An underused business succession tool: The WOC
By Steve Eide and Thomas Crouse
August 12, 2021
A small-business owner is looking for an exit strategy and likes the idea of selling to their employees. But after investigating employee stock ownership plans, the owner decides that the upfront and annual costs of an employee stock ownership plan (ESOP) are too much. They are ready to consider a third-party sale as an option. Giving up at this point would be unfortunate because there is another viable path to employee ownership yet to be explored — the worker-owned cooperative or WOC.
What is a worker co-op?
A worker-owned cooperative is a business enterprise jointly owned and controlled by its workers under a participative governance model, with each member having one vote. A WOC must comply with the cooperative statutes of the state in which it is incorporated. It is not subject to the complex web of requirements under ERISA and the federal tax code that regulate the operations of an ESOP.
Becoming an owner of a business under the WOC model is voluntary for its workers. It is usually conditioned on a cash buy-in from each employee who wants to be an owner. The price of admission often depends on what the average employee can afford and how much capital the business needs. It is not intended to represent the full value of the company.
When 71 co-ops were asked about the cost of buying-in several years ago, they reported a range of share prices in 2016 from $0 to $18,000, with half setting the price of membership at $500 or less. Ninety-two percent of the survey respondents required $5,000 or less.
When a worker co-op generates a surplus, members receive a share of it in cash or as an allocation to their individual capital accounts. These distributions are taxable to the worker, so at least 20% of the allocation will be paid in cash to help the worker pay the taxes. The manner of allocating the surplus to worker-owners is generally defined in the co-op’s bylaws.
Whereas consumer cooperatives allocate surpluses based on member purchases, and producer cooperatives look at the volume of product delivered by each member, the key input factor in a worker cooperative is labor. A common allocation formula distributes surplus based on each worker-owner’s hours in the past year as a percentage of the hours worked by all worker-owners. Some co-ops modify the formula by including years worked or compensation as additional factors.
Upon leaving the co-op, members receive their capital account tax-free but without interest.
Advantages of a worker-owned cooperative
Worker co-ops allow employees to control their own destiny. They avoid the risk that jobs might be lost or relocated during the transition of ownership from the founder to the buyer.
When compared to ESOPs, WOCs provide the following advantages:
- Workers may receive direct financial benefits during employment.
- Cheaper to implement; ERISA fiduciary rules do not apply and transition can be completed without an independent trustee.
- No ERISA reporting and disclosure requirements.
- Annual business appraisals are not required.
- Lower administrative expenses and less staff time needed for administration and legal compliance.
- WOCs are a practical solution for companies under 30 employees, which may be too small to support an ESOP.
- An owner of C Corporation stock can defer or avoid the recognition of capital gains under Code Section 1042 by selling to a worker co-op if certain conditions are met — similar to an ESOP transaction.
Which companies make good worker co-ops?
The WOC is an extremely versatile business model. It has been successfully used for start-ups as well as restructuring mature businesses.
In theory, worker co-ops can have any number of employees and worker-owners. In practice, however, operating under a democratic governance process gets more cumbersome as the size of the group increases. In a 2016 study of Minneapolis worker co-ops, the average number of owners was 12, which means the average number of total employees (members and nonmembers) might have been between 15 and 25.
Worker-owned co-ops can be formed in nearly any industry that does not require all owners to be licensed professionals. Notably, Minnesota’s co-op statutes do not restrict the business model to particular industries.
The Minneapolis study identified worker co-ops in diverse businesses such as screen printing, foodservice, home building and remodeling, and bicycle sales and repair.
The model seems to work particularly well where the business and its employees have a shared vision and a strong desire to benefit the community. The employees of one of the better-known co-ops, Namaste Solar, share the vision that they are, “Transforming Energy. Transforming Business.” Employees and volunteers at Extreme Noise Records in Minneapolis share the vision that the city needs a record store devoted to punk rock.
The vision can simply be to create a working environment where employees are heard and valued. Happy Earth Cleaning LLC is in the home-cleaning business in Minneapolis. It became a co-op in 2020 when the founders decided to move back to Washington state to be closer to family. They chose the cooperative model so that the existing employees could run their own business and continue its supportive work environment.
Steps in converting to a worker co-op
The road to a WOC involves four major stops along the way: planning, financing, buying out existing owners, and enrolling worker-owners.
One way to accomplish the conversion starts with the appointment of a provisional board for a to-be-created cooperative corporation. Since the board is establishing the democratic governance structure under which the co-op will operate, it is best to have a broadly representative board, or at least to solicit input from the prospective co-op members.
The initial functions of the provisional board are to create a business plan and prepare the co-op’s bylaws. Among other things, the bylaws will specify when decisions must be voted on by the membership and how profits will be handled.
Next, the board will determine an approximate value of the business and arrange financing through the sellers or a commercial lender.
Third, the sellers and the board negotiate the structure and terms of the business sale and close the transaction.
Meanwhile, the provisional board would have set the buy-in price for worker-owners and started educating them on the risks and rewards of co-op ownership.
Finally, with bylaws and a purchase agreement in place, ownership of the business transitions to the new cooperative entity. Workers can begin paying their buy-in to become part owners, start voting on business matters, and possibly serve on the co-op’s board of directors.
Giving due consideration
Business owners and their advisers should not give up on employee ownership as an exit strategy until due consideration has been given to creating a worker-owned cooperative.
The Minnesota Center for Employee Ownership serves as a free unbiased source for education and resources around all forms of employee ownership. With 52,000 business owners over the age of 55 in Minnesota exiting their business in the next 3-5 years, there is a crisis looming. What will happen to their legacy, employees, community? Business owners will look to their advisors on how best to exit. Contact us for more information on how we can be a resource for you www.mnceo.org, or reach Sue Crockett, executive director of MNCEO, at scrockett@mnceo.org
Steve Eide is counsel to Saul Ewing Arnstein & Lehr LLP, a full-service law firm with an office in Minneapolis. You may reach him at steve.eide@saul.com.
Thomas Crouse is a copy writer and founding member of Happy Earth Cleaning, a worker-owned cooperative. You may reach him at thomas.m.crouse@gmail.com.
