Earned and Unearned Profit

There are two different components that contribute to the profit of a firm. Earned profit is due to the labor of the members. Asset appreciation profit is due to the increase in value of assets due to market forces. This is unearned profit due to the ownership of assets. Conversely, decreases in asset prices due to market fluctuations, result in unearned losses.

Note that the depreciation of assets due to use is an operational expense that is the full responsibility of the members. The depreciation due to use must be disentangled from a market changes in asset price. For example a building can simultaneously lose value due to both use (being worn down) and a real estate market decline.

Any earned profit (or loss) must be appropriated by the members. Unearned profit can go to either the members or security holders, depending on which party has that right. This can be determined by defining the type of security that is issued. Preferred equity is a fixed value security that does not appropriate unearned profit associated with asset ownership. But other types of securities are possible.

To clarify the distinction, take a take a hypothetical worker cooperative that makes gold widgets. As part of their operations they hold a stock of gold. Over time, the value of the gold fluctuates in price. Clearly no work was done to change the value of the gold being held by the cooperative. No labor from the members was used. The change in value results from variations in the supply and demand of gold and speculation. This is a result of market forces, not the labor of the members. If the gold stock was later sold, the profit or loss from the change in gold value can be attributed to either the members or the security holders. The main point is that earnings (or losses) from asset price fluctuations are not necessarily the responsibility of the members.

If the members appropriate unearned profit then the securities issued to outside investors are fixed in value. This is the standard debt or preferred equity of worker cooperatives. It pays interest or a dividend but the face value does not change. In this case, the total nominal value investments in the worker cooperative does not change as the value of the assets owned by the cooperative fluctuates. The members bear the resulting profit or loss from the price fluctuations, not the preferred equity or debt holders. In this scenario, the outstanding investments would change only through the issuance or redemption by the cooperative.

Fixed value investments create the problem of passing unrealized gains or losses through to the members each period. For example, under the internal capital account structure, a portion of profits (including those from unrealized asset gains) must be paid to the members in the current period. This can create a situation where there are paper earnings, but cash flow is insufficient for payouts. Coop assets that are marked to market can create this predicament.

Deleveraging Member Ownership

If all the earning from a cooperative are attributed to the members who hold only a fraction of the assets, the members are leveraged. This type of leverage appears whenever debt it utilized and a worker cooperative is basically a debt financed firm. The earnings/losses from asset price fluctuations get concentrated in the member owners. Coop asset backed securities can be used to remove this leverage.

In some cases earnings and losses from asset price fluctuations should be separated from membership in a coop. Price fluctuations are a risk that has nothing to do with labor and earned profit appropriation. The securities of a worker cooperative should be structured to reflect that risk. The coop asset backed security reduces the risk to members from market price fluctuations which are beyond their control.

Let’s again take the case of a building owned by a worker cooperative. Pretend for a moment that the building was held on the books a fair market value, and not held at cost and depreciated. If the price of the building went up due to a real estate market increase, the nominal value of all variable coop asset backed securities would increase accordingly. Consequently, more interest would be paid.

In market transactions, there is typically no change to the asset value of a worker cooperative. It is only a swap of cash for assets of equal value. When something is purchased, its value is the price being paid.