There is widespread recognition that founding members of a cooperative (broadly referring to those members that join prior to profitability) are disadvantaged relative to the later members who join after the cooperative is profitable. The present system of creating a negative equity account or debiting the collective reserve account, helps shift future profits in a way that mitigates the burden on the founding members, though if fails to recognize the losses. And wage differential schemes also help balance the compensation over time.
The primary problem is the founding members’ capital contributions face an expected investment loss which is ignored. Those losses cannot be addressed in isolation. They are also tied to salary and wage compensation.
The convention has been to treat salary and wages separately from patronage or profit distributions (positive or negative). However, it is necessary to treat both the wage or salary level and profit or loss appropriation simultaneously. The case of wages or salary during the startup period is a good example. During that time, any increase in the wages or salary of the members results directly in a larger loss to the cooperative. And a larger loss to the cooperative means that the members need to make larger capital contributions to absorb that loss. These wage/salary losses translate directly into investment losses for the founding members investments. So there is no advantage in choosing to pay higher wages in the startup period when the cooperative has negative earnings. Paying higher wages during startup while a worker cooperative is not profitable has the net effect of taking money from one pocket and placing it in the other since members salary and wages are paid directly out of member investments.
It follows that the least expensive way to start a cooperative would be to not pay any wages or salary until the cooperative is profitable. This is because the members are receiving no net benefit, and are in fact being penalized to the extent that they need to borrow money personally to make the original capital contribution to cover their salary or wages. Members also pay income tax and FICA tax on the money they receive. So in practice the net transaction of using member investments to pay member salary/wages is not zero, but negative.
Of course current income is important and salary and wages are bounded below by minimum wage laws in many cases. But while minimum wages laws are certainly beneficial to employees in non-cooperative businesses, it remains unclear what the utility is in a business where all the workers are owners.
Members of a money losing worker cooperative have no intrinsic right to a salary or wage, even if contributing labor. That notion is a carry over from employee based businesses. Until profitable, the members of a worker cooperative are only obligated to appropriate any losses that arise, not be compensated for their labor.
We can see that it is insufficient to focus solely on salary or wages while ignoring earnings, positive or negative. This is the central fault of wage loss and compensation matching models, which correctly identify the reduced compensation as a problem, but ignore the magnitude of the losses during the startup period.
It should be noted that in practice the initial member investments in some new worker cooperatives are insufficient to cover the startup losses. If worker ownership is to be applied consistently with regard to profits and losses, the capital contributions from the founding members must be sufficient to cover startup losses. In many cases today, donation money either from individuals, non-profits, and foundations are used to cover these losses in the starup period.
Loss Factor Model
In this compensation model the members who join during the startup period receive additional compensation based on their net loss. The members would be compensated if and when profits arose for repayment. This compensation would be in the form of contributions to members’ internal capital accounts.
The coop profits would first go to founding members based on a loss factor times the member’s net loss. The coop could required these profits to be reinvested, increasing the members internal capital accounts. A member’s net loss is defined as their investment loss minus the member’s total compensation during the startup period. If a member’s investment started at $15000 and decreased by $9000 (to $6000), but they were compensated $2000 in wages during that time their net loss would be $7000. If there were a loss factor of 2 then the member would be have $14000 of future profits credit to their internal capital account for a total of $20,000.
The net loss (investment loss offset by salary or wage compensation) is used instead of the investment loss alone because it is the total change in member compensation that matters. There is no reason that members of a money losing cooperative should be entitled to compensation through salary or wages during that time. Their obligation is to appropriate the full value of the loss, in a manner of their choosing. This might include current wages offset by larger investment losses.
The loss factor compensates founders for making an investment that is expected to decline in value. Later members who join once the cooperative is profitable are not required to make such an investment.
There is some arbitrariness in how the loss factor is chosen. However, it should account for the expected decline of the investment, for the lost interest payments as the investment declines, and the unknown length of time and uncertainty that future profits will arise. What is known is that the loss factor does not equal one (which treats the investment like debt), it should be greater. How much greater than one must be determined.
The selection of a loss factor is must be balanced because the financial incentives for founding members to select a large loss factor are offset by their ability to recruit later members should the loss factor be too high.
The loss factor model solves the problem of the cooperative paying interest on intangible (nonexistent) assets. With the loss factor model interest payments are based on the tangible assets because the losses are no longer treated as debt. The interest expense becomes independent of the accumulated losses, which were never related to the asset level of the coop in the first place. Instead the loss compensation is paid if and when profits arise. The loss factor model is preferable to paying interest on the losses because it matches the payments to coop profits.
The important point about the loss factor is that the founders’ investment return is bounded and predetermined, and the share of future profits can be dependent on continued membership, keeping with cooperative principles. The loss factor entitles founding members get a specific predefined return based on an actual loss they suffered.
This model violates the cooperative principles by creating a claim on profits independent of labor.
A founding member of a worker cooperative who leaves before profitability bears a disproportionate loss in the scenario when the value of their internal capital account is reduced to reflect startup losses. This can be mitigated by reimbursing those losses at a later time should profits arise. This would be a sort of vesting that ensures the founding member would bear their share of the loss in event of default, but also not be unduly punitive if the cooperative later succeeds.
With loss vesting a founding member is paid the reduced value of their internal capital account when they leave. Those losses are reimbursed back to the original level if and when later profits arise. This would effectively make the whole. Outside the loss reimbursement they would have no claim on later profits as they are no longer members. This conflicts with the cooperative principles because a nonmembers is getting profits.
Another variant of this scheme would credit the founding member with future profits based on the loss factor, even if they left. This would further conflict the cooperative principles as the former member would have a claim on future profits above their original loss. However, there are situations where this might be appropriate.
Startup like problems for worker cooperatives also arise in cyclic industries such as agriculture. For example, take a farming worker cooperative where there are financial costs associated with the initial planning season but no profits until the harvest is sold. A member who was only around for the planning season but left before the harvest would bear the upfront costs (and losses) but would not participate in the profit as they would no longer be a member. A similar vesting system could be implemented where the initial member would bear the planting costs and have their internal capital account drawn down, but later be credited if there was a successful harvest. This would also hold the initial members responsible for planting mistakes that reduced the later harvest.
Loss Rate Model
A more sophisticated model to compensate founding members for their investment losses can be created by accounting for the duration of the loss in addition to the magnitude. Give the founding member a claim on profits proportional to their net loss at each time period, and add those profit claims together over the duration of the loss. Let L(t) equal the net loss (investment loss minus salary or wages) as a function of time t. Then choose a loss rate rL that compensates for the time and duration of the loss. Then a claim on future profits P is
P = rL ∑ 0T L(ti)
The sum over index i runs from 0 to T. Time runs in increments ti (representing each accounting period) from 0 when the business starts, to tT when the founders’ net loss returns to zero. The value P is the claim on future profits. Here P does not represent debt of the cooperative, as it bears no interest. It is paid out only if and when profits arise. Generally rL should be greater than the interest rate paid on debt issued by the cooperative. The rate should account for both the lost interest when the investment decreases in value, the loss in the investment itself, and the uncertainty of future repayment. The uncertainty of repayment arises because the claim is inherently unsecured by real assets and because the timing and magnitude of future profits are unknown.
Note that having the loss rate rL greater that the rate of interest does not necessarily mean the return from the loss is more favorable than holding debt that does not decline in value. That will be determined by the distribution of future profits in time. A larger rL means only the dollar value of the payout in the event the cooperative is successful will be greater than interest payments, ignoring the effects of time.
This model compensates the founder for being underwater on their investment. The longer or deeper they are underwater, the larger their claim on profits.
The current models with the negative equity account and (negative) collective reserve account give a claim to future profit that is exactly equal to the loss. In this way the whole round trip transaction of the investment loss reimbursed by future profits can be misdescribed as a fixed value debt transaction. Then there is no conflict with modern finance because the founders investments, if held fixed on the books, are not expected to decline in value. This is the great conceptual flaw of the coop community, for the problem is not confined to worker cooperatives. The problem arises in all types of cooperatives, it is just that in worker cooperatives the problem is most severe.
Differences in the two models for treating member investment in a worker cooperative startup are shown in the table below.
|Model||Negative equity or negative collective reserve account||Loss based|
|Member Investment||Nominally fixed||Declines|
|Interest||Paid on original, nominal value||Paid on reduced investment value|
|Member Departure Payout||Original buy-in||Reduced investment value|
|Profit goes to||Eliminate negative equity or collective reserve loss||Members based on investment loss|
Where does the money come from to compensate the founding members? The short answer is that the future profits of the cooperative are preferentially distributed to the founding members as compensation for their investment losses.
In practice, determining the loss factor or loss rate comes down to an issue of fairness. On one hand, actual investment losses arise from being a founding member. On the other hand, systems are generally designed to the advantage of the original members, and to the detriment of newcomers. A balance must be achieved. However, the technical challenge of determining a fair loss factor should not be an excuse for failing to acknowledge that losses are taking place.
Note that the current system of pretending the founding members have a fixed value investment already violates the cooperative principles by giving them a non labor based claim to profits. That claim is equal to their investment loss.
This quote, from a different struggle for liberation, seems applicable to the fight for labor rights as well.
Sometimes people hold a core belief that is very strong. When they are presented with evidence that works against that belief, the new evidence cannot be accepted. It would create a feeling that is extremely uncomfortable, called cognitive dissonance. And because it is so important to protect the core belief, they will rationalize, ignore and even deny anything that doesn’t fit in with the core belief.