Legal Case Study: Island Employee Cooperative

The Island Employee Cooperative (“IEC”)¹  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
• $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 long-term 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.

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-to-date 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.