How are the losses in the startup phase of a worker cooperative accounted for? Surprisingly, startup losses are not usually deducted from the members’ internal capital accounts. This is despite the underlying reality that the member investments must be declining in value.
There are two common ways which the losses are accounted for that avoid reducing the members’ internal capital account, at least on paper. One approach is to create a negative equity account to which the losses are attributed. During the startup period, member internal capital accounts are held at their original value and all losses are added to the negative equity account. This negative equity account must later be credited with profits until a zero balance is reached before any profits can be distributed to the members.
The negative equity account is a façade that makes it appear the member investments are not declining in value as startup losses occur. It should be obvious that negative equity can’t actually exist. Investment losses during startup actually occur and the negative equity account does not make them vanish.
To see what is actually happening, consider the case where a coop files bankruptcy during this period. The negative equity account does not mean the member internal capital accounts get repaid in full. The member investments (internal capital accounts) would bear any losses that occurred.
What is actually occurring despite the negative equity account is that the internal capital accounts are declining in value as losses occur. The internal capital accounts are later credited with profits until they return to their original level, corresponding to the elimination of the negative equity account.
An alternative method places the losses in the startup phase to the collective reserve account. Since the collective reserve account of a new cooperative must initially have a a zero balance, the collective reserve account has a negative balance once the losses are deducted. As with the negative equity account is actually the members internal capital accounts that are bearing the losses.
The main problem with the negative equity and collective reserve loss schemes is that they fail to recognize the founding members’ losses, and thus fail to provide adequate compensation. The founding members are required to effectively make an investment that is expected to decline in value, a situation that is particular to cooperatives. Conventional investments are only made if they are expected to only increase in value, or else they would be withheld.
Compensation for intentionally bearing a loss is different from compensation for the risk of default. The interest payments on the debt include compensation for the risk of default. Here we are dealing with a separate issue, a requirement that founding members contribute capital to cover real losses.
The negative equity and collective reserve accounting treat the founding members’ investment essentially like a security that does not change in value, instead of an investment that is expected to decrease in value as losses occur. This discrepancy between the treatment of the investment as fixed value loan, and the underlying reality of the decrease in value is the primary reason for the under compensation of founding members.
The startup accounting in worker cooperatives fails to accurately describe reality. It takes the initial investment losses and future profit distributions which are used to cover the loss (if the profits occur) and incorrectly describes the whole transaction as a fixed value debt purchase by the founding member. This keeps cooperative investments consistent with the modern financial framework where investments that are expected to decline in value can be safely ignored.
Under the current model, these investments losses result in a unique financial penalty for the founding members. This is the primary reason most entrepreneurs will select a different business model and is likely the dominant cause of the low rate of worker cooperative startups.
The startup issues also create problems with member departure and the interest that a coop pays.