Worker Coop Conversion Financing FAQs
Worker-owned cooperatives bring tremendous benefits to workers, to businesses, and to society more broadly, but are highly underrepresented and misunderstood in the U.S. today. We aim here to prepare lenders to take advantage of the convergence of two opportunities. The first is a forecasted $10 trillion business lending opportunity from baby boomer business owner retirements over the next 5-20 years. The second is the opportunity to scale the community impact of worker cooperatives by “converting” successful existing businesses to worker ownership.
These FAQs provide a basic overview of worker coops, call out the key differences in their financial statements and tax treatment, outline what it takes to transition (“convert”) a traditionally-structured business to a worker-owned coop, explain how financing these transactions works, and walk through the 5 C’s of Credit for these types of deals.
FAQs: General Information About Worker Cooperatives
What is a Worker Cooperative?
How are worker cooperatives managed?
There is no single way to structure a worker cooperative. Most mid- to large-size coops have traditional (hierarchical) management structures, along with a participatory culture and governance through “representative democracy.” With representative democracy, worker-owners elect the Board of Directors. There are a small number of decisions that need to be voted on by all worker-owners (such as selling the business, electing the majority of board seats, and amending the bylaws). Other key decisions are made by the board, and day-to-day business decisions are made by the appropriate manager.
Some worker coops prefer a more “flat” management structure, and some of these have used “direct democracy” at a larger scale. In direct democracy, all high-level business decisions are made by a vote of all worker-owners. Small worker coops are the ones that can usually use this approach most effectively, but there are some larger coops that have been able to continue to operate with this structure.
With either approach—and as in traditional business structures—effective business operations are only made possible by well-defined decision authority and processes.
How are profits shared?
FAQs: Worker Cooperative Conversions
Why do business owners decide to convert to a worker coop?
We have seen four common motivations for businesses to transition to worker ownership:
- As an exit strategy for the owner, whether leaving for retirement or other reasons
- As a component of the business’ mission, recognizing the employees as an important stakeholder group
- To create wealth-building opportunities for employees, especially in low-wage sectors
- Because it’s good business: employee-owned businesses have demonstrated their ability to be more financially successful than their peers, and to weather economic storms more effectively
How big is the opportunity for worker coop conversions?
Most privately-held businesses lack a succession plan—an agreement for what happens when their owners retire. Few family-owned businesses succeed to the 2nd generation (only 15%), with only 5% succeeding to the 3rd generation. The pending ‘silver tsunami’ of retiring baby boomers makes this a critical issue for communities to address. In the U.S. today, 76% of private sector employment is in companies not traded on the stock market (“closely-held” or “privately-held” companies). And, according to census figures, depending on geography, baby boomers own between half and two-thirds of businesses with employees, or nearly four million businesses, leading to forecasts like the one by Businessweek that “[t]rillions of dollars of business value are going to change hands in the next 10 to 20 years.”
The silver tsunami is forecast to be one of the biggest changeovers of privately-held businesses in U.S. history. Coop conversions enable us to tap this for the good of our workers and of our local economy
What is the financing opportunity for worker coop conversions?
To prevent business closures and create good jobs, organizations throughout the U.S. are engaging with companies to support their conversion to worker ownership. These organizations—including small business services, nonprofits, law firms, and cooperative finance institutions—analyze the feasibility of a business taking on the debt necessary to become worker-owned. Lenders can work with these organizations to access a market of vetted businesses, with business values ranging from under $300,000 to over $10 million that have support organizations vested in their continued success.
For lenders with a specific interest in financing worker cooperatives, conversions of existing businesses present the strongest opportunities based on both loan size and risk profile. Outside of the small number of existing mid-sized worker coops (those with more than 20 members), most worker coop financing opportunities are with very small or start-up ventures. With conversions of successful companies to worker coops, the companies often have established markets, positive financial history, experienced management teams, and demonstrated capacity to borrow, making conversions a relatively low-risk financing opportunity in the worker coop sector.
What is the difference between an ESOP and a worker cooperative and why would you choose on option over the other?
An employee stock ownership plan, or ESOP, is a type of employee benefit plan (like a 401(k) or profit sharing plan) that can be used to transfer partial or full ownership of a company to employees. With an ESOP, shares are not held directly by employees, but through an ESOP trust, which is administered on employees’ behalf.
Two key differences between ESOPs and worker cooperatives are:
(1) worker cooperatives are by definition democratically governed by workers, whereas ESOPs have only minimal requirements for worker voice (although they can be governed democratically)
(2) worker cooperatives are largely unregulated, whereas federal law governs many aspects of how ESOPs are administered, including allocation, vesting, valuation, distribution, and more.
Given the costs, ESOP experts generally advise that companies with fewer than 50 employees may be too small for an ESOP, although there are many exceptions. Worker cooperatives, on the other hand, typically have much lower transaction and ongoing administration costs, and are appropriate for companies of all sizes.
Tactically, what is a conversion to a worker-owned cooperative?
A worker cooperative conversion is similar to a management buy-out, but instead of just a few key managers purchasing the business, most or all employees are offered an equal ownership stake. A conversion has three basic components:
- The creation of a business entity that is a worker-owned cooperative. Depending on the situation, this can be accomplished by converting the existing business, or forming a new cooperative entity;
- A sales transaction executed between the current owner(s) and the new worker cooperative to sell the existing business (or its shares or assets) to the worker coop and execute a Purchase & Sale Agreement. Each worker-owner “buys in” to the coop and receives a single voting equity share. The sales transaction is typically financed by a group of lenders—the selling owner, a bank, and/or a Community Development Financial Institution (CDFI), or less commonly, by selling non-voting equity shares; and
- A transition of roles and culture among the new worker-owners to take on the ownership responsibility of the new entity and run it under democratic governance. Often, technical assistance from coop developers specializing in this work helps smooth this transition.
What are the steps in a coop conversion?
Once the decision has been made to transition to worker ownership, a business must prepare for the transition. The conversion team works to secure a business valuation, identify financing options and negotiate the terms of the sales transaction. The selling price of the company should be based on the market valuation as well the debt service capacity of the company. Lenders can play a valuable role in advocating for a price with terms that the cooperative can repay even if it does not meet forecasted performance targets. In addition to financials, the team drafts bylaws and decision-making frameworks for the new coop, and creates a training and support plan for the new worker-owners. This phase leads to a formal commitment to the coop conversion transaction by the selling business owner and the coop’s future worker-owners.
During the next phase, the conversion team finalizes the worker coop entity set up and the coop’s bylaws. The buyers and selling owner execute the agreed-upon financing options and complete the sales transaction, after which the business executes the coop governance structures and is officially a worker-owned company.
During the final phase, consultants or an internal team provide training and support for new worker-owners, support governance and decision-making processes, cultural transitions, and help former owner(s) with their exit or evolving role.
What supports help make coop conversions successful?
We recommend that businesses ensure they have the right supports in place, including experts in designing worker-owned business structures, legal counsel, financial and tax advising, and accounting support to transition the books to new financial structures. Effectively structuring the financing to not over-burden the new worker coop is critical.
In addition, it is important to invest in education and training for the selling owner and the future worker-owners, as well as ongoing support for key individuals who will help lead the governance and cultural transition. We recommend building in the cost of ongoing training and support into the sales financing, to ensure adequate investment for a period of 2-3 years after the transaction.
FAQs: Worker Cooperative Conversion Financing
How are worker coop financial statements different?
Lenders who have never worked with cooperatives before may be unfamiliar with the relationship between the cooperative and its worker-owners, and how the relationship is reflected in the financial reports of a cooperative. Although cooperatives are subject to the same set of Generally Accepted Accounting Principles in their financial reporting as are all other types of business entities, there are two main areas where cooperative accounting differs from that of a typical business: the balance sheet and how profits are taxed.
The balance sheet:
When a new worker-owner joins a coop (or in the case of a conversion, at the time of conversion), each worker-owner “buys in” to the coop and receives a single voting equity share. This buy-in becomes equity on the balance sheet, and is tracked in the individual capital account of each worker-owner.
How profits are taxed:
A worker cooperative can elect to receive single tax treatment (also called pass through treatment) for profits generated by worker-members (called surplus), which are allocated to those members based on their labor contribution to the cooperative. As mentioned previously, cooperatives can retain this allocated surplus in the business through member (worker-owner) equity accounts instead of paying it all out in cash to worker-owners. This retained patronage is tracked in the Individual Capital Accounts in the equity section of the balance sheet.
The cooperative’s bylaws provide for how members can redeem the equity in their Capital Accounts. When a worker-owner leaves the cooperative, typically their Individual Capital Account (equity) is paid out over a period of years. Equity redemptions are often subordinated to lenders’ rights.
How does an Internal Capital Account work?
How are conversions typically financed?
Like financing any small business, financing options for worker coop conversions include a combination of debt and also equity—coming from worker-owners or outside investors. Most worker coop conversions have been primarily debt-financed. However, equity financing is increasingly being utilized through issuing non-voting equity shares, including Direct Public Offerings (DPOs). See the Conversion Financing Case Studies for specific examples of how financing has been structured.
How is debt financing used for coop conversions?
Debt financing for coop conversions can come from a variety of sources, including banks, CDFIs, vendors, the selling owner, members, and individuals from the community. Generally vendor-financing will take a lien on the business inventory alone, totally separate from other lenders. Bank and CDFI debt will take a primary position on other business assets in relation to members, customers and the selling owner, all of whom play a gap financing role and often are subordinate or unsecured. Which stakeholders provide gap financing varies by the business, depending on which have the resources. Multiple lenders can clarify their relationships with each other through inter-creditor agreements, depending on what the lenders and the business feel is the best way to structure the deal.
Existing lenders that have experience lending to worker coops bring experience both with financing coops and with coordinating various lenders in a deal, so they can be a great option to play a coordinating role in situations with multiple lenders.
How is equity financing used for coop conversions?
The sale of voting shares to members through payment of the member buy-in is the central equity source in worker coop conversions, though often quantitatively small. These are sold on a one member, one share basis and each equity share imparts one vote to the holder. As such, these shares form the basis of the worker-owners’ democratic control of the coop.
There is wide variability on the buy-in cost based on the capitalization needs of the coop and the capacity of the worker-owners to afford the shares. Frequently, the coop will lend a portion of the buy-in to a new worker-owner, enabling full payment to be completed over time through a payroll deduction. Unless there is significant time between starting the coop organizing effort and the sale transaction, most of this equity won’t be available at the time of conversion. However, some lenders still take this equity pledge into account.
To raise additional equity, coops can sell preferred shares, including private offerings, which may include accredited investors, unaccredited sophisticated investors or some combination of the two; or Direct Public Offerings (DPOs), open to anyone within certain geographic constraints based on filings and state laws. These shares, like equity in traditional companies, offer a targeted rate of return on investment, dependent on the financial success of the coop’s operations. They often do not carry any voting rights.
Internally, the cooperative will also build up equity over time through worker-owner Internal Capital Accounts and retained earnings reinvested into the business. As described in the section “How are worker coop financial statements different?” the tax code allows coops to avoid double taxation of dividends paid to worker-members based on their labor, even when that equity is not paid out to members in cash. As long as the distribution meets certain legal requirements, retained patronage is not taxed, and the cooperative’s accumulation of reserves is enhanced. For a detailed explanation of how coop equity distribution works, refer to the Patronage and Tax section of the co-oplaw.org website.
Finally, some worker coops have succeeded in raising equity through contributions and grants, due to the coop’s social benefit. We have seen start-up worker coops bring enough equity to the table through contributions in order to attract other lenders, but haven’t yet seen it widely used for coop conversions. Grants or donations can also be leveraged to fund outside technical assistance (TA) support, which is often critical to complete the initial feasibility assessment.
What role can loan guarantees play?
In a worker coop, in which many individuals own a small part of the business, personal guarantees can be a challenge to enforce and collect on. As a result, when lenders are unable to collateralize the loan using only business assets, limited loan guarantees can play an important role, for example:
1. Limited guarantees from the selling owner or top management. These guarantees might expire after a set period of time or cover a fixed amount of the debt.
2. CDFIs may have more flexibility than banks, given the regulatory differences. Coop-focused lenders have used limited guarantees and have also used a vehicle similar to a CD-backed guarantee, where a guarantor provides a cash investment with a promissory note clarifying that the investment is at risk if the coop defaults. Structuring a guarantee this way provides interest income to the guarantor while assuring the lender that the cash will be available if needed. CDFIs generally provide a higher rate of return on these guarantees than a bank’s CD or money market fund rate. Furthermore, if the CDFI is a nonprofit and the guarantee is called upon, the amount is a tax-deductible donation, giving the guarantor favorable tax treatment. This option is not available to all CDFIs, depending on their policies and sources of funds.
Should lenders have industry expertise to finance a conversion in that industry?
The need for industry expertise does not differ between underwriting a conversion or a conventional financing applicant, though lenders should ensure that the valuation was conducted by a firm with industry expertise and access to industry-specific data. Lenders can also reach out to conversion experts with experience in the industry or converted companies in that industry for support around effective practices and common issues that may arise.
How are working capital and growth capital taken into account?
As with any business, converted coops need access to sufficient working capital. In the case where the available business collateral is fully committed for the business acquisition loan, lenders might struggle to approve additional working capital debt. As the financing case studies illustrate, rarely are member equity and senior debt sufficient to finance a conversion. The other financing sources, including subordinated debt and outside investor preferred equity, are essential not only to the coop’s ability to buy the business, but also to its continued operational and growth needs.
How is a conversion different when the selling owner plans to stay?
When the selling owner is also a key manager in the business, it’s important to understand whether and how that owner is staying with the coop after the transition. The owner may leave immediately, stay for a fixed amount of time to support the transition, or stay on indefinitely as a worker-owner in the coop.
There are a few benefits to the seller staying, even if just for a fixed amount of time. First, preserving the top manager in the business allows more time to train new management, whether a member-owner or a new hire. The amount of time needed varies. It can depend on the extent to which the selling owner has already shared management responsibilities with the employees, and how integrally involved the owner is in the day-to-day business operations and in setting and leading the strategic direction of the company. Second, retaining the selling owner in the coop also retains his or her business relationships with vendors, customers, and other stakeholders, which minimizes risk that the conversion will disrupt business operations. Third, by retaining the selling owner, the risk of the seller starting another business or joining a competitor is minimized. Finally, when the selling owner stays in the business, he or she may be more willing to keep more personal financing in the coop, including taking a promissory note from the coop in lieu of full cash payment for the business.
Some selling owners are not able or willing to stay with the coop, so including this as a requirement could prevent an otherwise attractive deal. Also, there can be some challenges when the selling owner stays on as a worker-owner. In cases where the selling owner had a bad relationship with employees, vendors, or customers, the coop might benefit by having the owner transition out of the business altogether. Finally, an existing employer-employee dynamic may continue, inhibiting the ability of the worker-owners to think and act like owners, and realize the full benefits of democratic governance.
Depending on the particular deal dynamics, lenders might require non-compete agreements, to avoid competition from an exiting owner; personal guarantees or other financial contributions by the selling owner, to help ensure that the seller is leaving the coop in good shape; multi-year technical assistance contracts, to develop the management and governance capacity of the coop, financed as part of the conversion package; or other tools in lieu of their continued leadership.
Who signs a loan on behalf of the coop?
There is no inherent difference between coops and other business types regarding signatory powers. They are governed by the bylaws. Frequently, General Managers will have the right to execute loan documents, but board approval is required before taking on debt.
FAQs: The 5 C’s of Credit
What are the 5 C's of credit?
In most ways, underwriting coop conversions follows the same principles as underwriting other small businesses, with a focus on the 5 C’s of Credit framework. The major differences are rooted in core structural differences between coops and other business forms: shared ownership and democratic control by many worker-members.
Capacity: Is the applicant able to repay the loan through operations?
Of the 5 C’s, capacity might be the most similar between coop underwriting and other small business underwriting. Coop lenders review past and projected financial statements, assessing whether projections are in line with historic trends and business plans, and whether projections demonstrate enough post-expense cash flow to service the debt and any other senior or pari passu debt.
Conversion financing is different from a typical working capital loan, however, because of the sheer amount of the financing needed to buy the company. The business is typically financing 80% – 100% of its market value, mostly through debt, to pay off the selling owner(s), and potentially more than its market value, taking working capital financing into account. Although there is not currently sufficient deal flow in worker cooperative conversions to understand trends in repayment rates for these deals, comparable transactions are commonplace with employee stock ownership plans (ESOPs) and leveraged management buy-outs. Despite the large leverage amount, ESOP companies have a very low default rate (0.5% according to the National Center for Employee Ownership). Seller financing, which is generally the most flexible debt in the deal, can be restructured to provide more flexibility in payback. It is beneficial to set expectations with the selling owners in the beginning that if the new cooperative needs more flexibility to repay the various lenders, that the selling owner is expected to restructure the terms of their financing.
Capital: Is the applicant taking on sufficient risk of failure?
Given the community-oriented nature of coops, consider not only member equity and loans, but also outside equity, contributions and grants, and subordinate debt to ensure that you are not the only party with skin in the game.
In coops comprised of many voting worker-owners, lenders should pay attention to how member equity enters and leaves the coop. Particularly, it’s important to confirm that redemption of equity to exiting worker-owners is subordinate to any and all lenders’ rights. Bylaws can clarify that equity can be redeemed over a period of years, rather than immediately, to help alleviate cash stresses.
Similarly, with likely multiple layers of financing, it’s important for lenders to understand how payments to other lenders and equity investors could affect their own payments. There needs to be enough flexibility to attract sufficient capital to make the deal work, but also enough clarity to know that the agreed-upon repayment terms are protected.
Additionally, with the seller having an incentive to complete the transaction, consider whether they have any ongoing investment in the coop’s success, as a member, guarantor, or lender.
Collateral: If things don't go as planned, how will the lender be repaid?
Regarding collateral, the main difference between coops and conventional small businesses is the availability of personal guarantees. This is also one area where unregulated lenders, like CDFI loan funds, may have more flexibility than regulated banks and credit unions.
While much of the lending world relies on personal guarantees as a core component of collateral assessment, personal guarantees are tricky to apply to cooperative businesses (though not impossible). Ideally, lenders could underwrite coop loans based only on business assets. When this is not possible, loan guarantees can help (see discussion above about loan guarantee options). Some cooperative lenders structure their guarantees proportionally by putting a cap on each member’s portion of the obligation to ensure that collection will not be targeted inequitably, but this could become cumbersome with a large number of guarantors.
Character: If the applicant is able to repay, will they? Do they have the skill and credibility to implement their plans?
Traditional lenders use credit scores to assess the character of loan applicants. Due to coops having many owners, this is not a viable option. Instead, consider:
- The commitment of the worker-owners to developing an ownership culture;
- The attractiveness of ownership to the workers based on the percentage of workers who will become owners or will be on an ownership track;
- The skill and experience in governance and management within the coop (or long-term commitments by external advisors to develop this capacity); and
- The strength and depth of leadership within the organization.
Furthermore, it may make sense for the lender to meet more than one representative of the business to ensure the representative is accurately representing the group.
If the selling owner is leaving the business after selling it to the employees, ideally, a group of fully-trained worker-owners would be ready to step in to governance roles, and fill any management gaps left by the departing owner. This is often not feasible when the selling owner wants to leave the coop in a short timeframe. Lenders can mitigate this by requiring long-term contracts with external advisors that fill experience gaps, and can support the development of governance, leadership and management capacity in the coop. Having provisions for long-term support written in as a loan covenant can give lenders more leverage if needed. Another potential solution is to have the business sale occur in phases, allowing more time to establish a new ownership culture and train key staff in the skills that will be lost when the owner leaves.
Conditions: What broader economic context might impact the borrower?
The final of the 5 C’s of Credit—Conditions—is largely the same for coops as for traditional businesses. It involves looking at trends in the economic sector and the geography of the applicant.
In addition to resources available to all small businesses, coops can access two additional types of resources to bolster their chances of success. Training and consulting services from coop-oriented associations and consultancies provide both business and cooperative support for coops nationally. Additionally, coops are uniquely positioned to take advantage of community support for local businesses, as their structure inherently creates many owners and spreads wealth broadly in a community. Making sure that coops are taking advantage of these resources and supports can make for a stronger borrower.
What is the success rate of worker coop conversion loans?
There hasn’t been sufficient deal volume to create data on the success rate of conversion financing.
Is there a secondary market for coop loans?
At this point there is no secondary market for coop loans that enables banks to sell their loans to free up liquidity. Potentially, banks that are seeking to free up liquidity could sell their loans to financial institutions committed to financing cooperatives, like those listed on page 14. At the time of publication, there are efforts to develop secondary markets for CDFI debt, which include cooperative lenders.
FAQs: How Can Lenders or Investors Get Involved?
How Can Lenders or Investors Get Involved?
By partnering with organizations like Project Equity and others that support businesses converting to worker cooperatives to finance the deals they have identified, lenders can participate in conversions that have already been vetted and that have a built-in business support network invested in the company’s continued success.
Also, lenders likely have current banking clients who are whole or part owners of companies that may be good candidates for a worker cooperative conversion. Lenders can refer clients who are considering their succession planning options to a worker cooperative conversion expert to discuss whether converting is feasible and would meet the owner’s goals. If the owner decides to pursue a conversion, the lender’s existing relationship with the owner may make the financing process easier.
For financial institutions and impact investors interested in participating in conversion deals without being the primary lender, a there are a of couple ways to start financing coop conversions. The most hands-off approach with the most diversified risk portfolio is to invest in existing cooperative loan funds. The Cooperative Fund of New England, Local Enterprise Assistance Fund, Shared Capital Cooperative, The Working World, and other cooperative-specific lenders offer this type of investment option.
Alternatively, a lender could purchase part of an experienced coop lender’s particular loan as a participant. The experienced coop lender would fully service the loan and correspond directly with the borrower while the participant would limit their risk to the performance of a particular business. Finally, an investor could co-lend with an experienced coop lender, drawing up their own loan documents with the borrower, and signing an inter-creditor agreement with the coop lender to clarify the rights of each lender.
FAQs: Lenders with Worker Coop Experience
Learn more about Lenders with Worker Coop Experience
Common Wealth Revolving Loan Fund
The Common Wealth Revolving Loan Fund (CWRLF), founded in 1987, is a non-profit community development financial institution operated by the Ohio Employee Ownership Center, serving Ohio and the nearby areas of contiguous states. The mission of CWRLF is to lend money to employee-owned companies or coops for expansion, facilities, machinery and equipment, vehicles, and working capital or for employee-buyouts.
Cooperative Fund of New England
The Cooperative Fund of New England is a Community Development Financial Institution founded in 1975. Its mission is to advance community based, cooperative and democratically owned or managed enterprises with preference to those that serve low income communities through the provision of prompt financial assistance at reasonable rates; provision of an investment opportunity that promotes socially conscious enterprise; and development of a regional reservoir of business skills with which to assist these groups.
Local Enterprise Assistance Fund (LEAF)
LEAF is a nonprofit certified-CDFI whose mission is to promote human and economic development by providing financing and development assistance to cooperatives and social purpose ventures that create and save jobs for low-income people. LEAF lends to coops nationally and since its founding over 30 years ago, has invested and leveraged over $98 million, resulting in the creation or retention of more than 7,600 jobs.
National Cooperative Bank
National Cooperative Bank (NCB) provides comprehensive banking services to cooperatives and other member-owned organizations throughout the country. What makes NCB unique is that the bank was created to address the financial needs of an underserved market niche – people who join together cooperatively to meet personal, social or business needs, especially in low-income communities.
Shared Capital Cooperative
Shared Capital Cooperative (formerly Northcountry Cooperative Development Fund) is a national loan fund and federally certified Community Development Financial Institution that provides financing to cooperative businesses and housing throughout the United States. Shared Capital’s mission is to foster economic democracy by investing in cooperative enterprises, with a focus on providing financing to coops to create wealth in low-income and economically disadvantaged communities.
The Working World
The Working World builds cooperative businesses in low-income communities, using a unique model that combines non-extractive finance with tailor-made business support. The Working World only secures financing with collateral purchased with the loan, does not use personal guarantees, and the loans are repaid only after the company is profitable.
The Lending Opportunity of a Generation: Worker Coop Con Financing FAQs and Case Studies by Cooperative Fund of New England, Project Equity, and Democracy at Work Institute is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.