There are a number of ways to structure an investment. Investments in cooperatives have typically followed the mainstream model where they are separated into debt of equity. The distinction between debt and equity is artificial as equity in the usual form of common stock doesn’t exist for a worker cooperative. The ownership and control of normally granted to the equity holders have to be relinquished to the members. Note that the ownership and control rights in a worker cooperative are functionally tied to the contribution of labor, and not any sort of investment.
Given the ideological baggage associated with equity, it is best to describe the features of a particular investment and whether they are appropriate for a given situation. Some options are listed below.
- Maturity: Fixed term, perpetual, callable by the cooperative
- Payments: Required (interest) or discretionary (dividends)
- For interest, penalty if payments are missed/delayed or default
- For dividends cumulative or noncumulative if payments are missed
- Seniority in the event of default
Assets and Payments
Fundamentally a coop has a certain amount of assets, and it makes payments on those assets over time. The payments reduce the assets of the cooperative. To avoid bankruptcy a coop must make required payments when they come due. The basic financial transaction is the present acquisition of money in exchange for a stream of future payments. The size and timing of the future payments determine the effective yield. Whether the investment is classified as debt or equity is not a fundamental issue.
Take a coop that has a choice of issuing preferred equity or a perpetual bond (a form of debt). Either choice results in the coop receiving the same amount of money. Both choices result in identical payment schedules.
In the preferred equity scenario, there is only equity, and there are no liabilities. In the perpetual debt scenario, there is only a liability no equity. Regardless of the classification, the total assets are the same in either case.
Payments can be considered dividends in the preferred equity case, or interest in the perpetual debt case. The perpetual debt payments can be looked at as interest only payments with fixed principal, or amortizing payments that fully pay off the principal as time goes to infinite. It matters little whether the payments are called interest, principal, or dividends. The value of the payments is the same in either case.
The only real difference in the preferred equity or perpetual debt choice is whether the payments are required or discretionary. Missed perpetual debt payments result in default, while preferred equity payments can be skipped. Coop assets and payments are otherwise the same.
The debt-equity debate generated by the internal capital account is a result of the arbitrary categorization of assets. Fundamentally, the internal capital account and associated repurchase agreement represents a liability for the coop, regardless of its classification as debt or equity.
Capital is just an asset utilized by the cooperative. Providing capital confers no rights to earned profit appropriation and grants no governing power. These are reserved exclusively for the members. The payments to capital contributors must be a fixed return and independent of the profit or revenue or the coop. It makes little difference whether the capital comes from members or non-members. Identical forms of capital should be entitled to the same return regardless of where it comes from. Members should be entitled to a return on capital they contribute.
Sometime members choose to receive no interest/dividends on their invested capital since not receiving interest results in higher profit which they appropriate anyway. This is fine so long as each member contributes an identical amount of capital and patronage is equally distributed between members.
Payments to capital contributors can be optional or mandatory. If they are mandatory, like debt payments, they must be paid when due. If they are optional, like preferred equity payments, they can be paid at the discretion of the coop.
The following are some guiding principles for the financial structure. The contain assumptions about which properties are desirable. The derived structure is a reflection of these assumptions:
– Protect rights of members (retain member control, earned profit/loss responsibility)
– Full member profit appropriation (though not necessarily in cash)
– Well defined asset ownership (no un-owned assets)
– Make coop liabilities as predictable as possible (no dependence on member departure)
– Smooth coop liabilities as much as possible (not earnings dependent)
– Maximize coop control of asset level (coop intentionally sets asset target)
– Minimize required payments (ones that could result in default/bankruptcy)
The validity and benefits of any assumptions can be debated. The assumptions are stated here so they can be easily analyzed.
There are various rights associated with ownership. Normally they are bundled together in what we call ownership of the asset. These rights include:
1) The right to sell, hold, or modify the asset
2) Responsibility for maintenance costs (or depreciation)
3) Denial of usage rights for others (you can’t use this, or only this way)
4) Right to asset value and profit or loss from price fluctuations
Ownership is traditionally bundled. When something is purchased, the entire package of rights is transferred. But there are also common arrangements where only some of the rights are transferred. The rental or lease agreement is one such transaction where only usage rights are transferred.
The ownership rights of things are intrinsically different from the inalienable rights of humans. Human rights come as a package that in inherently bound to each person. The ownership rights of things can be unbundled and sold or traded separately.
The unbundling of ownership rights provides flexibility in designing a coop ownership structure. We will proceed by unbundling the ownership rights and assigning specific ownership rights to various parties.
The Coop Asset Backed Security
A new security is used to unbundle the rights of assets owned by the coop. This security is called a Coop Asset Backed Security. The coop asset backed security transfers certain unearned profit rights associated with assets owned by the cooperative to the holder of the security.
It gives the coop asset backed security holder the right to interest based on the value of the underlying assets. All other asset ownership rights are retained by the cooperative. These include the ability to sell, hold, or modify the underlying assets, responsibility for maintenance and depreciation, and negative usage rights.
This coop asset backed security holder has no positive control rights regarding the governance of the coop (no vote). It entitles the holder to a fixed interest payment based on the nominal value, which is tied to the price of the underlying assets. But it allows the interest payment to be deferred during periods of distress.
Coop asset backed security holders retain one specific denial of usage right. They can block demutualization of the coop. This is not a governing right, it merely restricts the structures under which coop asset backed security holders allow their investments to be used.
The coop asset backed security is a hybrid security that has properties of both debt and equity, but does not nicely fit the definition of either. It is a perpetual security that exists indefinitely, similar to a perpetual bond. However, the nominal value (face value) of the security is tied to assets prices, a property commonly associated with equity and ownership. The coop asset backed security is a variable value, interest bearing security, with deferrable but cumulative payments.
When changes in asset prices occur it will be determined if they are the result of labor or external price fluctuations. If labor was the cause, then only coop asset backed securities held by the members will be adjusted to reflect the change. If the asset prices change due to market fluctuations then all the coop asset backed securities will be adjusted. The determination of labor contribution should be fairly straightforward.
The property rights of the coop asset backed security holder and cooperative are shown below.
Coop asset backed security
|Sell, Hold, Modify||
|Maintenance / Depreciation||
|Denial of Use||
|Capital Gains Right||
Higher nominal value ->
Increased interest payments
The difficulty is that payments are based on the value of underlying assets and the market value of assets are undefined in the absence of transactions (no liquid market). A custom machine used in production is one example.
The asset value of a worker cooperative is usually estimated and reported according to Generally Accepted Accounting Principles (GAAP). The asset value under GAAP can differ from the asset value based on the principles of economics. Economic value is added when work is done to create a product, as a finished product is a more valuable asset than raw materials. But this added value is not realized under generally accepted accounting principles until the product is sold.
The value of assets under GAAP (the book value) can also differ significantly from the market value since capital assets under GAAP are typically held at cost then depreciated. The cost principle means certain assets will not be held on the books at fair market value. The value of assets like real estate that are held in an appreciating environment can be worth more than their accounting value. In order for a coop to pay the correct amount of interest, all assets should be held at fair market value. This contradicts GAAP accounting.
The nominal value of the coop asset backed security is tied to the value of assets held by the cooperative, not the market value of the securities. The nominal value is the value upon which interest is paid. Private parties can agree to trade shares at any price they wish. Such third party transactions would be facilitated by accurate pricing of coop assets.
The coop asset backed security functionally brings the assets holding company within the cooperative. A worker cooperative could rent all its assets from an asset holding company, where that holding company would bear the risk from asset price fluctuations. The coop asset backed security internalizes the asset holding company in the same way the internal capital accounts internalize the banking function or the collective reserve account internalizes the insurance function.
In the case where the cooperative has an excess of assets these assets can be reduced by paying a special dividend that reduces the face value of all coop asset backed securities by an equal amount. This potentially unlimited dividend is not an earning payment. It is the conversion of the coop asset backed security into cash by the cooperative. The transaction monetizes a portion the securities.
Coop asset backed security holders are entitled to fixed interest payments. However, deferring a payment to coop asset backed security holder should not be cause for default. But coop asset backed security holders must eventually be compensated, even if the coop is unable to make payments during the current period.
There is a tradeoff between the survivability of the coop, and the rights of the coop asset backed security holders. To enhance survivability, the coop should be permitted to defer payments to coop asset backed security holders. This deferral can be accomplished by reserving the rights to make coop asset backed security interest payments in the form of super subordinate debt. This debt will bear marginally higher interest and be paid at the coop’s discretion. It would be junior to all other securities, except those held by coop members.
Coop asset backed security holders must be protected from a coop’s self-serving decision to arbitrarily issue interest payments in the form of super subordinate debt. This can be done by first requiring a suspension of payments to all investments held by members. In addition a higher rate of interest on super subordinate debt can also be imposed. And a mandatory reduction of member’s compensation until all super subordinate debt is paid off can be required. Taken together these measures should be sufficient incentive to suspend payments only in times of severe hardship.
Super subordinate debt will ensure coop asset backed security payments go to whoever held the security at the time the interest was due. Observe the problem with preferred equity dividends. If a preferred equity dividend is missed, it cannot be paid retroactively. Dividends cannot be declared for previous owners of preferred shares, only current owners. If the coop goes through a period of losses, where no preferred equity dividends are paid, the holder simply loses out. Increasing a subsequent preferred equity payment only compensates the correct party if the preferred equity was not sold. Otherwise, the prior owner is shorted and new owner over compensated. Dividend payments on preferred equity shares can only be skipped, not deferred.
Unlike the dividend payments on preferred equity shares which can be skipped, coop asset backed security interest payments are mandatory. It is only the form of the payment that can change: between cash and super subordinate debt. The coop basically reserves the right to securitize the interest payment in the form of super subordinate debt. This is similar to the right of the coop to make profit payments to members in the form of cash or coop asset backed securities if they wanted the money reinvested.
As the interest payments on coop asset backed security are mandatory, they represent a liability for the coop. The option of securitizing payments in the form of super subordinate debt is a mechanism that effectively makes the payments indefinitely deferrable. Interest payments are an operating expense which is the responsibility of the members.
The net asset value of a coop is zero in this model since all assets are liabilities. In the long term, the average return on assets must be greater than the interest expense if the coop is to survive. The coop must also retain sufficient liquidity to make its current liability payments, but only for those liabilities that are not coop asset backed securities.
The super subordinate debt option for coop asset backed security payments provides the coop with a perpetual source of liquidity. Easy access to liquidity can hide insolvency. Not all coops are viable and sometimes it is necessary to shut businesses, but it is important to know when. Sinking resources into a failed business is a recipe for disaster. The former Consumers Cooperative of Berkeley (CCB) is a prime example.
A condition to protect coop asset backed security holders from labor related losses is required. Labor related losses would not reduce the nominal value of the coop asset backed security, but could results long periods of deferred payments. Labor related losses could result in coop insolvency without triggering a technical default on coop asset backed security payments, which can be indefinitely deferred.
This can be solved if coop asset backed security holders be given a vote on liquidation if payments are not current (there is super subordinate debt outstanding) and net member investment falls below zero. This would allow coop asset backed security holders to decide to monetize the value of the assets backing their securities by sell the assets of the coop if those conditions were present, and in their view the coop was no longer viable. Liquidation would require some threshold of votes, determined before hand.
Ultimately, future payments depend on a coop generating positive financial returns. Investors in any coop security provide financing under the assumption that positive financial returns are a probable event in the future.
Seniority of Securities
We now have an alternative structure for a worker cooperative corporation. It can issue coop asset backed securities or standard debt to both members and non-members. Coop asset backed securities are perpetual securities which pay a fixed interest rate, but whose nominal value on which interest is paid, is adjusted to reflect coop asset value changes resulting from market fluctuations. Members may, for practical purposes, be required to own coop asset backed securities as a condition of membership. This would restructure or replace the internal capital account.
In a potential coop bankruptcy, who gets paid off first? We return to the principle of personal responsibility to determine which parties are first liable. As members are the responsible party making decisions concerning the coop, their capital investments are subordinate to those of all outside investors. Members would always take first losses in their investments.
The following three rules are proposed for determining the seniority of payouts in the event of default. They should be applied in order:
1) Outside investors claims are senior to all member claims. Member investments are the most junior investments in the case of default.
2) Claims on the longest duration securities of have highest payout priority. Coop asset backed security holders will generally get paid off before debt holders, since coop asset backed security are perpetual securities with infinite maturity, while the maturity of debt is typically finite. This ordering rewards long term financial commitment to the coop. A secondary criteria would pay off the longest held security first in the event of an equal maturity security. So whoever held a coop asset backed security longer would have a stronger claim. This would discourage speculative trading of coop securities.
3) Prioritize claims on lowest interest investments first. If there are two securities of equal maturity, but paying different interest rates, the lower interest security gets preferential treatment. The higher interest rate then reflects the extra risk in the event of default.
The first rule says the party that appropriates the first losses during default is the members. It is the members’ capital investments that collateralize other outside investments. The total collateral that can back outside investments is the sum of the member investments (both debt and coop asset backed securities).
The second rule for the seniority of securities prioritizes payout to the longest duration investments first. It says traditional debt seniority (with finite maturity) no longer holds. Since coop asset backed securities have no residual claimant (profit) rights, and no positive control rights, there is no compelling reason coop asset backed security investments should be subordinate to traditional debt. There is a similarity between debt and coop asset backed securities, since neither have control of the coop (a vote), nor rights to earned profits. This removes the motivation for the seniority of traditional debt.
The second rule assumes that the risk of default scales with the duration of the investment. Giving a perpetual investment like the coop asset backed security, seniority in the event of default has some advantages. First, it reduces the interest payments to coop asset backed security holders. In this scenario, it is likely that interest on debt will be higher than interest on coop asset backed securities. The consequence is an inclination to have a stronger dependence on coop asset backed security financing, as opposed to debt. Since the coop asset backed security is a more robust form of funding with deferable payments, this should benefit the stability of worker coops.
The third rule gives lower interest securities seniority in the case of default. It is possible that a coop will issue securities with different interest rates. This could be due to the different times of issue (as market rates fluctuate), or different stages in the coop’s development. For example, a coop might issue securities with higher interest at startup, and securities with lower interest once it was profitable. The different rates should be correlated with different levels of default risk, regardless of the timing of when the investments were purchased. Higher interest rate securities should carry a higher risk in default than lower interest securities. The risk for higher rate securities is that they have a lower payout priority in bankruptcy. An inverted interest based default priority would help protect less sophisticated investors. This would prevent their investments from receiving less return (often while being backed by inferior collateral), which frequently happens.
Making debt be subordinate to coop asset backed securities also gives debt holders an incentive to renegotiate the terms of the debt if it is not sufficiently collateralized (negative aggregate member investment). There are several options when a debt payment is missed. The debt holders may decide to renegotiate the terms of their debt, or convert it to a coop asset backed security. Or, if they believe the coop is no longer viable, they may decide to liquidate the coop. In that case they are only paid after coop asset backed security holders.
There are two forms of collateral backing outside investments: member investments which are subordinate in default and actual coop assets. With the proper accounting (not GAAP) which holds all assets at fair market value and excludes intangible and fictitious assets all investments are fully collateralized. Some reduction in the sales price of assets may occur because liquidations are distressed sales. Shortfalls are compensated up to the level of member investments.
There is one last technical issue with seniority. Members who leave the coop cannot receive immediate seniority for their investments. Otherwise members foreseeing default could quit the coop, and give their coop asset backed securities seniority over debt from lenders. Seniority of recently departed member securities must be delayed.
Full Asset Ownership
If the ownership of the coop assets is to be well defined the unallocated collective reserve account is eliminated. This is an old idea, the debt financed firm. Not having a collective reserve account would require two things. The first is member investments would not be paid out upon departure. The second is that interest payments are discretionary and cumulative, but not required.
There are several potential benefits to the coop asset backed security model. One of the major advantages of the new structure is the decoupling of asset price fluctuations and member earnings. In a large asset intensive business, the value of assets will be many times the potential investments by the members. Member investments will have a reduced risk of getting wiped out by asset price fluctuations. These fluctuations can be absorbed by a much larger pool of coop asset backed security investors. This new structure should better support large scale worker cooperatives. Currently, in asset intensive worker cooperatives the members must be highly leveraged. Restructuring the investments provides a lower leverage alternative.
The removal of the internal capital account repurchase should help smooth coop financing. Members will likely retain a long term commitment to their coop, as they will be holding investments even after they leave. This should reduce the time horizon problem where new and older workers have different views on how much should be reinvested in the coop. Intentional asset targeting by the coop should also enhance financial management.
The following are some benefits of the proposed investment structure:
– Predictable coop liabilities (no dependence on member departure)
– Smooth payment schedule (dependent on assets, not earnings history)
– Full member earned profit appropriation (though not necessarily in cash)
– Improved control of asset level (with intentional asset targeting)
– Well defined asset ownership (no un-owned assets)
– Robustness to asset fluctuations (decoupling of membership and asset ownership)
– Potentially reduced liabilities (where missed payments result in default)