twelve-month period
afterwards. 35 After rolling over the proceeds or their equivalent, if the seller chooses to hold the
replacement property until death, he or she can avoid taxation on the proceeds from the 1042 sale
32
See 26 U.S.C. § 1042
Scott Rodrick, An Introduction to ESOPs, Kindle Edition, Location 274, (Nat'l Cent. for Emp. Ownership, 14th
ed. 2014).
34
Corey Rosen and Scott Rodrick, Understanding ESOPs, Kindle Edition, Location 364 (Nat'l Cent. for Emp.
Ownership, 2014).
35
ESOP Tax Incentives and Contribution Limits, nceo.org, http://www.nceo.org/articles/esop-tax-incentivescontribution-limits (last visited March 20, 2015).
33
12
altogether. 36 Nor will the seller be taxed if he or she gifts the qualified replacement property, 37 or if he
or she transfers the property to a living trust 38 or a grantor retained annuity trust. 39
Eligible Worker Cooperative
In order to qualify for Section 1042 tax deferral, the selling business owner must transfer his or her
equity to an ESOP or an eligible worker cooperative. There is currently no administrative decision or
guidance on the precise definition of an eligible worker cooperative beyond the text of Section 1042
itself. Section 1042 provides that to qualify as a worker coop, part I of Subchapter T must apply to the
organization, a majority of the voting stock must be owned by the members, a majority of the members
must be employees, and a majority of the Board must be elected by the members on a 1 person 1 vote
basis.
In addition to these requirements, S. 1042 (c)(2)(E) provides that "[t]he term 'eligible worker-owned
cooperative' means any organization . . . a majority of the allocated earnings and losses of which are
allocated to members on the basis of patronage, capital contributions, or some combination thereof."
While this provision expressly requires that most allocated earnings or losses be allocated on the basis of
patronage or capital contribution, it does not require that most of the company's earnings be allocated.
Because the express terms of S. 1042 do not give any guidance as to how non-allocated earnings or
losses should be distributed, there is nothing within the provision that would suggest that a majority of
the company's non-voting stock must be owned by employees. This is important, as it provides owners
with the option of financing the sale of their business to their employees, while retaining a majority
ownership until the committee pays off the first seller-financed installment. For an example of such a
transaction, see the Select Machine case study below.
Qualified Replacement Property
In order to take advantage of Section 1042, a qualifying seller must reinvest, or rollover, the proceeds
from the sale or an equivalent amount into qualifying replacement property. 40 Qualified replacement
property includes stocks, bonds, notes and securities of operating corporations, incorporated in the
U.S. 41 Preferred shares may also qualify as replacement property, but only if convertible into common
stock at a reasonable price. 42
1042 for Entities Other than C Corporations
While a business must be a C Corporation to qualify for Section 1042, some businesses may be able to
take advantage of Section 1042 by converting into C Corporations.
S Corporations
S Corporations may simply revoke the S Corp election and elect C-status, enabling shareholders selling
to an ESOP or qualifying coop to take advantage of the 1042 tax deferral. 43 Moreover, five years after
36
Id.
26 U.S.C. 1042
38
I.R.S. P.L.R. 9141046 (Oct. 11, 1991)
39
I.R.S. P.L.R. 200709012 (Mar. 2, 2007) ("Provided that the Taxpayer is treated as the owner of the QRP held in
the GRAT under sections 671 and 675 at the time of the transfer, the transfer of QRP to the grantor retained
annuity trust does not constitute a disposition of the QRP under section 1042(e)");
40
Id.
41
Rodrick supra note 33, Location 269.
42
26 U.S.C. 409 (l)(3).
43
See Rosen supra note 34 at Location 565.
37
13
the sale, the corporation can reelect S status. Whether converting to a C Corp is advantageous will likely
depend upon whether the selling shareholders have a high "basis" in their shares. 44 If the selling
shareholders have a high basis in the S Corp stock, there is typically not a great advantage to revoking
the S Corp election and taking the 1042 deferral.
Computing an S Corp shareholder's basis is a technical process that varies based upon how the
shareholder acquired the stock, and requires knowledge of multiple provisions of the tax code and access
to a wide swath of company records. 45 Generally speaking however, a shareholder's basis is his or her
initial capital contribution, plus or minus the flow through amounts from the S corporation. 46 If the
shareholder acquired his or shares by forming the corporation, the initial capital contribution is the sum
of cash and the adjusted tax basis of property contributed to the formation of the corporation. If the
shareholder acquired the stock through purchase, the initial capital contribution is generally the cost of
acquiring the stock. Different rules apply for stock that was gifted, inherited, or converted from a C
Corp. 47 After determining the S Corp shareholder's initial contribution, the shareholder's basis is
increased by his or her share of the business' income, and correspondingly decreased by his or her share
of the loss. 48
Because of the complexity of determining a shareholder's basis in stock of an S Corp, and because of the
importance of other tax considerations, S Corps considering converting to C Corps in order to take
advantage of S. 1042's tax deferment should work closely with an accountant or other tax professional.
Partnerships and Other Ownership Interests
Outside of the corporate context, the IRS may count the holding period of a seller's non-corporate
ownership interests towards the 1042 three-year requirement once the ownership interest has been
converted into corporate stock. While there is nothing directly in the code that supports this proposition,
prominent organizations endorse it, 49 and an IRS private letter ruling lends some support as well. 50
However, sellers should be cautious, since the private letter ruling dealt with an LLC that had elected to
be taxed as a C corporation from the outset, and private letter rulings are not precedential.
Allocating the Purchase Price in an Asset Sale
The IRS Categories of Allocation
When a business is sold by asset sale, the parties must allocate the sales price across seven categories
provided by the IRS. The manner in which the sales price is allocated can significantly affect what tax
rate will apply. The seven categories include: (I) cash and cash like assets; (II) securities, including share
44
Rodrick supra note 33, Location 595.
See S Corporation Stock and Debt Basis, irs.gov, http://www.irs.gov/Businesses/Small-Businesses-&-SelfEmployed/S-Corporation-Stock-and-Debt-Basis (last visited March 24, 2015); see also Meredith A. Menden, The
Basics of S Corporation Stock Basis, Journal Of Accountancy (December 31, 2011)
http://www.journalofaccountancy.com/issues/2012/jan/20114319.htm.
46
Id.
47
See Menden supra note 45.
48
See S Corporation Stock and Debt Basis, supra note 45.
49
Rodrick supra note 33, at Location 292 ("if a seller received the stock as a gift or acquired it in a tax-free
exchange (e.g. a partnership interest converted to stock when the partnership incorporated) the three year holding
period includes the prior holding period of the donor of the partnership interest").
50
P.L.R. 200827018 (July 4, 2008) (ruling that the time period that sellers had held ownership interest in an LLC
partnership that had elected C Corporation tax status and subsequently converted into a C corporation would be
counted towards S. 1042's three-year requirement).
45
14
certificates, government securities, readily marketable stock or securities, and foreign currency; (III)
accounts receivables and debt instruments; (IV) inventory; (V) other tangible property, including land
and buildings, furniture, equipment and fixtures (improvements permanently attached to buildings); (VI)
and other intangible property, which includes covenants not to compete, intellectual property, customer
or client lists and licenses or permits granted by the government; and (VII) goodwill and going concern
value. 51
Conflicting Interests
Generally speaking, the seller will retain class I and II assets. Because the buyer typically does not
purchase these assets, none of the sales price will be allocated to classes I and II. Additionally, because
of the risks associated with collecting on accounts receivable, the seller often retains all class III assets
as well; although the seller might incentivize the purchase of accounts receivable by selling them at a
discount. In either case, there is not typically a strong preference to maximize or minimize the value
allocated to class III assets on either the buyer's or seller's part.
Most of the conflict between buyer and seller pertains to asset classes IV - VII. As will be explained, the
seller would like to minimize the amount of the sales price that would be allocated towards noncapital
and depreciable tangible capital assets, while maximizing the allocation towards real estate and
intangible capital assets. On the other hand, it will typically be in the buyers' best interest to minimize
the amount of the sales price allocated towards real estate and intangible capital assets, while
maximizing the amount of the sales price allocated towards depreciable tangible capital assets and noncapital assets.
Seller's Interests Explained
The reasons underlying the seller's preferences have been briefly alluded to above. For the seller, any
allocation towards noncapital goods will be taxed at his or her ordinary income rate. Additionally, any
allocation towards depreciated tangible assets will be subject to recapture taxation at the applicable
personal income tax rate, and thus will increase the seller's exposure to tax liability. Because much of
the common depreciable capital assets that a business is likely to possess can be written off in under 7
years, many of these assets are likely to be substantially or fully depreciated. Consequently, a substantial
portion of the sales price allocated towards those assets could be taxed at the seller's ordinary income tax
rate. If the seller is a C corporation, or an entity that has elected to be taxed as a C Corporation, that
means the applicable corporate tax rate. If the seller is a pass-through entity, the proceeds would be
taxed at the applicable personal income tax rate of the interest or shareholders.
On the other hand, by allocating the maximum amount towards non-depreciable capital assets held for
over a year, the seller can ensure that the proceeds are taxed at the long-term capital gains tax rate. And
while "goodwill and going concern value," and other intangible assets listed in Section 179 can be
depreciated, they cannot be fully depreciated for at least 15 years. Thus there is greater likelihood that
the asset will not be substantially depreciated. If the amount allocated towards these assets does not
exceed the book value, the proceeds will only be taxed at the long-term capital gains rate. Lastly, by
maximizing the amount allocated towards real estate, the seller can ensure that that portion of the
51
IRS Publication 544, available at
http://www.irs.gov/publications/p544/ch02.html#en_US_2014_publink100072483
15
proceeds is taxed at the real estate recapture rate of 25%, which often falls below the applicable ordinary
or corporate income tax rate.
Buyer's Interest Explained
The buyer's interests are most often served by a markedly different allocation of proceeds. For one thing,
the buyer receives no proceeds from the sale, and thus does not directly bear the tax burden of the sale.
For another thing, while the seller is more likely to minimize his or her tax burden by allocating a
greater portion of the proceeds to those assets that have a longer timeline of depreciation, the buyer is
directly benefited by allocating a greater portion of the proceeds towards capital assets with a shorter
depreciation timeline. This is so because the buyer will be able to use the amount of proceeds allocated
towards the assets as their future taxable basis, and will be able to fully write off the value of the asset in
the allowed amount of time. Where the allowed timeline for depreciation is shorter, the buyer can
quickly reduce his or her tax burden going forward. While inventory is not a depreciable capital asset, it
is a short-term asset that can be written off quickly, thus decreasing the buyer's tax burden in the near
future.
16
Valuing the Business and Determining a Sales Price52
Overview of Factors Affecting Business Valuation
There is no singular gold standard on business valuation. Nonetheless, there are many commonly used
methods, metrics, and market factors that a seller should consider in valuing his or her business. Some
factors that will affect the price of the sale include the seller's personal needs, and the terms of sale.
Additionally, in the cooperative conversion context, both the terms of sale and sales price will be
affected by the need for worker-owners to receive wages immediately after the sale.
In addition, a seller's personal needs may significantly impact the sales price. For instance, the seller's
desire to quickly complete the transaction and sever a future relationship may diminish the business'
value. By contrast, where the seller is seeking to stay on as a consultant, an employee, or a workerowner, the business' value will likely be greater, since the worker-owners will be able to draw from the
seller's experience in running the business.
In addition to the seller's personal needs, the terms of sale can have a significant impact on the sale price
of the business. Most sales of businesses are seller financed - meaning the buyer pays the seller in
installments over time. As such, the precise terms of sale, including the interest rate, repayment period
and amount paid down, can have a significant effect on the final sales price. Typically, to account for
the additional risk associated with longer-term financing, and for the disparity between the present and
future value of money, the longer the timeline for repayment, the higher the purchase price of the
business.
Last, in the cooperative conversion context, because most worker-owners will be relying on the business
for their primary source of income, the sale price and terms of payment must result in cash flow to cover
operating expenses, seller related financing, and salaries. The need for these cash flows can affect both
the overall business valuation and the final terms of sale.
Appraisal and Valuation Approaches
There are three basic approaches to business valuation used by professionals: income based valuation,
asset based valuation and market based valuation. 53 While the final sales price agreed upon between the
buyer and seller may not correspond precisely with the number resulting from any of these approaches,
each of the approaches can provide the parties with useful benchmarks, and thus provide a reference
point for buyer and seller during the negotiation process.
Income Valuation Methods
Income valuation provides a useful, but imperfect approach to affixing a value to a company. The utility
of this approach in the employee-owned company context is questionable, since it assumes that the
buyer is looking at purchasing the business merely as a source of investment income. Nonetheless, it can
provide sellers seeking to convert their business to employee-ownership with a reasonable benchmark of
valuation used by many businesses. Conversely the buyer can use this as a way to reduce the value of
the business—i.e. if they know the seller has a much lower expected rate of return (i.e. below 10%).
This may be a good method for employee committees to use in their negotiations with the seller.
52
This section draws heavily from Steingold supra note 24 at 5/2 - 5/7.
See Shannon Pratt and Alina V. Niculita, The Lawyer's Business Valuation Handbook 24 (American Bar
Association 2d ed. 2010).
53
17
There are two basic approaches to income valuation: the discounted cash flow or discounting method,
and the capitalization method. 54 The primary difference between the two methods is that the discounting
method considers the return on investment over the life of the investment, whereas the capitalization
method focuses on average returns within a single time period.
Discounted Cash Flow Method
Using the discounting method, an appraiser would determine what income the investor could expect
over the life of the investment, and then discount each increment of the stream of income back to present
value at a discounted rate of return, or discount rate. 55
The main benefit of using the discounting method is that it accounts for the time value of money. This
could potentially be beneficial for a buyer's committee that is weighing the possibility of purchasing the
business and wishes to determine whether the purchase of the business would make economic sense.
Although, as previously indicated, income valuation approaches are likely less applicable in the
cooperative conversion context. This may be particularly true of the discounting method, since the
potential life of each cooperative member's investment period might diverge significantly, based upon
the number of years he or she would remain employed at the firm.
Capitalization Method
The capitalization approach is expressed by the formula: Business Value x Desired Rate of Return 56 =
Expected Annual Profits. To use this method of valuation, the seller must first identify a target annual
rate of return that he or she expects would be attractive to an investment-oriented buyer, typically
between 10% and 20%. The seller must then identify, with reasonable accuracy, the business's profits
for the next few years. After determining the annual profit, the seller divides this number by the desired
rate of return. The resulting value would be the business' sale price.
For example, a Seller who reasonably anticipates that an investment-oriented buyer would want a 20%
annual return, and reasonably anticipates that the average annual profit over the next few years will be
$50,000, would divide $50,000 by .2, for a business valuation of $250,000.
Market Methods
Guideline Public Company Method
The guideline public company method seeks to find public companies engaged in similar business as the
private company being sold in order to find a potential free-market value of the equity. Using this
method an appraiser or qualified seller would calculate valuation multiples from financial data of
comparable public companies and apply the multiplier to the appropriate data from his or her
company. 57
This method is a bit more complicated than the other market methods and will likely require the
assistance of a business appraiser. Furthermore, it is probably not applicable to most small companies,
and should be limited to companies with annual revenues exceeding $5 million. 58 Nonetheless, it can
54
Id. at 25.
Id.
56
This is also known as the capitalization rate.
57
Id.
58
Paul R. Hyde, When to Use the Guideline Public Company Method, Business Appraisal Practice, Spring Summer 2004, at 5.
55
18
provide useful information for sellers, buyers' committees and their attorneys in assessing the potential
value of the company. If a seller is interested in learning more about this method of valuation, Shannon
Pratt's The Market Approach to Valuing Business is a great resource.
Sale of Comparable Businesses Method 59
Ideally, a seller will look to market data on the sale of similar businesses to inform the ultimate sale
price. This data, however, is not abundant and requires significant investment in time, and perhaps
money, to obtain. Nonetheless, acquiring such data can be a great resource in providing the buyer with a
reasonable estimate for what the business is worth. Resources for data on the sale of comparable
businesses include trade publications, business brokers, Internet sources such as
www.bvmarketdata.com's BizComp Service, and personal networks. Professionals, such as brokers and
appraisers, can greatly assist in obtaining data on the sale of comparable businesses.
Industry Formulas and Standards
Certain formulas have gained credence in particular industries, but these should be treated only as rough
approximations of business value, since they may be too broad to deal with particular factors affecting
the seller's individual business. Common industry specific formulas include Sales or Earnings Formulas,
which use some multiplier times gross sales or net earnings to identify a value, and Units Formulas,
which use some multiplier times the number of customer contracts in place, or the number of machines
in operation.
Asset Based Methods 60
Another basis of valuation is totally up the resale value of the business' tangible assets, and the value of
intangible assets, such as leases, business name, intellectual property and customer lists. A company's
asset based value should not be confused with its book value, which is an accounting term, and which
may reflect depreciation on assets, thus not reflecting the true collective value of the company's assets. 61
Asset valuation will be affected by outstanding or potential liabilities, unless the seller agrees to assume
sole responsibility for those liabilities.
Working with Professionals
While it is advisable for sellers to independently assess the value of their business, they are strongly
encouraged and may find it necessary to seek professional assistance, which can greatly contribute to
identifying a price range. Accountants can help organize and evaluate a business' financial data, apply a
pricing formula, and help present the pricing information in a compelling format. Brokers can help by
tracking down information about sales of comparable businesses, and tailoring the information to
current market conditions in the business' community. Appraisers can assist with company valuation,
and are typically astute at assigning accurate value to tangible property. Additionally, a good appraiser
might be able to identify business shortcomings and suggest ways to increase the business' value.
While professionals can greatly contribute to the valuation process, sellers must be mindful of the
potential shortfalls and limitations of professional assistance, and make sure that the professional they
59
This method is also often referred to as the guideline transaction method. See Pratt, supra note 53, at 25.
This method is also known as the Adjusted Net Value Asset Method, and is one of two asset-based approaches.
The other approach is known as the excess earnings method, and is really a hybrid of both the asset based approach
and the capitalization income approach. See id. at 27.
61
See id. at 11.
60
19
have identified has experience and a reputation of honesty. For instance, sellers should exercise caution
when working with brokers, who are often paid on a commission basis. The seller should be clear about
what they are seeking - market data on comparable business sales. Moreover, when working with
brokers, sellers should be leery of initial "free" appraisals that assign a very high value to the business,
as this is often a ploy to lure the seller into working with the broker who may charge a lot, only to
ultimately assign a more realistic value. When working with appraisers, sellers should be mindful that
most businesses' value exceeds the value of tangible assets, and accordingly should try to find an
appraiser experienced in valuing nontangible factors such as favorable leases and goodwill. Bankers or
real estate brokers might be able to help identify an appraiser with a good reputation. The American
Society of Appraisers may be able to as well.
20
Documents Required in a Cooperative Conversion
The documents required to convert a business to a cooperative are described below, although they will
vary greatly depending on the form of business and the chosen process of conversion. Regardless of the
process, there will likely be one large document that commits the parties to moving forward, outlining
the entire conversion process in detail (we call this the “Conversion Agreement” below). Then, to fully
execute the conversion, there will usually be a variety of smaller documents to create or convert any
necessary entities, deed over real property, give parties necessary authority, and make the conversion
official at closing. For Island Employee Cooperative, the time between executing the larger agreement
(the “Stock Purchase Agreement”) and the closing of the sale (which required simultaneous execution of
multiple documents) took approximately 6 months.
A Rough Timeline and Summary of Documents
Here, we have grouped the required documents into three primary steps. Note that, in the first two steps,
there will be two categories of documents: 1) Agreements between workers and owners, and 2)
Agreements between workers.
Step 1 - Letter of Intent + Employee MOU – the “Ok, Let’s Do This” Documents
One or two relatively informal and loosely-binding documents can be used to launch the conversion
process. Even before getting to this point, both the owners and the workers will have likely done a great
deal of exploration and assessment of the viability of conversion. Having concluded that they should go
forward, a Letter of Intent signed by participating employees and owners, can lay a rough road map of
the process, and a Memorandum of Understanding (MOU) signed by participating employees can
describe how employees will work together in negotiating the buy-out.
The Letter of Intent
The first roadmap document, which we’ll call “Letter of Intent,” outlines the terms and process that the
parties are contemplating and states that each party will make a good faith effort to iron out the details in
a more firmly binding and detailed agreement. This Letter of Intent might be between one and four
pages and could consist of simple bullet points. Although it is a short document and not intended to be
strictly binding, it would preferably give each party an obligation to go forward with the process and
make a reasonable effort to carry it out. This helps each party feel secure to commit time, money, and
effort to larger steps, such as forming an entity, applying for financing, and so on. At this point, the
owners might make an exclusivity agreement – agreeing to negotiate exclusively with workers and not
seek or entertain other offers to buy the business. The parties might also want to agree not to disclose the
details of the negotiations, if any of the business information is sensitive. Each worker may sign the
Letter of Intent as an individual party, or, if the workers have an MOU and have appointed a Steering
Committee, it may be signed by one or more individuals designated to represent the workers as a group.
The owners’ business entity (if any) should be a party to the agreement, and owners (as individuals)
should likely also be parties, to the extent that individual owner consent will be necessary to complete
the conversion.
Memorandum of Understanding (MOU) among Workers
The participating employees should all be on the same page about how to move forward, and they might
want to form a “Steering Committee” to lead the cooperative conversion process on behalf of the
employees. To officially appoint this committee to act on behalf of workers, the workers may want to
execute an MOU, signed by all involved workers, describing their purpose, any commitments of time or
money employees will pledge, powers granted to the Steering Committee, and how the workers will
make decisions as a group. This could be a short and informal document, or, alternatively, it could
21
mirror the Bylaws that the cooperative may eventually adopt, which has the benefit of giving the
workers practice in operating as a cooperative and understanding Bylaws.
Step 2 – The Conversion Agreement + Cooperative Governance Documents – the “Here is
Exactly What Everyone is Going to Do” Documents
When everyone is in agreement and ready to fully bind themselves to the conversion process, the owners
and workers will likely execute a lengthy contract that we will call the “Conversion Agreement.”
Additionally, if a new cooperative entity is to be formed, employees should execute Articles of
Incorporation, Bylaws, and any other formation and governance documents for the cooperative. All of
these documents are pivotal to the conversion process, and we strongly recommend that parties consult
with a lawyer to make sure that the terms are fair, in compliance with the law, and that no important
terms are omitted.
The Conversion Agreement
The Conversion Agreement is a detailed and formal document that binds all parties to complete various
steps in order to eventually finalize the conversion. This document would contain the sale price, list of
assets being transferred, information and assurances on which all parties are relying (representations and
warranties), promises by each party to do or not do things (covenants), and various contingencies
(conditions) that allow each party to back out of the deal if certain requirements are not met, such as
confirming the necessary financing. This document would describe all other documents that must be
properly executed to complete the conversion. Much like the purchase and sale agreement used in
selling a house, there may be a variety of due diligence tasks and intermediate steps between the
execution of the agreement and the closing of the sale. The Conversion Agreement might also be a
called Buy/Sell Agreement, Sales Agreement, Purchase Agreement, Stock Purchase Agreement, or
something similar. It will likely run between 5 and 40 pages, and include multiple attachments that
represent samples of other documents to be executed before or at closing. Since this document will have
many similarities to a buy-sell agreement used when selling any business, many samples of such a
document are available.
Although the Conversion Agreement will contain many terms not described here, below are a couple
terms worth describing in greater detail:
1. Non-Compete Agreement and Non-Solicitation Agreement: Non-Compete Agreements and
Non-Solicitation Agreements are often used in the sale of a business, since the selling owner(s)
are well positioned to create a business that directly competes with or poaches employees from
the sold business. A Non-Compete Agreement can specify a period of years and a geographical
area in which the selling owners(s) are prohibited from starting a specified type of business. The
Non-Solicitation Agreement can also state that the seller may not solicit or hire any of the
cooperative’s employees to work for the seller.
2. Consulting Agreement with Selling Owners: The knowledge and expertise of the selling
owner(s) can greatly benefit a business, particularly in the months or first few years after
transition to worker ownership. The Conversion Agreement could specify that the selling owner
will provide ongoing advice and consulting services to the business. For example, the Island
Employee Cooperative contracted with the prior owners to provide full-time consultation for a
period of four weeks following the sale, and 500 hours per year for the subsequent two years.
22
Cooperative Formation and Governance Documents
If the workers plan to form a separate cooperative entity, then they will form the entity by executing
and filing Articles of Incorporation and adopting Bylaws. If the cooperative chooses to form as an LLC,
the workers would instead file Articles of Organization and adopt an Operating Agreement. If the
cooperative will use a name that is substantially similar to the original business name, the original
business may need to write a letter to the Secretary of State giving permission to the cooperative to file
Articles using the name. The execution and filing of these documents would preferably take place prior
to the execution of the Conversion Agreement, so that the new cooperative entity can be a party to the
Conversion Agreement.
At formation, the Articles of Incorporation can specify that the Steering Committee will serve as the
Cooperative’s first Board of Directors, and the Board may then adopt a resolution to adopt the Bylaws
and admit members. To legally admit members, the Cooperative might also need to prepare a document
providing certain disclosures to members, as is required in California. Membership certificates are
generally not legally required, but could be used to give workers a more formal acknowledgment of their
new ownership interest. The Cooperative need not receive capital contributions from members at this
point, since doing so might first require some work to ensure that the Cooperative complies with
securities laws, but the Bylaws may provide for a capital contribution required at a later date.
Since the decision to execute the Conversion Agreement is a major decision of the sort that cooperative
members (as opposed to directors) are generally required to make, the Cooperative should then schedule
a members meeting to officially vote on any resolutions necessary to validly execute the Conversion
Agreement. All resolutions and meeting minutes should be kept with the Cooperative’s official records,
and the initial resolutions and minutes may be provided to the business owners to give assurances that
the Cooperative had the power to become bound to the Conversion Agreement.
If the workers do not plan to form a new entity, the Conversion Agreement should include an
attachment representing the Amended Articles and Bylaws that would eventually be executed when
conversion is complete. This is so that workers are fully informed of the nature of the entity that they
will soon own, govern, and rely on for the livelihoods. This also provides assurances to the owners that
they are indeed selling their business to a worker cooperative, and not to a group of workers who might
turn around and sell the business to the highest bidder.
Step 3 – Executory Documents – the “Now Everything is Final and Official” Documents
To make the conversion final and official, a variety of documents will likely need to be executed. An
escrow service may be used to facilitate the final execution of documents and transfer of funds, and
many of the documents will be signed at a single closing meeting. One or more of the documents may
be completed after closing, in situations where parties agree to take a specified action within a
reasonable period of time after closing (such as changing trademark registration). Some of the
documents needed before or at closing may include:
1. Redemption Agreements: Where the Conversion Agreement does not provide for the
automatic relinquishing of owners’ interest in the company upon the occurrence of certain
conditions, the owners may sign a document at this point to officially relinquish their interests in
the business.
2. Promissory Notes: The cooperative will likely execute promissory notes representing the
cooperative’s debt to the prior owners and/or to other lenders. A very basic sample promissory
note is provided in the back of this handbook, though institutional lenders will often use their
23
own form. If individual workers are receiving loans to finance their buy-in, workers will also
need to execute promissory notes individually.
3. Loan Agreements: Because promissory notes are generally short documents that simply
describe the terms of promised payment, some lenders may require the cooperative to sign an
ancillary Loan Agreement to provide for other obligations of the cooperative or lender. For
example, the lender may require that the cooperative receive technical assistance from a
specified provider, in order to ensure the financial viability of the cooperative.
4. Inter-Creditor Agreement: In cases where multiple lenders collaborate to support a
conversion, it may be necessary for the lenders to execute an inter-creditor agreement,
committing each lender to provide financing and specifying the priority of repayment and the
assets securing each loan. An Inter-Creditor Agreement was used in the conversion of the Island
Employee Cooperative, as described in the case study later in this handbook.
5. Share Certificates: The cooperative may prepare certificates evidencing the issuance of
preferred shares, if any.
6. Governing Documents: Where original business entity simply changes its structure, the new
Articles and Bylaws may be officially adopted at closing.
7. Leases, Lease Assignments, or Deeds: For businesses with a physical location, it will be
necessary to execute documents ensuring that the cooperative has secure land tenure. This could
involve the transfer of land by deed, the assignment of a lease (usually requiring the landlord’s
permission), or the execution of a new lease if the prior business owner will retain ownership of
the location and lease it to the cooperative. In cases where the original business entity simply
converts to a new structure or new type of entity, it may not be necessary to execute any
documents to transfer land title, since the land doesn’t change hands. However, since there may
be a name change to add the word “Cooperative,” it would be a good idea to amend any deeds
or leases to ensure that the owner/lessee name is up-to-date. Lastly, if ownership changes hands
and there are other tenants at the location, the tenants should be notified of the change of
ownership.
8. Assignment of Contracts, Bank Accounts, and Insurance Policies: Since businesses tend to
be parties to multiple contracts, including insurance policies, it may be necessary to obtain
agreement from the other contract parties and insurance companies to assign the contracts and
policies over to the new entity, if the cooperative is operating under a new entity. In addition,
bank accounts will need to be closed, assigned, and/or renamed. Documents evidencing these
assignments, contracts, policies, and accounts should be provided at closing, although some
may, by necessity, need to be completed after the closing.
9. Transfer or Licensing of Intellectual Property Rights and Trademarks: It cases where the
individual business owners personally own the rights to any intellectual property rights or
trademarks associated with the business, it will be necessary to transfer those rights to or license
them to the cooperative. This may be done in the Conversion Agreement, itself, if the individual
owner is a separate named party, or it may be done in an ancillary agreement. In the case of
registered trademarks, copyrights, and patents, the registration will need to be changed.
10. Consulting Contracts with Third Parties: While the Conversion Agreement may commit the
prior owners to ongoing consulting with the cooperative, the Conversion Agreement may also
require that the cooperative enter into separate contracts with other technical assistance
24
providers. For example, the lenders that supported the conversion of the Island Employee
Cooperative required that the cooperative enter into technical assistance and professional service
contracts with three agencies, in order to receive support in grocery management, marketing,
merchandising, business planning, cooperative governance and operations, and accounting.
11. Letters and Resolutions Affirming Authority: Prior to closing, it is wise for the parties to
collect documents that verify that all parties to the Conversion Agreement have the full legal
authority to bind the entities and complete conversion. That way, it is unlikely that someone
would later challenge the validity of the conversion on the basis that the parties did not have the
necessary authority. For example, the attorney for the original business entity may write an
opinion letter stating that the owners have made a valid decision to convert the business and that
no laws or obligations to third parties prevent them from doing so. In addition, the cooperative
can provide copies of Board resolutions and Member resolutions, signed by the Secretary,
verifying that the cooperative has made legally binding decisions to commit to the conversion.
12. Tax Clearance Letters: The business should provide evidence that it has filed all tax returns
and paid all taxes. This evidence may take the form of a letter from an accountant or from the
local, state, and/or federal taxing authority.
13. Bill of Sale: In the case of an asset sale, a bill of sale – or multiple bills of sale – will officially
transfer ownership of certain assets, such as intellectual property, client lists, inventory,
equipment, files, records, and so on.
14. Securities Offering and Registration Documents and/or No Action Letter: In some cases,
when the cooperative receives capital contributions or loans from cooperative members, the
cooperative may need to take additional steps to ensure that the receipt of capital from members
complies with securities laws. See the financing chapter of this handbook for additional details
on when securities law will be relevant, and what paperwork may be required.
15. Final Valuation of Inventory: For businesses that maintain inventory, the value of the
inventory can fluctuate on a day-to-day basis. The final value of the inventory will need to be
determined as close to the date of final sale as possible, causing the business sale price to shift
slightly.
16. Deeds of Trust: If any loans will be secured by real estate, it may be necessary to file (or
“record”) a Deed of Trust along with local property records, to ensure that the lender’s right to
the property is protected in the event of a default on the loan, and to make prospective
purchasers aware of the security interest.
17. Resignation of Officers and Directors: Except in the case of an asset sale, the officers and
directors of the original entity will need to submit their resignation. This is because the
relinquishing of their ownership interests will generally not automatically result in removing
them from governance and administrative roles.
Step 4 – A Few Final Formalities
After closing, the parties may have a handful of additional papers to prepare and file, particularly for
tasks that cannot be completed until after closing. Tasks that may occur after closing might include
changes to contracts with third parties, changes to bank accounts, changes to trademark registration, and
any other action that is both contingent on successful closing and on third party action. Generally, the
Conversion Agreement or other contracts executed at closing will bind the parties to completing these
additional tasks as quickly as possible.
25
Additionally, the cooperative may need to file a Statement of Information or a similar document with the
Secretary of State to provide an updated list of directors and officers. If it plans to do business under a
name that is different than the entity’s legal name, it will usually need to file a Fictitious Business Name
(“Doing Business As”) Statement.
In the case of an asset sale from one entity to the new cooperative, it is possible that the original entity
will then want to dissolve, which requires a handful of formalities to wind up the business, file
certificates of dissolution, final tax returns, and so on.
26
Financing Cooperative Conversion
Legal Considerations Related to Financing Cooperative Conversion
In order to purchase the business they work for, workers generally need to aggregate capital from
multiple sources, which might include:
• Themselves – in the form of member buy-in, loans, and preferred shares,
• Loans from economic development nonprofits, community development financial institutions
(CDFIs), or governmental agencies,
• Loans from community banks and credit unions,
• Loans from friends and family,
• Loans from prior owners of the business,
• Grants and donations,
• Micro-loans from the public, raised through crowdfunding and/or a direct public offering, and
• Non-voting “preferred” shares with a fix return sold to investors.
Each type of financing can be customized with terms to fit the unique needs of the cooperative and the
funder, and some of those terms and options are discussed below. In addition, each type of financing
may come with legal considerations related to securities and tax, also discussed below.
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, the provision of capital often comes hand-in-hand with a share of control of the
business and the potential to maximize profits from the investment. Worker cooperatives, by definition,
put control in the hands of workers and they distribute earnings primarily on the basis of the value and
quantity of the workers’ labor.
As such, the individuals and entities that finance cooperatives generally do so with the expectation of
receiving a fixed return that is generally set at not much more than market rate or prevailing rates of
return. Financing sourced from mission-driven organizations or government funds may even come at
below-market rates, in recognition of the powerful social and economic benefits that worker
cooperatives bring to communities.
Rewarding Cooperative Founders
The patronage-based distribution of earnings in a worker cooperative generally need to be adapted in
order to reward the workers who took risks in founding the cooperative and who stuck with the business
during lean years. Often, in the years following cooperative conversion, the cooperative may need to
commit a substantial portion of its earnings toward making payments on the loans or preferred shares
that financed the transaction. This will reduce the cooperative’s net income available for distribution as
patronage dividends, meaning that workers who took the risk to convert the business to a cooperative
will receive fewer financial rewards than workers who join in years after the loans are paid off.
As a result, it is good practice to offer addition financial incentives to the workers who take part in the
conversion and work to pay down the loans. Some cooperatives do this by allowing the members’
capital contributions to accumulate interest. However, in cooperatives where the workers provide very
little in the way of monetary capital contributions, they still “capitalize” the business with their labor. As
such, some cooperatives pay a “bonus” later on, directly based on the estimate of what workers would
have made had the financing payments been distributed more evenly over a longer period.
27
Multi-Stage Buy-Outs
Depending on the size and value of the business, it may be difficult to obtain all financing necessary to
purchase the business in a single transaction. In such cases, some cooperatives complete the buy-out in
multiple stages, as Select Machine did (see the Select Machine Case Study later in this handbook). The
cooperative or individual workers could receive loans to complete a partial buy-out, and, after paying
down those loans, obtain more financing in one or more additional stages to complete the buy-out. In
order for the owner to take advantage of the 1042 rollover, at least 30% of the business must become
owned by the workers through a qualifying cooperative after the initial transaction.
Since this means that the business would become a cooperative that is only partially owned by the
workers, it brings up interesting questions related to both governance and allocation of earnings, since
the concept of a worker cooperative, by definition, requires control by and distribution of earnings to the
workers. This issue is further discussed in the Governance section of this handbook. In the case of Select
Machine, it meant that the sellers had to give up substantial control despite retaining a majority
shareholder interest after the initial transaction. In other cooperative conversions, it’s possible to create a
second entity that is fully owned and controlled by the workers, and which slowly buys shares from
primary business owners over time. This scenario is not ideal, but it is an option where the sellers are
unwilling to finance the complete buy-out with a promissory note.
Legal Limitations on the Form of Financing
The form of financing has implications for the cooperative’s eligibility for Subchapter T taxation, and
may have implications under the state’s cooperative statute. To be eligible for pass-through taxation
under Subchapter T, a cooperative must distribute its earnings based on patronage. 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. In
addition, 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.
Considerations Related to Different Sources of Financing
Worker-Sourced Financing
The workers, themselves, are often a key source of capital for a cooperative conversion. One modernday version of the Rochdale principles for the operation of cooperatives states that “Members contribute
equitably to, and democratically control, the capital of their co-operative.” This means, first of all, that
each member has “skin in the game,” which creates a greater sense of ownership and responsibility for
the cooperative. As the principle also expresses, in an ideal cooperative, each member would contribute
equally to the capital.
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. Some could have access to
a substantial amount of capital to contribute, while others could have little to none. As such, it is
common for cooperatives to make arrangements for unequal contributions. Note that, regardless of the
28
amount of capital contributed by each member, everyone should have the equal voting power inherent in
the democratic principles of cooperatives.
In general, it’s important for the workers to contribute at least some capital, in order for the cooperative
to become eligible for other sources of 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 first,
before seeking outside funding.
With regard to worker-sourced financing, the cooperative will need to determine:
•
•
•
•
•
•
•
•
How much an ownership share will cost? We have seen worker cooperatives set member
share prices at anywhere from $10 to $15,000. The cost will depend on a number of factors,
including members’ ability to pay, the need for capital, access to other financing, and the value
of membership.
Will there be one or multiple classes of shares? As described below, some cooperatives create
a category of preferred shares to incentivize both members and non-members to contribute
additional capital.
Will the cooperative pay interest on member shares? Most cooperatives that 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 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?
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.
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.
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
good 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. See the chapter on employment law for more details.
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
29
that would not be present if the same capital were provided in the form of a membership share.
•
•
May members purchase preferred shares? As described below, preferred shares are generally
structured to pay a fixed return, making them similar to loans. However, repayment of the
preferred shares are generally subordinate to repayment of loans (though may or may not be
subordinate to 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.
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. We summarize some securities law basics
below. The decisions about the structure and size of member contributions may be influenced by
securities law considerations, so please read on.
Preferred Share Financing
Some cooperatives choose to have "preferred shareholders," meaning a class of investors who contribute
a sum of money and, in exchange, get a fixed regular dividend with no (or very limited) governance
rights attached. Cooperatives that issue preferred shares typically do so with terms that allow the
cooperative to redeem the shares at face value at a later date.
A few key benefits of offering preferred shares, rather than promissory notes, are:
1) The preferred shares look like equity – rather than debt – on the cooperative’s books, which
looks better to lenders.
2) The redemption of the preferred shares is generally subordinate to any loans, which protects
lenders.
3) If the cooperative goes bankrupt or closes due to losses, generally, preferred shares are not
outstanding liabilities that the cooperative must pay.
Disadvantages of preferred shares over promissory notes:
1) A primary disadvantage of issuing preferred shares is that the earnings used to pay regular
dividends are subject to double taxation, unlike loan interest payments, which are generally tax
deductible business expenses.
2) A cooperative that distributes a substantial portion of its earnings as dividends on preferred
shares may come under scrutiny of the IRS, with regard to its compliance with Subchapter T.
The Real Pickles Case Study included in this guide illustrates an example of successfully using preferred
shares to finance a cooperative conversion.
Seller Financing
In cooperative conversions, it is very common for the former owner to finance at least part of the buyout. Often, a seller does this by accepting a promissory note 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 – to ensure that the sellers are paid over 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.
30
To protect the seller, safeguards can also be built into the governance documents, such as supermajority
voting requirements for decisions affecting the owner’s proprietary interests, and other reserved rights to
withhold consent for major corporate changes until the seller has been fully repaid. See the Governance
section of this handbook to learn more about how a transitioning Owner might retain some amount of
control during or even after the conversion. In addition, see the section below for a discussion of other
safeguards to protect lenders.
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 can more easily defer and manage capital gains. In tax law, under the
doctrine of cash equivalency, a promissory note may not be treated as equivalent to cash if it is not
readily redeemable for cash. Since there is risk that the workers will not fully pay off the promissory
note, it would therefore be unjust to fully tax the seller on the note as if it were cash. As such, this allows
the seller to stretch payment 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. More research is
needed to describe the tax consequences of seller financing here.
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:
•
Have a person, guaranty fund, or other organization guaranty the loan, by signing an
agreement to pay the loan obligations in the event that the borrower is unable to. A seller is
often in a good position to guaranty a loan from a third party, since the majority of the loaned
funds are presumably paid to the seller to begin with. Guaranty funds exist for this purpose, is
there is potential that cooperative-focused loan guaranty funds could be develop to drive capital
toward cooperative development.
•
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. In the case of the Island
Employee Cooperative, two entities remained after the 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 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
multiples sources, one or more lenders may demand that its loan be in first position for
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repayment. In this case, an Inter-Creditor 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. See the Island Employee Cooperative Case Study in this handbook for more details.
Even if a cooperative cannot obtain loan financing at the time of conversion, it may be able to refinance
the initial transaction and pay off the original lenders by receiving a bank loan later on. 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?
Pre-Selling Goods and Services to Finance the Buy-Out or Guaranty the Financing
Increasingly, it may be possible for a business to find enthusiastic support among its customers for a
worker buy-out. In some businesses, worker cooperative conversion may be the only option for keeping
a business in a community. And in general, growing awareness of the benefits of cooperatives could
motivate customers to go out of their way to support worker ownership. One way customers can provide
such support is to pre-purchase goods and services from the business. For example, if 500 customers
each buy $200 gift cards for a store or cafe, that would provide $100,000 in capital to support a worker
buy-out. Of course, the $100,000 becomes a “liability” of another sort, payable in products or services,
which may lower the cooperative’s cash flow after the conversion. As such, any pre-selling arrangement
should be reviewed to estimate the timeline for redemption of the gift cards and to ensure the overall
financial viability of the arrangement for the cooperative. In addition, in any pre-selling arrangement
where there is risk that the cooperative could not deliver on the gift certificates, it’s important to ensure
that the arrangement complies with securities laws, described below.
Crowdfunding
Obtaining small loans from or selling preferred shares to community members is an increasingly viable
option for financing a worker cooperative conversion. Generally, securities laws prevent businesses
from advertising investment opportunities to the public without first overcoming extensive regulatory
hurdles. See the Securities Law section below for a discussion of new opportunities emerging from
securities law reform and crowdfunding law. Within existing laws, some cooperatives have also done
the regulatory work to offer investment opportunities to the public, including Real Pickles, described
below.
Securities Law Considerations
Does the financing arrangement comply with securities law?
Securities laws generally require that when a business offers an opportunity to invest in or lend to the
business, it must register that offering by submitting detailed paperwork and disclosures to securities
regulators and to the prospective lenders or investors. However, some types of securities are exempt
from registration, as described below. When a cooperative receives financing from individuals, in
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particular, as opposed to institutional lenders, the arrangement should be reviewed to ensure that it
complies with securities law.
What is a security?
You create a security when you ask people to put money into your business and you offer to return that
money, and/or offer them a return or share of earnings. For example, a security could be:
• Selling stock in your business
• Asking people to lend money to your business
• Offering a share of your business’s profits
• Offering interests in limited liability companies
• Offering a membership in a cooperative
It is important to know what is or is not a security because when you sell or even offer to sell a security,
it needs to either: 1) Be registered with the U.S. Securities and Exchange Commission and/or with the
state agency where you want to raise money, or 2) Qualify for an exemption from registration.
Registration can be an expensive, time-consuming process. If possible, a cooperative should try to find
an exemption, which is simpler and less expensive.
Common Exemptions
The following bullets describe ways to raise capital with relatively few securities compliance hurdles.
More extensive and federal level securities compliance rules are beyond the scope of this handbook, but
the following pathways may offer significant capital raising opportunities. Additional information about
securities laws may be found at www.CommunityEnterpriseLaw.org.
•
Offering Securities Only in Within Your State: If the cooperative plans to offer securities
only within the state where it does business, it will generally not need to register the securities
with the federal Securities and Exchange Commission (SEC). This is called the federal “intrastate exemption.” It will, however, need to register or find an exemption at the state level, so
read on.
•
Capital Contributions by Managing Members: If the worker-members will be participating
substantially in the management of the business, the capital contributions or loans by those
members are generally exempt from securities registration. However, be sure that you
understand the details of securities laws in your state before drawing this conclusion.
•
Specific Cooperative Exemptions: In some states, the purchase of a membership share in a
cooperative is specifically exempted from the definition of security or from the requirement to
register. For example, under California Corporations Code Section 25100(r), a California
cooperative can raise up to $300 from each California member without registering the securities.
Any person who purchases a security under this exemption becomes a member and must have
voting rights in the cooperative. As noted above, if a cooperative member will be participating
in the management of the business, the members’ capital contributions may be exempt from
registration, which means that the member can contribute more than $300 to the cooperative. It
is primarily for non-managing cooperative members that you would need to use the 25100(r) or
a similar exemption.
•
Donations: When people give money without the expectation of receiving anything in return,
securities regulations do not apply. Many entrepreneurs are use crowdfunding websites such as
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Kickstarter.com and Indiegogo.com to raise money for enterprises. Note that many
entrepreneurs using such sites provide non-monetary rewards to donors, which, in some cases
could create securities.
•
Pre-Selling: It has become increasingly popular to financing a business by selling products and
services in advance, often in the form of discounted gift-certificates. Pre-selling products and
services before a business starts can be considered a security, particularly in California and
roughly 16 other states that apply the “risk capital test” in determining what a security is. The
pre-sole products or services may be securities when there is risk that the buyer won’t get the
product or service they have purchased. However, if you’re an existing business and you are
raising capital to expand or improve the business, pre-selling products and services might not be
considered a security, because there is much less risk that people will not be able to redeem their
gift certificates. This means that pre-selling could be a viable – and legal – way to finance
cooperative conversion, since the business is already in operation and may not have difficulty
redeeming the certificates.
•
Financing from “Friends and Family:” In some states, selling a security to someone with
whom you have a preexisting relationship often does not require registration. In California, for
example, the Limited Offering Exemption (California Corporations Code Section 25102(f))
offers a special exemption for private (not advertised to the public) securities offerings sold to
no more than 35 people within the state, so long as the investors have a preexisting personal or
business relationship with the principle owners of the business offering the security. The
preexisting relationship would need to consist of “personal or business contacts of a nature and
duration such as would enable a reasonably prudent purchaser to be aware of the character,
business acumen, and general business and financial circumstances of the person with whom
such relationship exists.” The 25102(f) exemption also applies to securities sold to investors
who have enough financial experience to protect their interests, or who have experienced
professional financial advisors, whether or not there is a requisite preexisting relationship with
the investor.
•
Financing from Wealthy Investors: There are generally very few hurdles involved in selling
securities to accredited investors, often defined as people 1) people with $1 million in net worth
(excluding their home) or $200,000 in annual income, or 2) entities with more than $5 million in
assets.
•
Crowdfunding Exemptions: At the time of writing this manual, we are still waiting for the
Securities and Exchange Commission to release regulations governing the recently enacted
federal crowdfunding exemption in the Jumpstart Our Business Startups (JOBS) Act, which
would lower hurdles to publicizing opportunities to make small loans or equity investments in
businesses. In the meantime, multiple states have adopted their own crowdfunding laws, and
California is currently considering two bills – AB 577 and AB 722 – which would open many
new doors to financing cooperatives with relatively low compliance hurdles.
•
DPO Crowdfunding: In places where crowdfunding laws are not yet in effect, a Direct Public
Offering (DPO) is one of the only viable methods to advertise and issue securities publicly. A
DPO essentially requires that the securities offering be registered in and approved by the state
where it is being offered. This generally requires a good amount of paperwork and the
preparation of a substantial disclosure document for investors. Real Pickles is a cooperative that
raised capital from local investors by doing a DPO of preferred shares. Real Pickles had to
34
register the securities by filing a “prospectus” document with the state securities agency, then
provide the document to prospective investors. The prospectus included detailed information
about the business and the investment, a memorandum of understanding between the buyers and
the sellers, the cooperative’s Articles of Organization and Bylaws, and Real Pickles’ financial
documents.
When in Doubt, Seek a No-Action Letter.
During the conversion process, if you have doubts about whether your arrangement for the sale of
cooperative memberships or other securities is exempt from registration, you can write to securities
regulators and seek what is called a “No Action Letter.” This is what the Island Employee Cooperative
did. The request described, in great detail, the businesses and the way in which it planned to issue shares
and memberships to employees, and the request cited Maine law as a basis for arguing that the securities
should be exempt from registration. The Maine Office of Securities wrote back (approximately four
months later) with a statement indicating that it would not take action and not require the registration of
the offering, so long as the shares sold to members are non-transferable and redeemable only by the
cooperative (which is generally how most cooperative shares are structured).
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Governance During and After Cooperative Conversion
Introduction
There are potentially infinite ways to design a company's governance, and a wide variety of ways to
transition governance in the process of converting to a cooperative. There is an art to governance design,
with many policies, practices, roles, and rules than can be arranged into place to produce a desired
outcome. One desired outcome of cooperative conversion is to give power to workers. The transfer of
power may or may not implicate an immediate change in the day to day life of a business, but it will
create the conditions for the evolution of a company that, in the long run, focuses on the concerns of its
employees.
A Few Basic, But Powerful, Governance Rights
At their legal core, cooperatives are obligated to give members only a few basic governance rights,
including:
• The right to an equal vote in the election of the Board,
• The right to request and vote in an action to remove Board members,
• The right to take part in at least one member meeting per year,
• The right of access to information about the cooperative, its members, its Board meetings, and
finances, and
• The right to approve/disapprove dissolution, merger, and other major decisions.
When a company converts to cooperative, these are sometimes the primary new governance powers that
the worker-owners will give themselves as members. These rights may not sound like they amount to
much, but they are quite powerful, in that they give members the ability to alter the direction of a
cooperative through Board elections, helping to keep cooperatives ultimately accountable to members.
While these powers may sound simple enough to grasp, a new worker-owner may not be familiar with
strategies and opportunities for exercising their rights, which calls attention to the need to train workers
on how to exercise their new rights. In particular, companies that did not previously have a Board of
Directors may need training to understand the potential roles of a Board. Democracy is powerful when
people are informed and active participants in the democratic process, and educating new workerowners about the process can bring more genuine democracy.
In some cooperatives, workers will choose to give themselves a much wider variety of opportunities and
processes to shape the direction and day-to-day work of the cooperative. Whether it’s through
participation in committees, collective management structures, distributed governance, rotating
management positions, consensus processes, or other strategies, workers may grow more intimate with
the company's governance in the process of converting to a cooperative.
The Transition to Workplace Democracy
In some cases, the cooperative buy-out may happen gradually and may involve multiple intermediate
steps. The transition of governance may, likewise, be gradual, particularly in companies where workers
must complete the buy-out over time and borrow money from multiple sources – including, quite
possibly – the selling owners. Full worker control may be an ultimate goal, but the intermediate
governance structures may take many forms.
How Much Will Governance and Management Change?
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When companies change ownership, whether or not to become a cooperative, the workers, customers,
and a wide variety of stakeholders often worry about the changes to be brought by new owners.
Sometimes new owners bring dramatic changes (even closing the business), and other times, the
transition is made to feel as seamless as possible.
On one hand, stability is a highly valued quality of a business, and it offers a very good reason to
continue core governance and operational structures during ownership transition. Such structures may be
key to the company's success and profitability, and it's not necessarily wise to shake things up in the
moment where many parties are taking a great financial risk. Employees, in particular, have their
livelihoods at stake during a transition. As such, they may wish to retain the status quo in governance,
even if they find management structures to be stifling.
On the other hand, new governance structures may be the primary incentive for workers to buy their
employer's business, and worker control could unleash widespread innovation in a company. In many
companies, workers tend to be an undiscovered treasure trove of information. They sense the needs and
impact of a company's work and operations at nearly every level of the system, and their experiences
and insights – if tapped – could perpetually refine a company's efficacy and performance. This potential
has been acknowledged in business management texts for nearly a century, but top-down approaches to
management have left decentralized governance models at the margins of the mainstream business
world.
Legal Governance Requirements
The entity a cooperative forms at the state level and the tax status it chooses at the federal level will
dictate certain limits and possibilities for how the cooperative may operate. For example, corporations
must have boards of directors, and must follow certain election and meeting notice procedures; business
taxed as cooperatives under Subchapter T must have democratic voting.
Laws Governing Cooperative Corporations
The statutes governing cooperative corporations generally function to create:
• Due process for the group, so that an individual doesn’t have too much power over the group,
• Due process for an individual, so that the group doesn’t have too much power over the
individual,
• A Board of Directors with the ultimate legal duty to make decisions in the best interest of and to
ensure proper operation of the company, and
• Fallback rules in case the group doesn’t adopt clear rules.
The due process rules generally specify minimum standards for how often meetings are held, how
certain major decisions are made, how members and directors must receive notice of meetings, how
members and directors can be expelled, how often elections are held, and so on. These rules prevent a
complete tyranny of structureless-ness where members have no idea how to voice their needs and
concerns. Even in a cooperative that has failed to prepare or follow Bylaws, a member can refer to the
cooperative corporation statute to understand his or her basic rights, and even petition a court or attorney
general to force the cooperative to follow the due process rules.
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Laws Governing Cooperatives Taxed Under Subchapter T
To receive the benefit of pass-through taxation under Subchapter T of the Internal Revenue Code, a
cooperative must adhere to the ways in which courts and the IRS have interpreted the requirement for
democratic control by workers. In one case, Puget Sound Plywood, Inc. v. Commissioner of Internal
Revenue (44 TC 305 - Tax Court 1965), the U.S. Tax Court described democratic control as follows:
“Implementation of the [principle] relating to democratic control is effected by having the
worker-members themselves periodically assemble in democratically conducted meetings at
which each member has one vote and one vote only, and at which no proxy voting is permitted;
and these workers there deal personally with all problems affecting the conduct of the
cooperative.”
Laws Governing Partnerships and LLCs Operating as Cooperatives
A cooperative that chooses to structure as a partnership or LLC will be subject to very few mandatory
rules regarding governance and due process. Partnerships and LLCs will, however, be subject to
statutory fallback rules if their Operating Agreements do not give enough specificity about how
decisions are made and how finances are managed. Such companies are generally free to adopt highly
customized governance and financial structures, if the partners/members agree to such structures. This
flexibility can be a good thing in some cases, especially for cooperatives that are thoughtful about how
they design governance. In other cases, a company that fails to establish basic procedures for the
democratic process could devolve into a tyranny of structureless-ness where some members have very
little control and no ability to meaningfully exercise rights of control.
The Critical Importance of Understanding and Adhering to Governance Documents
Beyond the basic governance rules applicable to cooperatives, regardless of chosen entity, there remains
a good amount of flexibility in the details of the Bylaws and Operating Agreements. It is critically
important that cooperatives adhere to rules they choose to adopt. Otherwise, actions can later be
challenged and invalidated on the basis that they were taken without adherence to adopted procedures. It
is very common for cooperatives to fall into habits of operating informally, without regard to the
procedures they have adopted. Later, especially when there are disagreements, chaos can ensue as
members seek to invalidate prior decisions.
The moral to this story is that members should become familiar with and practice their governance
procedures with care. To facilitate this, it is very helpful to ensure that governance documents avoid
legalese and are written in plain-English (and/or another primary language of workers). Additionally, inperson trainings and simulations for workers can greatly facilitate adherence to governance documents.
Finally, it helps to designate one member or a committee of members responsible for regularly
reviewing procedures to ensure that the cooperative is following its chosen roles. In some cooperatives,
we have referred to this role as a “Cooperative Trustee,” meaning someone with a duty to ensure that the
democratic principles of the cooperative are being faithfully upheld.
Some Basic Components of Governance
In most cases, conversion to a cooperative should involve learning and training about new ways to
operate. Future cooperative members may wish to form a working group to examine questions of and
possibilities for governance. When designing governance structures for a newly converted cooperative,
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here are some of the key considerations:
•
What are the governing bodies and what realms does each control? Board of Directors?
Advisory Board? Bicameral governance? Role of committees?
•
How are governing bodies elected or appointed? Member-elected board? Board-appointed
advisory council? Specific appointments by outside organizations (such as a nonprofit that has a
right to appoint one board seat)? How long do people serve? If there are elections, what is the
nomination process for candidates?
•
Who are the members? If applicable, what are criteria for membership? Who can become a
member and participate in governance? Are there different classes of members with different
powers?
•
What is the division of power between the board and members? What are the rights and
responsibilities of directors? Of members? When can members invalidate board action?
•
What are avenues for member and stakeholder participation and influence? How can
members and stakeholders take part in suggesting or dictating new directions for the
organization?
•
Can the functions of the organization be delegated into semi-autonomous committees?
•
How are meetings held? Who can participate in meetings? How often are meetings and how do
people receive notice of them? Are meetings in person or virtual? How is the agenda set? How
is the meeting facilitated? Are there rules of order?
•
How are proposals brought, considered, and adopted? Who can bring a proposal, when, and
about what? Is there a clear process for exploring the proposal? Is it adopted by a majority?
Supermajority? Consensus? By Holacratic procedures?
•
Transparency and Communication? How can the organization efficiently and clearly
communicate governance structure, rights, responsibilities, and activities to members and
stakeholders?
•
Central organizations and outside governance: What could be the role of a centralized trust
or federation of organizations that dictates some activities and decisions of the member
organizations?
Governance Transition Scenarios
This section offers a handful of scenarios and considerations for the transition of governance during
cooperative conversion, although the transitions will play out in a wide variety of ways.
1. Simple Transition: Transfer Ownership / Retain Management
In companies where management and ownership are separate to begin with, it is possible that
governance will not change very much upon conversion. In many companies, owners/shareholders hire
managers and set the basic management structure, but may otherwise not involve themselves in the
details of the business. Upon handing control to workers, a worker-elected board could very well choose
to continue operating under the exact same management structure.
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2. When Former Owner Becomes Worker Owner
In cooperative conversions where the original owners will become worker-owners alongside the
employees, it will be critical to take steps to overcome what many people refer to as “founders’
syndrome.” It can be hard for an enterprise to break away from habits of relying on founders to take on
certain responsibilities and make primary decisions. New worker-owners may be cautious about
exercising their rights to influence the business, and the original owners may feel a stronger sense of
entitlement to control of the business.
One strategy for overcoming founders’ syndrome is to adopt highly structured meetings and decisionmaking processes that demonstrate to workers their ability to voice their concerns, bring proposals to the
enterprise, and influence the direction of the business. For example, at the Sustainable Economies Law
Center, a nonprofit that functions as a democratic workplace, the eight employees make decisions using
a proposal process very similar to that of Holacracy (see www.holacracy.org for more information). This
has helped the Center move away from reliance on its founders for direction, and enables any employee
to bring and respond to a proposal. Proposals are brought and considered by asking employees for
feedback in a series of circles, meaning that everyone is given a space to be heard. Meetings are
carefully facilitated so that people cannot speak out of turn and interrupt one another.
Other strategies for overcoming founders syndrome include: 1) Rotation of roles and responsibilities, so
that workers don’t get pigeon-holed into a set of roles where they have very little power, 2) Equalization
of pay so that everyone has a strong sense of ownership and a sense of equal status, and 3) Training
workers on various aspects of running the business and on democratic processes.
Note that this can be difficult when the original owners retain a higher financial stake in the business,
such as by holding a promissory note to be paid by the cooperative. A worker-owner that has more at
risk than other worker-owners may have a greater sense of entitlement to influence decisions in order to
protect the financial stake. As such, it can be a good idea for cooperatives to work toward equalization
of the financial resources each member has at risk.
3. Transitioning to Collective Governance
We generally use the phrase “collective governance” to refer to a structure where all members
participate in the management of the business. While many small worker cooperatives are managed
collectively, it may be somewhat more difficult to transition a conventional business to collective
governance than it would be to establish collective governance when starting a new business. It is hard
to unravel management hierarchies that are already in place, and it requires a high degree of structure
and process to break old habits. See the above paragraphs for tips on reducing hierarchies and creating
more equal participation in governance.
Collective governance can be empowering to some workers, and overwhelming to others. Participating
meaningfully in the management of the business requires a good deal of knowledge, time, and attention.
As such, a cooperative that desires to transition to collective governance may choose to do so gradually
over time.
4. Transitioning to Distributed Governance
Distributed governance can be achieved by breaking the functions of an enterprise into multiple semiautonomous spheres of control. Doing so essentially creates multiple small collective governance circles
within a larger organization, meaning that workers can exercise a great deal of influence over their
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immediate realm of work and responsibility, but do not necessarily need to participate in management of
the company as a whole. This has been achieved in many large companies, some of which are profiled in
the book Reinventing Organizations, by Frederick Laloux. Holacracy and Sociocracy are models for
distributed governance, and have been adopted by large companies like Zappos, and recently by at least
one worker cooperative, Three Stone Hearth in Berkeley, CA.
When Departing Owners Maintain Some Control
Even when a business converts entirely to worker-ownership and former owners cease active
involvement in the business, there are some situations where the former owners wish to retain a certain
amount of power temporarily or indefinitely. One of the core cooperative principles is that cooperatives
should be autonomous, meaning that they are independent of outside control. As such, giving temporary
or ongoing control to former owners can be seen as undermining of the cooperative principles. At the
same time, there are some valid reasons, described below, to allow some degree of control by former
owners.
Reasons Former Owners Might Retain Some Control
The two most common reasons that former owners wish to retain some degree of control are:
1) The owners helped finance the buyout, so they still have "skin in the game," even if it's in the
form of a promissory note, and
2) The owners want the business to retain a certain social/environmental mission or continue to
serve a certain group of stakeholders.
Retaining Control to Protect Financial Stake
If a former owner wishes to retain some control in order to protect a financial stake, this brings up the
big picture question: How much voice should we give to capital? Giving power to capital is almost
antithetical to the concept of a worker cooperative, but giving people no means to protect their
investment would prevent a flow of a capital to cooperative development. Thus, a balance generally
needs to be struck.
To protect a former owners’ financial stake, it is not uncommon for the cooperative’s governing
documents and/or loan agreements to give former owners the right to approve or veto any decision by
the cooperative to:
• Make a major expenditure,
• Pay out dividends, bonuses, or patronage distributions,
• Raise wages by a certain percentage,
• Borrow money,
• Restructure,
• Expand the business, and/or
• Dissolve.
Retaining Control to Protect Mission
Even when a former owner has no substantial financial stake left in the cooperative, the former owner
may wish to retain control to ensure that the cooperative continues to serve a social or environmental
mission, and/or to ensure that it remains a cooperative and does not sell out to a conventional business.
This is especially comment when a former owner forgoes the potential for financial gain in converting
the business to a cooperative.
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To protect the former owners’ vision, the cooperative’s governing documents or another contract could
give the former owner the ability to approve or veto any decision by the cooperative to:
• Change the mission or change certain socially responsible policies of the company,
• Convert or sell the company to a conventional business,
• Change the dissolution provisions of the business (which may require distribution of remaining
assets to a nonprofit or another cooperative), and/or
• Change the formula by which profits are allocated or distributed.
The former owner could also retain a right of first refusal to buy the company back, at a specified price
or using a specified appraisal method, in the event that the cooperative desires to sell the company.
Specific Strategies for Giving Control to Former Owners
The list below offers specific strategies and legal documents wherein certain powers and rights can be
allocated to former owners. Note that some cooperative entity statutes will not allow Bylaws to give
power to non-members. In such a case, power can still be given through contract, such as through a loan
agreement. Hybrid statutes and structures (cooperative LLCs) tend to afford a greater degree of
flexibility in governance. This can be helpful, but also dangerous, since a company could call itself
cooperative without actually adhering to the democratic principles of cooperatives.
Rights and powers can be given to former owners by:
•
Granting rights in a contract, such as a loan agreements, other financing contracts, or lease.
These rights could require that the former owner be given notice whenever the cooperative
takes a certain type of action or makes a certain kind of decisions, and the contracts could give
the former owner the right to approve or veto certain decisions.
•
Giving the former owner one vote through retained membership, and requiring that certain
decisions be made unanimously or by a supermajority, which gives the owner’s one vote
significant power over those decisions.
•
Allowing one or more Board seats to be appointed by specific individuals or organizations.
This may not be allowed under some cooperative corporation statutes, but in California it is
allowed under Corporations Code Section 12360(d).
•
Allowing the former owner to nominate candidates for the Board, which would put the
candidate on the ballot to be voted on by members. Many cooperative corporation statutes fail
to address the procedure by which Board candidates should be nominated, which can leave
space to give outside individuals the right to at least put someone on the ballot.
•
Having the former owner serve on the Board and on an "Empowered Committee" for a
specified period of time after conversion. An empowered committee generally must consist of
a minimum number of directors and it generally holds the same power as the Board with regard
to realms of control delegated to it by the Board, except with regard to a few major decisions.
•
Allowing the former owner to appoint all or part of the initial Board, which will serve for a
specified period of time, after which elections will be handed over to members.
•
Adopting Bylaws provisions that cannot be changed except if approved (or not actively
vetoed) by specified individuals. For example, the Bylaws provisions related to dissolution,
42
sale, and distribution of assets can be very important in preventing a cooperative from selling
out to a conventional business. As such, the former owner may want to retain a right to veto any
attempted changes to those provisions of the Bylaws. This may not be allowed under many
cooperative corporation statutes, but it is allowed in California under Corporations Code
Section 12331.
43
Employment Law and Worker Cooperative Conversions
When converting a business to a worker-owned cooperative, it is possible that the conventional and
legally-recognized employee-employer relationship could begin to blur as a result of the new
distribution of ownership and control. It brings up the question: Will or should the worker-owners
remain classified as employees? If so, do all employment-related regulations continue to apply?
Generally, having employees comes with a list of obligations and requirements for the employer,
including:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Paying for overtime work;
Ensuring proper work hours and breaks;
Withholding and remitting payroll taxes and other withholdings;
Maintaining workers compensation insurance;
Complying with occupational safety and health laws;
Allowing employees to organize and join unions;
Verifying eligibility to work in the U.S.;
Adhering to standards and practices that protect employee benefit plans;
Posting notices and posters related to employee rights; and
Adhering to certain recordkeeping requirements.
If the employment relationship ceases to exist upon conversion to a worker cooperative, most or all of
the above requirements will cease to apply. There are pros and cons to maintaining the employee status
of the worker-owners. On one hand, the above requirements can be expensive, due to the administrative
demands of compliance and due to the direct cost of workers compensation insurance and payroll
services. A recently converted worker cooperative may show increased margins by avoiding the above
requirements, or it may choose to invest the savings in other types of benefits and protections for the
worker-owners.
On the other hand, the requirements listed above offer a substantial degree of protection to the workerowners in cases where the tyranny of some worker-owners would result in exploitation of other workersowners. If this is the case, however, it is arguable that an employment relationship does exist, and the
cooperative could not have sidestepped employment law to begin with.
It is critically important to evaluate the question of employment status carefully. Failure to properly
classify someone as an employee could result in an expensive lawsuit or fine when a labor department or
worker decides to call out the actual employment relationship. Below, we provide some of the leading
case law on determining the difference between a business owner/partner and an employee. Even with
the detail provided below, we strongly suggest seeking the advice of an employment lawyer to ensure
that workers are properly classified.
When are Worker-Owners Employees?
It is widely accepted that if you start a sole proprietorship and work for yourself, you are not your own
employee. How does that apply when three people own, manage, and work for their own business in
partnership with one another? How about when 100 people own, manage, and work for their own
business? And does it matter what kind of business entity is formed?
44
Employment laws exist primarily to balance the relationship between “master” and “servant,” and
generally do not apply when there is truly no master/servant relationship. In 2003, the U.S. Supreme
Court, in Clackamas Gastroenterology Associates, P.C. v. Wells, was asked to decide whether the
Americans with Disabilities Act applies to working shareholders of a small professional corporation.
The outcome of the case turned on whether the shareholders were employees of the business. The Court
summarized the following guidelines for determining when a master-servant relationship exists:
1. Whether the organization can hire or fire the individual or set the rules and regulations of the
individual's work;
2. Whether and, if so, to what extent the organization supervises the individual's work;
3. Whether the individual reports to someone higher in the organization;
4. Whether and, if so, to what extent the individual is able to influence the organization;
5. Whether the parties intended that the individual be an employee, as expressed in written
agreements or contracts;
6. Whether the individual shares in the profits, losses, and liabilities of the organization.
Note that not every court or labor department will apply the same test, and there are many tests that have
been developed for determining who is a partner to an enterprise. Another case that summarized the
factors courts consider is Simpson v. Ernst & Young, decided by the 6th Circuit in 1996. The court
named the following factors as relevant to the determination:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
The right and duty to participate in management;
The right and duty to act as an agent of other partners;
Exposure to liability;
The fiduciary relationship among partners;
Use of the term 'co-owners' to indicate each partner's 'power of ultimate control;
Participation in profits and losses;
Investment in the firm;
Partial ownership of firm assets;
Voting rights;
The aggrieved individual's ability to control and operate the business;
The extent to which the aggrieved individual's compensation was calculated as a percentage of
the firm's profits;
12. The extent of that individual's employment security; and
13. Other similar indicia of ownership.
One thing that the above tests tell us is that if a worker cooperative chooses not to classify workerowners as employees, it must give substantial management power to those worker-owners, and must
adopt clear safeguards to prevent the devolution into a more hierarchical structure. It is also possible that
the relationships could change over time, as management structure changes. Thus, it is even a good idea
to conduct periodic “audits” to ensure that all workers are properly classified. Below, we provide
additional guidance on determining how much control each worker-owner must have in order to be
classified as a “partner,” rather than employee.
45
How much control must each cooperative member have in order to be considered a “partner” rather than
an employee?
If all members of a small worker cooperative serve on the Board of Directors and take part in collective
management processes, then, arguably, each member could be considered a “partner” for the purpose of
some employment laws. But where do courts draw the line? How much control do the workers need to
have in order to be considered partners?
One case that examined the question of who is a “bona fide partner” is Wheeler v. Hurdman, decided by
the 10th Circuit in 1987. In that case, the court actually de-emphasized the need for each partner to have
a significant amount of control, noting that the practical needs of the business may result in partners
giving up a certain amount of control over the day-to-day, and abdicating such control to managers,
teams, or committees. The court essentially recognized the following practical reality: Any time a group
of people voluntarily works together, each individual gives up a certain amount of control to the group
or to members of the group. What is important is that the individual gives this power voluntarily.
In another case, Fountain v. Metcalf, Zima & Co. (1991), the 11th Circuit focused on certain voting
rights as the indicator of control, and not on the actual realities of management in the firm. There, the
court ignored the argument that a managing partner was running the firm autocratically, and focused
instead on the fact that the plaintiff partner “had a right to vote his thirty-one percent ownership on
member/shareholders' amendments to the agreement, on admission of new member/shareholders, on
termination of relationship with member/shareholders, on draws, and on distribution of profits and
income.”
In contrast to Wheeler and Fountain, however, other courts have focused heavily on the issue of control,
and found that factor to be a deal-breaker. For example, in 1987, the U.S. District Court of the Southern
District of New York in Caruso v. Peat, Marwick, Mitchell & Co. examined the employment status of a
partner in a 1350-member accounting firm, and the court looked at three primary factors:
1. The extent of ability to control and operate the business,
2. The extent to which compensation is calculated as a percentage of the firm's profits, and
3. The extent of employment security.
On the question of “ability to control and operate the business” in the Caruso case, it was significant that
the firm was “managed by a board of directors separated from plaintiff by six levels of hierarchy” and
that the plaintiff tended to seek approval of management-level partners in decisions about his own work.
The court held that the plaintiff was, indeed, an employee.
The Court in Clackamas also focused heavily on the question of control and common law definitions of
the master-servant relationship. The Court wrote that “[i]f the shareholder-directors operate
independently and manage the business, they are proprietors and not employees; if they are subject to
the firm's control, they are employees.”
Another case that examined this issue specifically in application to a worker cooperative was Wirtz v.
Construction Survey Cooperative, decided by a federal district court in Connecticut in 1964. In that
case, the court emphasized numerous elements in support of a finding that the cooperative members
46
were not employees, even though two members of the cooperative exercised management over the
others:
“It is true [that two members] exerted some measure of leadership over the [other members].
But the Court finds this was due to their longer experience, more extensive knowledge, and
driving interest rather than due to positions of control or power. What little guidance they
supplied was by consent not authority.”
The lesson with all these cases is: there is no clear set of rules to determine when members of a worker
cooperative are employees. Some of the cases described above indicate that, even with somewhat
hierarchical management structures, working co-owners of a business may still avoid classification as
employees. However, if you want to argue that members of your worker cooperative are not employees,
then the safest thing to do is to:
1. Have all members serve on the Board of Directors.
2. Make decisions by a consensus process, supermajority voting, or another process that gives each
member a strong voice in each decision.
3. Give each member a lot of control over his/her own work, or create many semi-autonomous
departments or committees that control their own work, procedures, and hours.
4. Make it somewhat difficult to fire people, by requiring a vote of a large number of members.
5. If you put some people in a position to manage and supervise others, ensure that they can easily
be moved out of their supervisory roles by a proposal brought to the cooperative by the people
they supervise.
Does it make a difference if you form a partnership, LLC, or cooperative corporation?
In some jurisdictions and under some statutes, courts have leaned toward the assumption that
shareholders of corporations should be treated as employees when they work for the corporation they
co-own. In other jurisdictions, the fact of incorporation is merely one factor, among many, that a court
would consider in determining whether an employment relationship exists. Generally, corporations are
required to treat their officers as employees for tax purposes. This does not, however, mean that a
corporation must treat its officers as employees for the purpose of wage and hour law, workers
compensation, and other realms of employment law.
Uncertainty about whether incorporation automatically creates an employment relationship has caused
stress for some worker cooperatives, which are often formed as some type of Cooperative Corporation.
As a result, some worker cooperatives have chosen instead to form as partnerships or limited liability
companies (LLCs), entities where a court is less likely to find that managing partners and managing
members are employees.
The U.S. Supreme Court, in the Clackamas case, and other courts have found that a “partnership,” rather
than employment, relationship exists even when the entity is a corporation. In 2009, the court in Godoy
v. Rest. Opportunity Ctr. of New York, Inc. also held that the members of a worker-owned cooperative
were “partners,” in spite of the fact that they were working under a corporation. Many courts may
ultimately consider the incorporation status of an entity as relevant, but only as one factor among many
in determining whether an employment relationship exists.
47
The lesson here is: If you are planning to form a cooperative corporation, as opposed to a partnership or
LLC, be extra attentive to the question of whether there is an employment relationship, and talk to a
lawyer.
Workers Compensation Insurance and Cooperative Conversion
In some cases of worker cooperative conversion, even if the worker-owners continue to treat themselves
as employees, they may become exempt from certain legal requirements, such as the requirement to
provide workers compensation insurance. For example, Section 3351 of the California Labor Code
contains exceptions to the requirement that all employees be covered by workers’ compensation
insurance, such as "where the officers and directors of the private corporation are the sole shareholders
thereof," or where the “working members of the partnership or limited liability company are general
partners or managers,"
Thus, in the case of a cooperative corporation operating in California, if the directors are the only
members (meaning they are the only “shareholders”) of the cooperative, then they may not need to be
covered by workers’ compensation. Most worker cooperatives that are managed collectively meet this
requirement. However, if there are cooperative members who do not serve on the Board of Directors,
then it’s possible that workers compensation will be required for everyone. Note that a worker
cooperative that hires non-member employees will definitely need to carry workers compensation for
those employees. Note also that a worker cooperative that chooses to form as a partnership or LLC will
also be exempt from carrying workers compensation if the working partners/members all participate in
management.
At least one business that we know of converted to worker-ownership, brought all new worker-owners
onto the Board, cancelled workers' compensation insurance for those worker-owners, and spent the
savings on health benefits and long-term disability insurance.
Could conversion affect union status of workers?
If employees take over ownership of the business they work for, they may still elect to form a union or
remain part of a union, so long as a specific union’s policy allows them to remain members. However,
the worker-owners might lose their protected right to organize, meaning that if managers or a group of
workers seeks to block organizing, the worker-owners may have no recourse. The National Labor
Relations Act (NLRA) protects the right of employees to organize unions and collectively bargain with
employers, and it prevents employers from intervening in and backlashing against such organizing.
Conversion of a business to a worker cooperative could move the worker-owners outside of the
protection of the NLRA if the worker owners have an “effective voice” in the operation and policies of
the business. In any cooperative where the worker-owners elect the Board and can serve on the Board
(which is most worker cooperatives), it is quite possible that the NLRA would not protect the right of
workers to organize. In addition, the worker-owners might not have a protected right to organize if there
is a conflict of interest between the worker-owners and the non-owner workers of the business.
Whether members of a worker cooperative have a protected right to form or join unions is addressed in
great depth by attorney Neil A. Helfman in his 1992 article “The Application of Labor Laws to
Workers’ Cooperatives,” and by Deborah G. Olson in her 1982 article “Union Experiences with Worker
Ownership: Legal and Practical Issues Raised by ESOPs, TRASOPs, Stock Purchases and
48
Cooperatives,” Wisconsin Law Review.
The application of the NLRA to worker-owned businesses has also been examined in the following
cases:
•
•
•
NLRB v. Union Furniture Company, 67 NLRB 1307 (1946) (holding that employeestockholders who chose the Board of Directors from amongst themselves had substantial control
over corporate policy and divergent interests from non-proprietary employees).
Brookings Plywood Corp., 98 NLRB 794 (1952) (holding that employee-shareholders who
could collectively influence company policy had sufficient control over corporate decisionmaking to fall outside of the protection of the NLRA).
Everett Plywood and Door Corp., 105 NLRB 17 (1953) (holding that employee-stockholders in
a cooperative were protected by the NLRA).
49
The Role of Lawyers in Cooperative Conversions
The Need for Lawyers to Support Cooperative Conversions
While many conventional businesses operate and transact without much help from lawyers, cooperative
conversions are perhaps uniquely in need of legal expertise and support. The reasons for this include:
• Cooperatives have unique governance, financial, and tax requirements that are not commonly
understood by laypeople, banks, landlords, and other institutions and individuals vital to the
business.
• Selling a business, under any circumstance, involves many steps, tax considerations, securities
law considerations, and other technical details that are best handled by someone trained and
experienced in handling such transactions.
• Business owners and employees have a lot at stake during a cooperative conversion, and each
should receive independent advice.
Employees may be particularly vulnerable during the process of conversion, because they may be taking
a risk with both their jobs and their personal assets. In an ESOP, a trust that manages the employees’
ownership interest has fiduciary duties to the employees; that is, it is obligated by law to act in the
employees’ best interests, mitigating some of the risks of assuming ownership. By contrast, converting a
business to a worker cooperative comes with fewer worker protections.
There will, for at least the next few years, likely be a gap between the demand for legal services and
supply of lawyers competent to assist with cooperative conversions. There are simply very few lawyers
in the U.S. with expertise on worker cooperatives. As such, this is also a call to action: Lawyers
everywhere should learn about worker cooperatives and position themselves to be of service to the trend
of cooperative conversions. Competence to advise on cooperative conversions entails basic knowledge
of Subchapter T and Section 1042 of the tax code, of the processes and tax consequences of selling a
business, of employment laws, of cooperative entity choices and structure, and of basic securities law.
In coming years, organizations like the Sustainable Economies Law Center and Democracy at Work
Institute will likely begin to offer trainings for lawyers seeking to develop expertise in these areas. In the
meantime, the U.S. Federation of Worker Cooperatives and the National Cooperative Business
Association both maintain lists of professionals, including lawyers, accountants, and business strategists,
able to assist cooperatives.
Roles of Lawyers
Lawyers generally assist with a wide variety of questions and tasks in the process of cooperative
conversion, including:
• Helping to choose and structure the business entity and laying out a roadmap to the conversion
process,
• Drafting most or all documents described in the Documents section of this handbook,
• Filing paperwork with governmental agencies,
• Ensuring that the transactions, financing arrangements, and membership structure comply with
securities laws,
• Ensuring that the cooperative governance and financial structure comply with Subchapter T of
the Internal Revenue Code,
• Advising on the impact of the conversion on employment law,
50
•
•
•
•
Reviewing the financial statements and records of the business to ensure that there are no
concerning liabilities,
Advising on the details of the proposed cooperative Bylaws and advising the workers on their
rights with regard to finances, voting, and influencing decisions,
Reviewing the conversion transactions and explaining the tax consequences for the entities and
individuals, and
Verifying that the business is current on all filings and payment of taxes.
In some cases, financial or tax advisors might be more suitable to advising parties on some components
of the conversion, particularly in assessing the financial viability of conversion and personal tax
consequences. Lawyers are not necessarily good with numbers and may not know how to spot issues on
financial statements. A financial or tax advisor could actually sit down and do math with a client in
order to play out different financial scenarios and outcomes. This process is important, as it may reveal
situations where an individual or entity is taking on too much debt or failing to budget for the payment
of certain taxes.
Why Multiple Lawyers Will Likely Be Involved
A key question in the cooperative conversion process is: Which parties need their own lawyers?
While it may be convenient and cost-saving to have just one lawyer involved in the conversion process,
a single lawyer cannot effectively consider and protect everyone's interests simultaneously. Lawyers
must follow professional ethical rules, which strongly urge, but do not absolutely mandate, that each
party to a transaction be represented by independent counsel. This is to ensure that each party is fully
advised of her rights, responsibilities, and risks when entering into a transaction, and that, when the
interests of parties are in conflict, each party’s attorney can advocate for an ideal outcome for her client.
It is common for business partners to seek separate counsel when forming a business and negotiating the
terms of the partnership or operating agreement. After formation, however, it is typical for only one
lawyer to work with and represent the business entity. Thus, once the conversion is complete, it is likely
that most lawyers will drop out of ongoing involvement, and the cooperative will work with one lawyer
to assist with legal needs going forward.
Even when multiple lawyers are involved in the conversion, the process need not be adversarial and may
be highly collaborative. All parties might discuss the conversion openly and come to a general
agreement about the plan for and terms of the conversion. When it comes to drafting the key legal
documents, it is common for one lawyer to take the lead and prepare drafts, which other lawyers review.
In The Ideal Scenario: Everyone Would Get Independent Advice
During a worker cooperative conversion, each worker, each selling owner, and each entity is technically
a separate party, and each might want to consider seeking independent advice on the financial and legal
considerations, particularly when borrowing money, guarantying a loan, lending money, or contributing
capital. A lawyer can help an individual or entity assess financial risks and goals, and make requests for
changes to the legal documents in order to protect the client. In a perfect world, where lawyers would be
affordable and where cooperative-specialized lawyers would be in abundant supply, the ideal scenario
would be for every party – both individuals and entities – to get independent counsel.
If each employee does seek independent advice, it will ideally cost no more than $500. If legal services
are more costly, it becomes decreasingly likely that an employee would seek independent counsel. As
51
such, it will be important for lawyers to prepare themselves for advising a single employee on the legal
implications of worker cooperative conversion, without creating undue cost for the employee. A lawyer
could be prepared with a basic check-list of documents to review and matters to discuss with the client,
in order to make the process quick and efficient.
Second Best Option: Involve at Least Two Lawyers
In reality, since it may be hard for each party to seek out independent legal advice, the best affordable
option may be for one lawyer to represent the owner or group of owners selling the business (or the
business itself) and a second lawyer to advise workers as a group. The lawyer advising the workers as a
group would likely require that everyone sign a waiver to acknowledge the potential for conflicts of
interest, such as situations where one worker is taking greater risks than others. If one individual plans to
put substantially more capital at risk than others, that particular individual may wish to seek separate
counsel.
For Simple Conversions: When One Lawyer Might Suffice
It has happened that businesses have converted to worker cooperatives with the help of only one lawyer
representing the entity that is converted. When there is a shortage of affordable lawyers, this may be a
viable option if the conversion does not require workers to take a significant financial risk, if the
business has no debt or liabilities, and if the conversion does not affect the employment status of the
new worker-owners. In such an arrangement, if there are very few risks for employees who become
worker owners, it’s conceivable that no harm would be done if only one lawyer is involved.
Nevertheless, it is always advisable to have someone looking out for the interests of the workers,
conducting due diligence to ensure that there are no hidden risks and liabilities.
52
Legal Case Study: Island Employee Cooperative62
The Island Employee Cooperative (“IEC”) was created after Vern and Sandra Seile, owners of a
supermarket, grocery store, and pharmacy/variety store, merged and sold their businesses to their
employees. The IEC conversion powerfully illustrates the importance of worker ownership as a
succession plan for retiring business owners. The stores are located in remote locations in Maine, and,
without the stores, local residents would have to travel 25 to 45 miles to obtain similar goods and
services. At least one of the stores had been in operation for half a century, and the stores provided jobs
for over 60 area residents. After a full year of listing the businesses for sale, the owners had received
only one offer, which was too low. Since selling the businesses to an outside owner could have resulted
in consolidation of the stores and reduction of jobs, selling the business to workers may have been the
best option to enable the owners to retire while keeping the jobs and essential stores in the community.
Exploring Cooperative Conversion
The Cooperative Development Institute (“CDI”) assisted the Seiles in exploring the benefits of and
potential for conversion, after which the Seiles picked twelve of their most experienced employees to
meet with a representative of CDI, Rob Brown. All of the handpicked employees had prior experience
with cooperatives (such as the Stonington Lobster Fisherman Producer Cooperative) and had some
passing familiarity with employee cooperatives. During the meeting, ten of the twelve employees
volunteered to form a Steering Committee if, upon further deliberations with all of the employees, there
was enough support to move forward with the conversion.
Forming the Steering Committee
Rob Brown organized a meeting with all of the employees, more than sixty people. At this meeting,
Brown gave a presentation about cooperatives, and afterwards took a written commitment of interest
from employees. The document was a way for employees to express their interest in forming an
employee cooperative and electing the aforementioned ten employees to form a Steering Committee to
represent the employees during the conversion process. About 80% of the employees signed the
commitment of interest and the Steering Committee was formed.
Forming the Cooperative
Brown met with the Steering Committee on a weekly basis for a few months to teach them about
cooperatives, sharing example Bylaws and other documents to help inform the Steering Committee
about potential governance options for the cooperative. The employees formed a corporation and
structured it as a cooperative, the majority of employees became members of the cooperative, and the
members elected the Steering Committee to serve as the first Board of Directors. At the time of this
writing, the cooperative has forty-five members, out of a total of sixty employees.
Financing the Purchase and Structuring Agreements with Lenders
Coastal Enterprises, a community development financial institution (CDFI), helped the cooperative to
convene multiple lenders and obtain the necessary financing to purchase the business. The cooperative
obtained the following loans:
• $500,000 from Associated Grocers of New England
• $1,000,000 from Coastal Enterprises
• $800,000 from the Cooperative Fund of New England
62
We are enormously grateful to IEC and to attorney Clifford Ginn for taking the time to explain the legal details
to us.
53
•
$3,300,000 from the selling owners, who took a $1,500,000 promissory note and a second
$1,800,000 promissory note, with the intention that the National Cooperative Bank could later
acquire the second note.
Each lender conditioned its loans on the provision of financing by the other lenders, meaning that they
all went in together to help complete the conversion and to ensure that the businesses would continue to
thrive. The lenders executed a detailed Inter-Creditor Agreement that defines the respective rights of the
lenders in relation to each other, the priority of repayment for each loan, and which assets would be used
to secure which loans. The purchase of the businesses came with purchase of real estate, which was used
to secure the loans. The Associated Grocers loan had first priority to be secured by the stores’
inventories, which, although fluctuating, were valued at over $930,000 at the time the businesses were
sold. In addition, some of the loans were secured by corporate stock (explained below). The selling
owners’ $1.5 million note was subordinated to the other loans, and there was an additional provision that
would require a holiday on loan payments for that particular loan in the event that cash flow of the
cooperative falls below a certain level.
To further ensure that the loans were secure, the lenders conditioned financing on the following
agreements from IEC:
• That IEC could not dispose of its assets, dissolve, or merge the business entities without lenders’
consent.
• That capital expenses over $100,000 require pre-approval of the lenders.
• That distributions beyond normal wages and salary are not permitted without permission of
lender, meaning that patronage dividends generally cannot be paid without permission of
lenders.
In addition, to ensure the ongoing health of the businesses, the lenders required IEC to contract for longterm consulting services with the selling owners, Independent Retailers Shared Services Cooperative
(“IRSSC”), CDI, and Specialized Accounting Services. IRSSC, a consulting organization with
significant expertise in the retail grocery sector, trains managers, negotiates contracts with suppliers,
performs marketing and merchandising, develops business plans, and trains worker-members to read
financials.
Worker Buy-In
The worker-members made approximately $300,000 in capital commitments, although a portion of that
was not provided in cash, but was to come out of employee salary withholdings over time. The
cooperative issued two classes of shares, one of which – Class B – is intended only for the roughly 45
employees who took the risk of becoming the founding members. Both Class A and B shares had a
$1,000 buy-in, with one Class A and six Class B shares required for the founding members. The Class B
shares were structured to accrue interest at a rate of 6% and either the cooperative or a member holding
Class B shares could compel redemption after five years.
The Purchase Agreement and Conversion Process
The entire process of conversion took 13 month to complete, with a purchase agreement having been
signed in January, 2014 and sale closing in June, 2014. Both CDI and IRSSC provided substantial
assistance to the employees, helping with the development of business plans, governance documents,
purchase agreement, investment structure, and due diligence.
54
Before the purchase, two of the stores (both LLCs) were merged into the third (a corporation called
Burnt Cove). All of the Burnt Cove Corporation’s stock was then sold to IEC for $5.6 million by means
of a Stock Purchase Agreement. Since the selling owners were able to benefit from the 1042 tax
deferral, the cooperative was able to negotiate a lower purchase price than might have been paid by a
conventional buyer.
The Burnt Cove Corporation continues to operate as a subsidiary of the cooperative, and has not merged
with the cooperative, which makes the IEC case somewhat unique. It is a Type D conversion, per the
typology we described earlier in this handbook. A primary reason that the entities did not merge is that
the corporation’s stock was pledged to secure some of the loans received by IEC, and a cooperative
generally cannot pledge stock as a security interest without undermining the entity’s cooperative legal
structure. According to the IEC Bylaws, the corporation’s Board of Directors must be the same
individuals as the cooperative’s Board, which is elected by cooperative members. When the loans are
paid off, it is quite possible that the Burnt Cove Corporation could convert to a cooperative and then
merge with IEC, or simply sell its assets to IEC. Further research is likely needed to assess the pros and
cons of keeping a separate entity as a subsidiary of a worker cooperative, particularly with regard to the
tax implications.
Additional Steps and Documents Required in the IEC Conversion
The sale of any business – whether to a cooperative or conventional business entity – generally requires
a good deal of paperwork and due diligence. To complete the transaction in the case of IEC, parties
needed to transfer title of land and buildings, release each other from liability, notify other tenants of the
change in ownership, re-assign insurance policies and other contracts, verify that all entities were up-todate on necessary filings and taxes, properly take Board or Membership action to remove and appoint
directors and officers, and execute documents to purchase business assets. In addition, the sellers agreed
to not create a similar business (grocery, drug store, or hardware store) in the same county for 5 years,
and that the sellers will not solicit any of the employees to work for them during that time.
55
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.
When Beavers and Sagaser began considering retirement in 2006, the company had 11 employees and
sales of $2.5 million in 2006. 63 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. Beyond that, they 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." 64
Exploring 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), a standard exit strategy
incorporating features of employee ownership, would be too expensive for a small operation like Select
Machine. 65 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.
Selecting a Buyout Committee and Assessing Feasibility
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. 66 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.
63
Barbara Taylor, A Creative Way to Sell Your Business N.Y. Times (October 29, 2010, 7:00 AM)
http://boss.blogs.nytimes.com/2010/10/29/a-creative-way-to-sell-your-business/.
64
Joan Raymond, Unlikely Pioneers, Bloomberg Businessweek, (March 19, 2006)
http://www.businessweek.com/stories/2006-03-19/unlikely-pioneers.
65
Id.
66
John Logue, The 1042 Roll-Over Cooperative in Practice: A case study of how Select Machine became a co-op
(Ohio Emp. Ownership Ctr. 2006)
https://docs.google.com/viewer?url=http://american.coop/sites/default/files/1042rollovercoopsmncasestudy.pdf&chrome=trues.
56
Preparation of Offering Statement and Vote to Convert
At the completion of the feasibility study, Mark Stewart prepared an offering statement for the
employees. 67 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.
Deciding on Cooperative Financial and Patronage Structure
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
To finance the deal, Logue and attorney Mark Stewart developed a multi-stage buy-out plan wherein 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. 68
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 workerowners to run the business successfully.
Executing the Conversion and Partial Buy-Out
The sale and conversion happened simultaneously. 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 workerowners' 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.
67
68
Id. at 3.
Raymond supra note 64.
57
Completing the Gradual Buy-Out
While the cooperative planned on purchasing the outstanding 60% of stock by 2010, the dismal
economy led the workers to elect 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 outset 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.
The conversion, from the first discussion with OEOC to first stock redemption, took six months, and the
stock redemptions took six years to complete.
Acknowledgments:
This summary was written by staff and interns of the Sustainable Economies Law Center and Green
Collar Communities Clinic, based on an interview with Todd Brewster, 10-31-14, and from various
secondary sources, including:
• http://dept.kent.edu/oeoc/oeoclibrary/1042_rollover_co-ops_MN_case_study.htm
• Roy Messing (2011). “Transitioning a Private Business to a Worker Cooperative: A Viable
Community Development Tool.” Grassroots Economic Organizing (GEO) Newsletter, Volume
2, Issue 8. http://geo.coop/node/637.
• Joan Raymond, “Unlikely Pioneers,” Bloomberg Businessweek, March 19, 2006,
http://www.businessweek.com/stories/2006-03-19/unlikely-pioneers.
• John Logue, “The 1042 Roll-Over Cooperative in Practice: A case study of how Select
Machine became a co-op,” Ohio Employee Ownership Center, 2006,
http://american.coop/sites/default/files/1042rolloverco-opsmncasestudy.pdf
• Barbara Taylor, “A Creative Way to Sell Your Business,” N.Y. Times, October 29, 2010,
http://boss.blogs.nytimes.com/2010/10/29/a-creative-way-to-sell-your-business/
58
Legal Case Study: Loconomics Conversion to a Freelancer-Owned Cooperative69
Background
Loconomics is a company that some would place in the realm of the “sharing economy” or “peer
economy.” Along with Airbnb, Handy, Uber, and Task Rabbit, Loconomics is an online platform where
people may offer their services to strangers who use the platform to book, pay for, and review the
services. The service providers who use the platform include babysitters, dog walkers, house cleaners,
massage therapists, psychotherapists, and handy people. They are also part of the “freelancer economy,”
which is made up on a growing number of people who operate independent businesses, do temporary
work, moonlight, and generally work on an independent contractor basis. Organizations like the
Freelancers Union have recently been calling attention to the need to create greater income security and
better working conditions for this growing sector of society, which, by some estimates, currently
encompasses more than one third of the workforce.
A Freelancer-Owned Cooperative
Loconomics offers a solution to this need. In contrast companies like Airbnb and Uber, which take a
large cut of freelancers’ earnings and which operate primarily for the benefit of their shareholders,
Loconomics is now what founder, Josh Danielson, describes as a “freelancer-owned cooperative,” a
company that is owned and democratically governed primarily by the freelance workers that benefit
from the company’s service. Some of the ways in which a freelancer-owned cooperative would likely
differ from a conventionally-structured company in the sharing economy is that it is more likely to:
• Work to ensure predictable work for freelancer members,
• Keep fees low,
• Distribute dividends to freelancers,
• Offer benefits and supports services to the service providers,
• Bargain on behalf of freelancers (for insurance and other benefits),
• Create rules and culture that benefit freelancers and help maintain freelancer independence and
mobility, and
• Empower freelancers to propose and carry out initiatives within the company.
Loconomics as a Conventional Shareholder-Owned Corporation
Loconomics was previously a for-profit company structured as a California Benefit Corporation with
eleven individuals holding stock and/or stock options. Each of these eleven shareholders contributed
time, and – in some cases – money, to the founding of the company and the creation of the platform. In
2014, the platform was nearing completion and was already in use by a handful of service providers.
Josh Danielson approached the Sustainable Economies Law Center (SELC) to seek legal assistance with
converting the company to a cooperative.
Documents Required in the Conversion
SELC assisted by helping to prepare:
• A letter to the shareholders to explain the thinking behind and process of cooperative
conversion,
• A Stock Redemption Agreement (attached as a sample),
69
Although Loconomics is not strictly a worker-owned cooperative, we have included it here since it is structured
in a similar spirit to support workers, and because the conversion process included steps that would be similar in
the conversion of company to a worker-owned cooperative.
59
•
•
•
•
A Promissory Note (attached as a sample),
Amended and Restated Articles of Incorporation (attached as a sample),
Amended Bylaws, and
Amended Terms of Use for the platform.
Redemption of Stock and Stock Options
To convert the Benefit Corporation into a California Consumer Cooperative Corporation, Loconomics
first redeemed all outstanding stock shares and stock options in exchange for promissory notes.
Loconomics was fortunate to have all shareholders agree to forego the potential for profit maximization,
in exchange for locking in a fixed return based on the agreed-upon valuation of the company. Had even
one shareholder refused to voluntarily redeem stock for a promissory note, the conversion process would
have had to be different (a Type C conversion), since the only way to force redemption of the stock
would be to create a second entity and merge the original Loconomics entity with the new entity.
Fortunately, since everyone consented, the process was simpler, and Loconomics needed only to amend
its Articles and Bylaws to become a cooperative.
Valuation and Promissory Notes
There was no clear way to value the company, given that very few people were using the platform at the
time. Appraising tech start-ups is difficult, because Loconomics could have become huge and worth
billions, or it could have fizzled out and been abandoned. Josh proposed and everyone agreed that the
company be valued at approximately $750,000, based on a decision to compensate each of the eleven
people at a rate of $75 per hour for the time they put into the creation of the platform and the risk they
took in building the company. Thus, Loconomics now has $750,000 in outstanding promissory notes.
These promissory notes accumulate interest at a rate of 5%, and are repayable over the term of 5-10
years, with repayment beginning two years after executing the notes. Each shareholder signed a Stock
Redemption Agreement in which they relinquished their interest in the company in exchange for
promissory notes that outlined the terms of repayment.
Amending Articles and Bylaws
After redeeming all stock, Loconomics filed Amended and Restated Articles of Incorporation that
officially converted the company into a cooperative corporation. The Board had the power to adopt and
file the amended Articles, because the corporation, at the time, had no shareholders, and had not yet
admitted members. After filing the Articles, the Board appointed a new Board to serve on behalf of the
cooperative. At the time of this writing, members have not yet been admitted into the corporation.
Membership Structure
Ultimately, Loconomics adopted Bylaws that made it a multi-stakeholder cooperative, allowing the
following to be members:
1. Individual freelance service providers (who would make up the vast majority of members),
2. Worker-owned cooperative service providers,
3. Nonprofit service providers filling unmet needs in the community,
4. Loconomics employees, and
5. Loconomics independent contractors.
Each member, regardless of their above category that they fall into, receives one vote in the election of
the Board of Directors. When there is surplus income, each member would receive a patronage dividend
on the basis of how many hours of services they booked using the Loconomics platform, or, in the case
of the company’s workers and independent contractors, how many hours they worked for the company.
60
Legal Case Study: Real Pickles
Background
Normally food business founders dream of an exit strategy that involves selling the business to a large
player in the food chain. Think Odwalla or Naked Juice. For Real Pickles owners Dan Rosenberg and
Addie Holland, however, selling their business to a large corporation would have compromised their
business’ social mission “to promote human and ecological health by providing people with delicious,
nourishing food and by working toward a regional, organic food system.” 70 Converting to an employeeowned business was a way for the owners to preserve Real Pickle’s social mission long after selling
their ownership stake. In 2012 they formed a cooperative with their employees. And in 2013, after
owning the business for twelve years, sold Real Pickles to the new cooperatives, Real Pickles
Cooperative, Inc.
The Deal
The founders landed on a sales price of $524,000 for the business and entered into an MOU with their
three employees to sell the business to the new coop. The founders stayed on in the business and,
alongside their three employees, became worker-owners of the coop. The buy-in for each work-owner,
including the two founders, was $6,000—which was a total of $30,000 in member capital invested in the
cooperative. The plan was to raise the bulk of funds to purchase the business from the direct public
offering. The owners agreed to extend a loan, at 4% simple interest rate, for the balance of whatever was
not raised by the direct public offering.
The breakdown of the deal was that the new cooperative would purchase all of the assets and liabilities
of Real Pickles, the partnership. Included in that purchase was $400,000 of goodwill. In addition, the
cooperative assumed about $145,000 in debts. The owners owned the property out of which Real Pickles
operated and agreed to a long-term lease at an annual rent of $67,500 and granting a right of first refusal
to the Cooperative upon sale of the property.
The Financing Strategy
Real Pickles used a direct public offering of preferred shares to finance the majority of the sale of the
business to the cooperative. The preferred share program was similar to that used by Equal Exchange, a
large Massachusetts-based coffee roaster. In determining the preferred share offering terms and sale
price, the founders sought financial expertise from PVGrows, a local organization that provides financial
and technical advice to area food businesses. For the actual legal involved in doing the direct public
offering, Real Pickles hired Cutting Edge Capital (CEC), a consulting firm that specializes in providing
legal and technical assistance for direct public offerings.
Real Pickles started the crowdfunding campaign in March 2013 and amazingly, finished it in two
months. They were able to get seventy-seven community investors, including other cooperatives, to
purchase the minimum share amount, and raise the entire $500,000 offering amount.
Each share cost $25, and investors were required to purchase a minimum of 100 shares, which meant the
minimum investment was $2,500. Rosenberg described this minimum investment amount as “low
70
Jonathan Ward, Community Investment in the Local Food System at 2 (Cmty. Involved in Sustaining Agric.,
2014) available at http://community-wealth.org/content/community-investment-local-food-system.
61
enough to allow for relatively broad participation, while high enough to keep our investment pool a
manageable size.” 71
Preferred share terms
The terms of the offering were laid out in the articles of incorporation, the offering prospectus and the
investment flier. The cooperative had two classes of shares- membership shares and preferred shares.
Membership shares are reserved for the worker-owners, and are the only voting shares in the
cooperative. The preferred shares carried no voting rights, but had a target dividend rate, set at 4%
annually. The preferred shares were non-cumulative and the board reserved the right not to declare them
in a given year. The preferred shares were non-transferable, except to the Cooperative. Preferred
shareholders were able to redeem their shares after five years, if the Cooperative had sufficient funds to
repay them. The Cooperative could redeem the shares (i.e. buy out the shareholders) at any time. The
offering prospectus clearly laid out the risk for preferred share investors- that they were not guaranteed a
dividend, and were not guaranteed that their preferred shares would be redeemed when they requested it.
The prospectus further explained that preferred shareholders had no voting rights, beyond the minimum
voting rights guaranteed by Massachusetts law. Election of the board of directors was the sole power of
the membership shares.
71
Id.
62
Legal Case Study: Colorado Recovery
Background
In 2006, Dr. Richard Warner founded Colorado Recovery Center, a Boulder-based residential treatment
facility for adults suffering from serious mental illness. Dr. Warner founded the Center to create an ideal
environment for patient recovery, in which patients would be respected, encouraged, socialized and
empowered. Currently, the Center has over 40 employees, and provides psychiatric services and therapy
as well as daily outpatient services for over 100 patients in the Boulder area.
Two years after opening the Center, Dr. Warner was diagnosed with terminal cancer, and realized that
he would eventually have to either close or sell the Center. Because the Center boasted a highly
motivated staff, and because so many Boulder residents had come to rely on the Center's services, Dr.
Warner decided to sell it and ensure that it remained in operation. But Dr. Warner did not want outside
investors to purchase the Center and treat it merely as a means of acquiring a return on investment.
To ensure that the Center continued to fulfill its mission, Dr. Warner decided to sell the Center to
interested employees, who would exercise voting power on the Board, and to interested patient families.
It took three years from the time that Dr. Warner decided to convert his business into an employeeowned business to the time when the first employees gained an ownership stake in the business.
Key Personnel
Converting Colorado Recovery Center into to an employee-owned business required a great deal of
professional assistance and internal support from individuals with crucial business knowledge and
acumen. Warner worked with two attorneys, Jason Wiener, who joined the board as a founding member
and consultant, and external counsel Maureen Eldredge. Throughout the entire process, external board
member R.C. Mercure helped structure and navigate the conversion, drawing upon his 57 years of
experience in business management and investing.
Determining the Sales Price and Incorporating
In order to create transferable equity interests, Dr. Warner converted Colorado Recovery Center from an
LLC into a Colorado Corporation. The new corporation included a board of directors, which included
Dr. Warner. The board needed to determine a sales price for the business, but decided that an external
evaluation would be cost prohibitive. Thus, the board's finance committee decided to conduct its own
valuation. The finance committee came up with a price, about $100,000, that they thought would enable
the transaction to move forward.
Corporate Structure and Financing
To structure the sale of the business, the board created three classes of shares. Class A shares would be
the common voting shares. Class A shares would be restricted to employees, who would be restricted to
ownership of one Class A share. Class B shares would be preferred, nonvoting shares sold to interested
patient family members who were interested in ensuring that the Center would continue providing high
quality care to their loved ones. Although Class B shareholders did not have direct voting rights, they
were able to select two Board seats indirectly through a nominating committee. After determining the
sales price, the board sold the Class B shares to patient family members through a private placement.
This provided the board with sufficient capital to proceed with the sale of Colorado Recovery to the
Class A shareholders.
In order for an employee to obtain a voting Class A share and become an owner, he or she would be
required to purchase a predetermined number of Class C shares. In order to ensure that all employees
63
would have the option of assuming an ownership role, the board created a novel, income-based share
purchase plan for high-income employees, middle-income employees, and low-income employees.
High-income employees, such as psychiatrists, would be required to purchase more class C shares
relative to lower income employees in order to obtain one Class A share and become an employeeowner. Low-income employees were afforded the option of purchasing the required class C shares over
the course of three years.
In December of 2014, one third of the employees at Colorado Recovery became worker owners. While
Colorado Recovery does not necessarily plan for every employee to become an owner, the owners and
the board have resolved to ensure that the potential for ownership remains open to all employees.
64
Sample Documents
The sample documents provided in this section include three documents used for a Type A
conversion, where the original business entity simply files amended Articles and adopts
amended Bylaws (as opposed to forming a second entity):
1. Amended and Restated Articles of Incorporation for a California stock
corporation converting to a California Consumer Cooperative Corporation, along
with a sample letter to the Secretary of State. Note that the California Corporations
Code is not entirely clear about the exact process and documents required to convert a
conventional corporation to a cooperative corporation. Nevertheless, the Secretary of
State has accepted a document substantially similar to the following, and explained to us
on the phone that the process to convert to a cooperatives is the same as to convert to a
nonprofit, as described in California Corporations Code Section 911.
2. Redemption Agreement by which any shareholders and stock option holders may
relinquish their interests in the company in exchange for a promissory note.
3. Promissory Note to be held by any former shareholders and stock option holders in
exchange for the redemption of their interests.
4. Articles of Incorporation for a Massachusetts Cooperative Corporation using
Preferred Share Financing. These are sample articles of incorporation based on those
used by Real Pickles for their preferred share financing program described in the case study.
65
Restated Articles of Incorporation
The undersigned certify that:
1. They are the president and the secretary, respectively, of OLD CORPORATION, Inc., a
California Benefit Corporation.
2. The Articles of Incorporation of this corporation are amended and restated to read as follows:
Article 1. The name of this corporation is NEW CORPORATION COOPERATIVE,
INC.
Article 2. This corporation is a cooperative corporation organized under the Consumer
Cooperative Corporation Law. The purpose of this corporation is to engage in any
lawful act or activity for which a corporation may be organized under such law.
Article 3. The voting rights of each member of the corporation are equal, and each
member is entitled to one vote.
Article 4. The proprietary interests of each member of the corporation are unequal and
the rules by which the proprietary interests are determined shall be prescribed in the
Bylaws of the Corporation.
Article 5. The liability of the directors of this corporation for monetary damages shall be
eliminated to the fullest extent permissible under California law.
Article 6. The corporation is authorized to indemnify the directors and officers of the
corporation to the fullest extent permissible under California law.
3. The foregoing amendment and restatement of Articles of Incorporation has been duly
approved by the board of directors.
4. The foregoing amendment and restatement of Articles of Incorporation does not require
approval by shareholders because there were no outstanding shares of the corporation on the
effective date of this amendment.
We further declare under penalty of perjury under the laws of the State of California that the
matters set forth in this certificate are true and correct of our own knowledge.
Date: _________________
____________________________
NAME, President
____________________________
NAME, Secretary
66
April ____, 2015
Secretary of State
Document Filing Support
Unit, 1500 11th Street, 3rd Floor
Sacramento, CA 95814
RE: Restated Articles of Incorporation of OLD CORPORATION, Inc.
Dear Secretary of State:
With this letter, we file Restated Articles of Incorporation for OLD CORPORATION, Inc.,
which also hereby changes its name to NEW CORPORATION COOPERATIVE, INC. Please
contact me at ______ if you have any questions.
We have enclosed a check for $30.00 and a self-addressed stamped envelope.
Sincerely,
…
67
Redemption Agreement
Background Information: NAME OF COMPANY is a California Corporation that is in the
process of converting to a California Consumer Cooperative Corporation, which requires
COMPANY to first redeem all stock and stock options from current shareholders. Now,
COMPANY and NAME1 wish to clarify the terms of the redemption of NAME1’s stock.
1. Parties: The parties to this agreement are NAME OF COMPANY and any of its
successor entities (“COMPANY”) and FULL NAME (“NAME1”), a shareholder of
NAME OF COMPANY
2. Value and Purchase Price of Stock: NAME1 is the holder of stock and/or of stock
purchase options (collectively referred to as “the Stock”) in COMPANY. COMPANY
and NAME1 hereby agree that the current value NAME1’s Stock is __________, and
this amount shall be the Purchase Price for the purpose of this Agreement.
3. Payment and Redemption: NAME1’s Stock shall automatically be surrendered to
COMPANY when COMPANY delivers a signed promissory note in the principle
amount of the Purchase Price to NAME1. The parties agree that the promissory note in
the amount of the Purchase Price represents full consideration for the purchase of
NAME1’s interest in COMPANY. Upon receipt of the promissory note, NAME1 shall
no longer have voting rights in NAME OF COMPANY
4. Representation and Warranties: NAME1 warrants and represents to COMPANY that
NAME1 is the absolute beneficial owners of the Stock, with good and marketable title
thereto, free and clear of any liens, charges, encumbrances, securities interests, or rights
of others, and that NAME1 is exclusively entitled to possess and dispose of the same.
COMPANY warrants and represents to NAME1 that the Corporation is not bound by
any agreement or restricted by any provisions contained in its incorporation documents
or bylaws that would prevent or prohibit the transactions described in this Agreement.
COMPANY warrants and represents to NAME1 that the purpose of this stock
redemption is to convert COMPANY into a cooperative corporation.
By signing below, COMPANY and NAME1 agree to the above terms and conditions of this
Redemption Agreement.
Dated: ____________________
COMPANY
_______________________________
By:
PRESIDENT NAME, President
Dated: ____________________
________________________________
FULL NAME
68
Promissory Note
Background Information: NAME OF COMPANY is a California Corporation that is in the
process of converting to a California Consumer Cooperative Corporation. COMPANY and
NAME1, a former shareholder of COMPANY, have entered into a separate Redemption
Agreement requiring COMPANY to deliver this promissory note to NAME1, thereby
converting NAME1’s stock in COMPANY to a loan payable to NAME1 by COMPANY.
COMPANY and NAME1 wish to clarify the terms of the repayment of this loan, as follows:
1. Promise to Pay: Thus, for value received, COMPANY (“Borrower”) hereby promises
to pay to the order of FULL NAME (“Lender”), at an address provided to Borrower by
the Lender, a sum of $__________________(the “Principal”), together with interest on
the unpaid Principal balance accruing at an annual rate of ______%, with all Principal
and interest due and payable by the following date:
______________________________.
2. Payment Plan: Borrower shall pay Lender ____________________
[monthly/quarterly/annual] installments of at least $_______________ commencing on
or before _______________ (some date in the future). Each payment under this Note
shall be credited first to interest then due and any remainder to Principal. This Note may
be prepaid, at any time, in whole or in part, without premium or penalty, as long as any
Principal prepayment is accompanied by a payment of interest accrued to the date of
prepayment on the amount prepaid.
3. Default: If Borrower fails to pay any sum due under this Note within six months of
when it becomes due and payable, this shall be considered a Default. In the event of a
Default, the Lender may, at his/her option, declare this Note to be immediately due and
payable.
4. Collection Costs: Borrower agrees to reimburse the holder of this Note for all costs of
collection or enforcement of this Note, whether or not suit is filed (including, but not
limited to, reasonable attorney fees and expenses), incurred by the Lender.
5. No Intention to Resell this Note: Lender represents and warrants that he/she is
purchasing this Note for his/her own account and not for the purpose of re-selling the
Note to someone else.
6. Lender is a California Resident: Lender represents that he/she is a resident of
California.
7. Relationship Between Borrower and Lender: Lender represents that he/she has a
preexisting personal or business relationship with PRESIDENT NAME and this
relationship has involved sufficient contact to enable Lender to be aware of the
character, business acumen, and general business and financial circumstances of
COMPANY and its founders.
69
8. Governing Law: This Note shall be governed by and construed in accordance with the
laws of the State of California.
By signing below, Borrower and Lender agree to the above terms and conditions of this Note.
Dated: ____________________
Dated: ____________________
COMPANY, Borrower
Signature:
By:
_______________________________
PRESIDENT NAME, President
Name:
FULL NAME, Lender
Signature:
________________________________
Address:
________________________________
________________________________
70
ARTICLES OF INCORPORATION
Article I (Name): The exact name of the corporation is Converted Cooperative, Inc. (the
“Cooperative”).
Article II (Purpose): The purpose of the Cooperative is to operate a small, democraticallyorganized business helping to build a regionally-based, organic food system that supports
ecological and human health.
Article III (Authorized Stock): This Cooperative is authorized to issue fifty (50) shares of
common stock, designated as “Membership Shares,” and two hundred fifty thousand (250,000)
shares of preferred stock, designated as “Preferred Shares.”
Article IV (Rights, Preferences, and Privileges of Stock): The Membership Shares and
Preferred Shares have the following preferences, voting powers, qualifications, rights, and
privileges:
1. Membership Shares
(a) General Ownership of Membership Shares shall be limited to employees of the
Cooperative. No employee may hold more than one Membership Share. Holders
of Membership Shares shall be designated as “Members.” Individuals seeking to
become Members must meet qualifications established by the existing Members
in accordance with the bylaws. Membership Shares shall be issued for a fee to be
determined by the Board of Directors in accordance with the bylaws. Members
of the Cooperative shall have all the rights and responsibilities of stockholders
under General Laws Chapter 156B, except as otherwise provided in Chapter
157A.
(b) Voting Rights. Each Membership Share is entitled to one (1) vote on matters on
which the Members are entitled to vote.
(c) Redemption. When a Membership is terminated for any reason, the amount in
the Member’s Internal Capital Account will be redeemed in exchange for debt,
cash, or a combination thereof in accordance with the bylaws. The Cooperative,
when redeeming a Membership Share, shall have the right to reduce the amount
redeemed by any debt the Member owes to the Cooperative.
2. Preferred Shares
(a) Dividend Rights. Dividends shall be payable to holders of the Preferred Shares
(“Preferred Holders”) when, as, and if declared by the Board of Directors.
Dividends shall not be cumulative. Preferred Stock is not entitled to participation
rights to distributions paid to Members.
(b) Redemption By Cooperative. The Cooperative reserves the right to redeem any
or all Preferred Shares at any time, at the sole discretion of the Board of
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Directors. If the Cooperative elects to redeem Preferred Shares, holders of the
redeemed shares are entitled to receive an amount equal to the amount originally
paid for the Preferred Shares as adjusted for any future stock splits, stock
dividends, recapitalizations or the like (“Original Issue Price”) of their shares
plus all declared but unpaid dividends (“Redemption Price”). The Cooperative
will notify Preferred Holders of the Cooperative’s intention to redeem such
Preferred Holders’ shares in writing thirty (30) days before the effective date of
the redemption.
(c) Redemption by Holder. Preferred Holders are entitled to request redemption of
their Preferred Shares at the Redemption Price by submitting a written request
for redemption to the Cooperative. If the Board of Directors determines that a
requested redemption may impair the Cooperative’s ability to operate
effectively, the Board of Directors may limit, postpone, or refuse the
redemption.
(d) Voting Rights. Preferred Holders have no voting rights, except as required by
law.
(e) Conversion Rights: The preferred shares are nonconvertible
Article V (Restrictions Imposed Upon Transfers of Stock): The Cooperative imposes the
following restrictions on transfers of stock:
1. Membership Shares: Ownership of Membership Shares is limited to employees of the
Cooperative.
2. Preferred Shares: Preferred Shares are nontransferable, except to the cooperative.
Article VI (Other Lawful Provisions)
1. Liquidation Rights: If the Cooperative is liquidated or dissolved, the funds and assets
legally available to be distributed (“Available Funds and Assets”) to the Cooperative’s
Members and Preferred Holders shall be distributed as follows:
(a) first, to Preferred Holders, an amount equal to the Original Issue Price of their
shares plus all declared but unpaid dividends; provided that if there are not
sufficient Available Funds and Assets to pay the amount due to all Preferred
Holders under this provision, the funds will be distributed on a pro rata basis
according to the number of Preferred Shares owned;
(b) second, if Available Funds and Assets remain after the liquidating distribution to
the Preferred Holders described in paragraph (1)(a), to the current Members an
amount equal to the Members’ Internal Capital Account balances; provided that
if there are not sufficient Available Funds and Assets to pay the amount due to
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all Members under this provision, the funds will be distributed on a pro rata
basis according to the Members’ respective Internal Capital Account balances;
(c) third, any remaining Available Funds and Assets shall be distributed to one or
more organizations, selected in accordance with the bylaws, whose missions are
consistent with the purposes of the Cooperative.
2. Indemnification: The Cooperative is authorized to indemnify directors for breach of
fiduciary duty, unless any provision of law imposes personal liability. This section shall
not limit the liability of a director for breach of duty of loyalty to the Cooperative or its
stockholders, acts or omissions in bad faith, intentional misconduct, knowing violations
of law, actions described in G.L. Chapter 156B Sections 61-62, or any transaction in
which the director derived an improper personal benefit.
3. Amendment of Bylaws: The Board of Directors may make, amend, or repeal the
bylaws, except with respect to any provision thereof, which, by law, the articles of
organization, or the bylaws requires action by the Member
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