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. In light of this, 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.

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 modern-day 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 a result, it is common for cooperatives to make arrangements for unequal contributions. Note that, regardless of the 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 will 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 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 buy-out. 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.

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, and there is potential that cooperative-focused loan guaranty funds could be developed 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 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 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 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 “intra-state 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 $1,000 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; however, voting rights of non-worker investors in a California worker are limited to approval of certain major decisions like dissolution and merger. 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 $1,000 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 use crowdfunding websites such as 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 finance 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: The federal government recently enacted a crowdfunding exemption in the Jumpstart Our Business Startups (JOBS) Act, which lowers hurdles to publicizing opportunities to make small loans or equity investments in businesses. This law, along with various state laws that have created similar exemptions in recent years, will likely 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 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).