How To Convert Your Existing Business Into a Cooperative

A Bite-Sized Legal Guide

Who should use this guide?

Worker cooperative member-owners, lawyers and other cooperative technical advisors.

Introduction

Many worker cooperatives are start-ups: new business entities created out of whole cloth.  However, forming a new business entity is not the only way to create a cooperative business. Existing businesses with traditional capitalist ownership structures can also be converted into worker cooperatives, with significant potential advantages for the existing owners and their employees.

Conditions for Success

Not all existing businesses are well suited to a worker cooperative structure. If a business has high employee turnover or low employee loyalty, selling to the employees will not be a good option. Additionally, for many large or capital-intensive businesses, securing financing for a sale to the employees may not be feasible.

However, in businesses with a smaller number of dedicated employees, and particularly companies where employees bring specific skills to the workplace—for example, in many small manufacturing, craftsperson, artisan, or specialized services industries—cooperative conversion may be a good fit. Conversions are particularly likely to succeed for companies where the existing owners take an active management role and have identified employees willing and able to take on those responsibilities.

The Legal Framework

Section 1042: Introduced in 1984, this refers to a special provision of the Internal Revenue Code which provides business owners with an incentive to sell their businesses to their employees. Section 1042 allows owners of closely held businesses^[1] who sell at least 30% of more of their stock to their employees (through an ESOP or “eligible worker-owned cooperative”) to shelter their capital gains from taxation if they roll over the sale proceeds into other qualified domestic securities within 12 months of the sale. To qualify for a “1042 rollover,” the seller must have owned the stock for more than three years; the seller must reinvest in a portfolio of domestically operating companies; and the buyer must purchase at least 30% of the outstanding shares.

Subchapter T / State Cooperative Law: Owners can take advantage of the tax benefits provided by Section 1042 if they sell their shares to their workers as a cooperative that comports with the provisions of Subchapter T of the Internal Revenue Code.^[2] Subchapter T prescribes certain requirements regarding the tax treatment of the cooperative’s income and the members’ patronage income, which are described elsewhere in this manual. In addition to following these provisions, a converted cooperative will also have to comply with the relevant law governing cooperatives in the state in which the cooperative is incorporated.

The Steps Towards Executing a Cooperative Conversion

Often, the decision to convert to a worker cooperative begins with the owners. As mentioned above, the Section 1042 sale may be an attractive option for owners who are looking to preserve their business while transitioning away from it and sheltering their capital gains from taxation. If the owners decide to pursue a cooperative conversion, the process of a conversion may take the following steps:

1. Owner’s Decision. First, the owner should decide to sell the business to the employees, based on an understanding of the benefits of cooperative conversion as well as the attendant risks.
2. Cooperative Steering Committee. Next, the owner should approach employees who are potentially interested in becoming members of the cooperative. Once the owner has identified a “critical mass” of interested employees, those employees should form a cooperative steering committee that is authorized to act on their behalf.  A company with few employees may not need a steering committee.
3. Professional Advising and Appraisal. The Steering Committee should engage professional advisors, such as lawyers and accountants, to investigate the feasibility of a cooperative conversion, the financial health of the business and its actual and potential liabilities. This will require the cooperation of the selling owner. The Committee should also obtain an independent appraisal of the value of the company’s stock.
4. Draft and Sign a Sales Agreement. The sales agreement should articulate the terms of the sale, including a list of assets belonging to the business and the agreed upon sales price.^[3]The sales agreement may also include such representations as demanded by the transacting parties or the lenders. The sales agreement should establish a date for the closing meeting, where the parties will sign documents to transfer ownership to the employees and reorganize the business into a cooperative.
5. Closing Meeting. At a minimum, the business ownership should transfer at the closing meeting. However, it is not unusual for several distinct events to occur at the closing meeting: in addition to a transfer of ownership, the business will be reorganized into a cooperative, and the lenders and the cooperative will sign a lending agreement.

Stock Redemption Agreement. The parties will sign a stock redemption agreement to transfer ownership, in the form of shares, from the sellers to the employees. The agreement should stipulate the terms of the deal, including the number of shares, the share price, and any other representations and warranties required by the parties or the lender. The agreement may also describe how the owner will support the employees’ financing of the stock purchase. In the case of a multi-stage sale, the agreement may articulate the future steps to complete the cooperative’s purchase of the owner’s stock.

Amend Governance Documents. The sellers or the buyers (depending on whether the reorganization is planned to occur before or after the transfer of ownership) should amend the business’s key founding and governance documents to adopt a cooperative structure. In California, the business must file a Certificate of Amendment of Articles of Incorporation with the Secretary of State to amend its articles.^[4] In addition, the business will require new bylaws provisions regarding, for example, membership, the board of directors, how shares are voted, and how profits are distributed. The bylaws should also comport with the requirements of Subchapter T as well as the relevant state cooperative law. At this point, the business is officially a worker cooperative, at least on paper.

Offering Statement. The offering statement is a document prepared by the seller for the prospective worker-owners disclosing all the relevant risks associated with the transaction. (This addresses the “buyer beware” problem described above.) An offering statement will outline the risks of selling shares and transferring control; the risks of employee investment in the company; the terms of the Stock Redemption Agreement; and the securities and tax law issues surrounding the transaction and the continuing operation of the business. It will also describe the company’s reorganization into a worker cooperative, including attaching the new articles and bylaws (spelling out the terms and conditions of membership), as well as its business planning and finances. The purpose of the Offering Statement is to make a fair disclosure to potential members of the risks and responsibilities of becoming a worker-owner; it also provides lenders with a clearer understanding of the transaction.

Secure Financing. Before closing, the sellers and employees will have already assessed and identified lending sources. As mentioned above, lenders may require some form of support or guarantee from the seller or the cooperative. As such, the lender may be present at the closing meeting to formalize the lending documents and to ensure that their interests are represented in the other transaction documents, such as the stock redemption agreement, governance documents (limiting patron dividends), insurance certificate (for secured assets), employment contract, or consulting contract.

6. Elect Federal Taxation Under Subchapter T. Following the reorganization and redemption of the owners’ stock, the converted cooperative should terminate its existing election under the federal income tax laws and instead elect to be taxed under Subchapter T. This will enable the partial pass-through taxation characteristic of worker cooperatives, and permit the selling owner to take advantage of the tax benefits under Section 1042.
7. Selling Owner: 1042 Election. If applicable, after the initial sale of shares to the cooperative is executed, the selling owners should elect to have their capital gains income from that sale taxed under Section 1042. As mentioned above, if the owners reinvest their sale proceeds within one year, taxes on those capital gains will be deferred.
8. Future Operations/Loan Repayment. The converted cooperative will continue its business operations, albeit with a new board, new governance structure, and new system of distributing profits. The selling owners can continue as members of the cooperative, provided they meet all the conditions of membership (such as working for the cooperative full-time). In the years following the transaction, the cooperative will need to dedicate its profits towards repaying the loan that financed the transaction. This will depress the cooperative’s cash flow, thus most of the patronage allocated to members will be in the form of equity interests rather than cash payments until the loan is repaid (although Subchapter T requires that 20% of all patronage allocations must be in cash). The decrease in their disposable income will affect the members’ own financial planning, and during this time the members will be exposed to the enterprise risk of the business.

Conclusion

Converting an existing business to a cooperative is a complex transaction involving a number of legal and financial issues and risks. Indeed, successfully executing a conversion may require some novel, outside-the-box thinking. But the potential benefits of cooperative conversion are enormous—not least of which is the fact that the now-cooperatively-managed business is already up and running. More broadly, establishing conversion as a viable model for selling a business could encourage more businesspeople and lawyers to challenge the conventional wisdom and consider cooperative conversions when thinking about how to structure their deals.

Sources:

1. Business Succession Planning Options, OEOC Succession Plan. Blog, http://www.oeockent.org/successionplanning/blog (last visited Nov. 8, 2012).

2. John Logue, The 1042 Roll-Over Cooperative in Practice: A Case Study of How Select Machine Became a Co-Op, OEOC (Jan. 2006), http://dept.kent.edu/oeoc/oeoclibrary/1042_rollover_co-ops_MN_case_study.htm.

3. Roy Messing, Transitioning a Private Business to a Worker Cooperative: A Viable Community Development Tool, Grassroots Econ. Organizing (2011), http://www.geo.coop/node/637.

4. Mark C. Stewart, Employee Cooperative as a Plan for Business Succession (2008), available at http://dept.kent.edu/oeoc/oeoclibrary/Conf2008StewartSellingThroughWorkerCooperative.pdf

5. Mark C. Stewart and Eric D. Britton, Shumaker, Loop & Kendrick LLP, Selling Stock to Employees Through a Qualified Worker-Owned Cooperative and Sheltering Capital Gain: The IRC § 1042 Rollover (Jan. 14, 2010).

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Revised January, 2019.