What will be the main activities of the co-op?  How will it earn revenue?

Does it need to raise capital?  If so, how will it raise capital?  Through member contributions and/or through outside investors?

Will all the workers be members?  (in other words will there be employees that never become members?)

Will there be a probationary period before a worker can become a member?  If so, how long?

Can the co-op pay all the workers at least minimum wage from the very beginning and pay all the other costs associated with having employees like employment tax, workers comp, etc.?

Will all the workers have the legal right to work in the United States?

Will the workers be more like employees or independent contractors?

How do you want the co-op to be governed?  By a board elected by the members, by the members themselves, by one or more managers?

Would it bother you to have to observe certain “formalities” (such as holding regular governance meetings, complying with rules about meeting notice, keeping meeting minutes, having elections, having officers)?

How will decisions be made?  Majority vote, super-majority, consensus, modified consensus?  Will different decisions be made in different ways?

If you will have a board, what do you want the term of office to be?  Do you want term limits?  Do you want to have any qualifications for who can serve on the board?  Can only members serve on the board?  How many board members do you want?  Do you want staggered terms?

If you have officers, what officers do you want to have and what will be their duties and qualifications?

Do you want to have committees?  If so, what powers do you want them to have?

How do you want to distribute excess revenues?  Do you want some of it to be able to be held within the co-op and not become the property of the members?  Do you want to pay dividends to the members?  Do you want to pay dividends to investors?  How will you decide how much of excess revenues to allocate to various uses?  How will you decide how much of the patronage dividend to pay in cash versus an allocation to the member’s capital account?

How will you allocate losses?

How will you set member capital contributions?  Do you want there to be a limit on how much they can increase from year to year?

Do you want to have member capital accounts?  If so, do you want to pay “interest” on the balance in the member accounts?  How often do you want to redeem member accounts?

When a member leaves the co-op how will their capital account be redeemed?

What do you want to happen with the assets of the co-op upon dissolution?

Given your business plan, what are your biggest concerns about taxes?  Dividends being taxed twice (at the entity and investor level)?  Having to pay a tax on gross receipts?  Having to pay employment tax on distributions?  Having to deal with “pass through” tax treatment?

Who will have check signing authority?  Who will have the authority to sign contracts on behalf of the co-op?

Would it bother you to have an entity that is not well understood by most lawyers and accountants?

Is it important to you to use the word “cooperative” in your name?

How will you decide whether to admit new members?

How will you decide whether to remove members?  How will you decide whether to remove managers, directors, officers?

Do you want the founders to receive some sort of extra benefit to compensate them for the risks they took?

How will you decide on amending your governing documents – a majority of members, 2/3 of members . . . .?

A prototypical producer co-op is made up of farmers that each work independently on their own farms.  They each contract with the co-op to provide a certain amount of produce that the co-op will market for them.  Patronage dividends are paid based on the amount of produce each member markets through the co-op.

Imagine a different scenario: a group of bookkeepers gets together to form a bookkeepers’ co-op.  Should the co-op be a worker co-op or a producer co-op?  Note that in California and in many other states, there is not a separate statute for a worker co-op versus a producer co-op.  So the co-op would form under the same statute in either case.  The important question is whether the bookkeepers would treat themselves as employees or independent contractors with respect to the co-op.

Co-op members will often prefer to treat themselves as independent contractors to avoid the compliance issues that come with having employees.  Whether they are co-op members or not, (in most cases) employees must be paid minimum wage, have workers compensation insurance, have employment taxes withheld from their pay, etc.  But co-ops should be careful about choosing this route.  Before treating co-op members as independent contractors, the co-op should consider whether the members comfortably fall within the IRS’s definition of an independent contractor (for example, how much control does the co-op have over the day-to-day activities of the members? are the members free to work for others? do the members purchase their own supplies and equipment? etc.).

The IRS, as well as other regulatory bodies, is very concerned about workers being misclassified as independent contractors.  The penalties for misclassification can be harsh.  So do some careful thinking before treating co-op members as independent contractors!

Another thing to be aware of is that a corporate officer must always be treated as an employee and not an independent contractor.  So if a co-op member is paid for serving as secretary, treasurer, or some other officer position, those payments must be treated as wages, subject to withholding of employment tax.

After I say that, the inevitable response is always “then how does REI do it?”  REI is a cooperative and sells memberships all over the country.

Great question!  I called REI’s corporate lawyer to ask why REI does not consider its memberships to be securities.

He said REI’s memberships are very far from the definition of a security because people don’t join REI to get financial returns.  While REI members do get patronage refunds each year, these are more like a discount on what they buy than a financial return – kind of like the discounts that people pay to get when they join Costco.

REI is so confident in this opinion that it has never requested a no action letter from the SEC.

It also helps that REI memberships are non-transferable and cannot appreciate in value.  It doesn’t hurt that the price of a membership is so low.

One benefit of allowing cooperatives to participate is that there is a state securities registration exemption for Washington cooperatives.  So promoters of community energy projects can use the co-op structure to bring in a diverse group of investors without having to register a public offering.

Click here for the bill.

Great job Stanley!

Equal Exchange purchases coffee and cacao from farmer cooperatives throughout the world and processes it into products that it sells to retailers.  All products meet rigorous standards for fairness and sustainability.

All of the employees of Equal Exchange (with the exception of new employees that have not completed an initial probationary period) own voting shares in the business.  Only employees may own voting shares.  The employees elect the board, with each employee having one vote.

To become a worker-owner at Equal Exchange, you are required to buy your ownership share, which currently costs $3,250 (the amount is adjusted for inflation each year).  To ensure that all employees can afford to buy their share, Equal Exchange offers a four-year no-interest loan for share purchase.  When employees leave, they must sell their share back to the cooperative.

In addition to voting rights, the employees are entitled to a share of the profits.  At the end of each year, 40% of the after-tax profits (or losses) are allocated to the workers.  Last year, each worker’s share was approximately $5,000.  The remaining profits stay in the company as retained earnings.

The company has been profitable every year but one for the last twenty years.

When the company needed to bring in outside capital, it created a second class of shares – a non-voting share.  These shares were originally priced at $25 (the price was increased to $27.50 after demonstrating a track record for paying reasonable returns).  After an initial offering to friends and family, the company sought out accredited investors to purchase shares in private offerings.

In exchange for their investment, the non-voting shareholders receive an annual preferred dividend (paid before the workers receive their patronage dividend).  The board decides each year how much the dividend will be, with a target of 5%.  Most investors choose to reinvest their dividend in non-voting shares.  The investors may redeem their shares after five years.  The shares are non-transferrable.

The following chart shows the performance of the Equal Exchange non-voting shares compared to the S&P 500 over the last 10 years.

Equal Exchange set up its financial model so that, while workers and investors can benefit from company profits, no one can benefit from increases in share prices.  This brilliant innovation ensures that none of the company’s stakeholders will ever be tempted to sell out to Starbucks or Hersheys.  The way this was accomplished was to prohibit the transfer of shares and to include a “sellout protection clause” in the company’s formation documents.  This clause requires that if the company is ever sold, all of the capital gains will be donated to fair trade organizations.  The workers and investors cannot receive capital gains on sale.

Many cooperatives have a great deal of difficulty raising outside capital because few investors are willing to purchase non-voting shares.  Yet Equal Exchange has raised over $8 million by selling non-voting shares.  How did they do it?  A number of mechanisms give non-voting investors comfort that the interests of the voting shareholders (the employees) are aligned with their interests.

These mechanisms include the following:

• The highest paid employee at Equal Exchange can never be paid more than four times what the lowest paid employee receives – this ensures that Equal Exchange’s profits will not be diverted to pay outrageous salaries
• The worker-owners receive half of their patronage dividends in non-voting shares so they have an interest in paying a fair return to the non-voting investors
• The workers are required to invest their own capital in the company and share in profits as well as losses, giving them a meaningful stake in the success of the company
• The workers spend time visiting the farmers and learning about how the company operates, putting them in the best position to make decisions about how the company is run.

The only thing that was missing from the model was a way for the public to invest in Equal Exchange.  The cost to sell shares to the public is prohibitive (as discussed at length in previous blog posts).  To remedy this problem, Equal Exchange partnered with a bank to create a company-specific certificate of deposit.  Investments in the CD go to a line of credit that can be used by Equal Exchange as working capital.

For more information, see Equal Exchange’s web site (http://www.equalexchange.coop/index.php) and blog (http://eeinvest.wordpress.com/).

• specifically allow cooperatives to receive Small Business Administration loans
• raise caps on SBA loans
• create the Small Business Early Stage Investment (SBESI) program, which would provide matching grant funding for venture capital investments in early-stage small businesses in targeted industries including agricultural technology, energy technology, environmental technology, life science, information technology, digital media, and clean technology
• make several other changes to SBA programs intended to improve them and make them more accessible.

The bill has been referred to the Senate Committee on Small Business and Entrepreneurship.

A recent weeklong conference in Sonoma, California – The Economics of Peace – featured a day devoted to lectures and workshops on the cooperatives associated with the Mondragon Cooperative Corporation (MCC). This event marks the third occasion in the last six months where representatives from the MCC, located in the Basque region of Spain, appeared in the US. Previously both Cleveland and Detroit hosted discussions with the MCC. While US developers of worker cooperatives have toured the Mondragon complex since the 80’s, these recent visits are noteworthy as firsts for the MCC.

Let me begin by noting the amazing success of an experiment (the term the MCC uses) begun by a poor parish priest over sixty years ago. Today, the MCC is a complex worth 24 billion dollars and employing 100,000 in 120 enterprises all over the globe. It comprises factories, banks, insurance agencies, and a network of retail stores throughout Spain. Globally the MCC invests in industries located all over Europe, Latin America, and Asia.

In the early 90’s Mondragon learned that a large French retailer planned to open in Spain Wal-Mart-size “big box” stores. Since Mondragon has a large domestic appliance presence in Spain, to lose retail outlets to a foreign operator threatened their national distribution. Mondragon began buying up various retails chains throughout Spain.

About ten years ago co-op membership was opened up to these new retail workers on a limited basis to ease the transition into the corporation, but the job growth of these retail outlets was outstripping the rate at which membership was attained.  So early this year Mondragon decided to open up membership to all of the 40,000 retail employees. This appears to be a successful policy.

Mondragon has acquired other firms for similarly strategic reasons. For example Mondragon manufactures machinery that makes solar panels, but does not fabricate the panels themselves. MCC purchased a Chinese manufacturer to serve as a supplier for these machines using Mondragon’s designs. Similar practices occur all over the globe. The MCC doesn’t buy these firms to spread cooperative principles, but to invest in them for their larger economic viability. In some cases these firms may not be profitable, but with new proprietary inputs, Mondragon expects that over a period of time they will be. Mondragon argues therefore that if the firm is not profitable when purchased why would the workers want to buy in?

In other cases Mondragon might find itself in a country with no legal avenue for creating a worker-cooperative, or where the government actively opposes such a development.

Along with its huge manufacturing operations, Mondragon facilitates financial services all over Spain and beyond. It also supports a development agency and a university. The MCC’s bank aids the development agency to guide both new and established firms to succeed. These efforts in turn are supported by the research conducted through the university.

At Mondragon worker participation underlies the entire structure since the whole edifice is founded on the votes of the workers in general assembly. The workers elect the management of the co-ops.

At Mondragon the members of the co-ops are somewhat insulated from the worst excesses of capitalist volatility. During this depression the worker-members agreed to wage cuts and reduced hours in order to spread the misery more equitably. The non-member workforce, which numbers approximately 15% of the total, faced lay-offs as in any capitalist firm.

I will end with one story that Michael Moore tells about his worried anticipation when the section from Capitalism: A Love Story on worker cooperatives was shown at the AFL-CIO convention. He braced for, at best, a bitter silence and, at worst, a vocal guffawing when a hall full of union members saw workers in his film expressing their satisfaction with jobs they controlled through their cooperative, democratic structures. The response from the audience was rousingly positive. Loud applause and cheers.

The Mondragon Model in the United States

In Cleveland, Ohio the Evergreen Cooperative Laundry will be the first of a series of worker co-ops to be established. It is part of a multi-billion dollar initiative of the Cleveland Foundation to redevelop a neighborhood that needs employment.

The idea of worker co-op development in the neighborhood came out of a community wealth-building roundtable held in December, 2006. The Cleveland Foundation, the Gund Foundation, and the Sisters of Charity called upon the nonprofit Democracy Collaborative to organize the event.

The new laundry will use the least toxic chemicals available, use an energy-saving water recycling system to reduce heating costs, install skylights, and eventually install solar panels. It will be one of the greenest laundries in the country.

Currently a series of training programs are underway to enhance the skills of the 25 new workers. Besides the usual basic job skills and the specialized machine training, environmental sustainability practices and procedures and training in cooperative participation have been added to the curriculum.

In addition to the laundry, there are plans to develop a solar installation and service enterprise and an industrial scale greenhouse. Inspired by the Mondragon model, after start-up costs are met, each new co-op will support future co-op development with a small fraction of its profits.

This Fall in Western Wisconsin, construction will begin on the Driftless Foods Co-op’s first manufacturing enterprise, an individual quick-frozen vegetable processing plant. Planned future projects include sustainable poultry processing, hydroponic tomato production, and a regional pet-food line.

In related news, in spite of the federal attorney general’s pledge not to prosecute state law compliant medical marijuana dispensaries, there have been several recent raids in California and Washington.  Follow this link to a New York Times Magazine article about the difficulties caused by the conflict between state and federal medical marijuana law.

Why is it important to know what a security is?  Because if something is a security, it is subject to a great deal of regulation at both the state and federal level.  A business cannot offer a security to investors without first registering the offer with government regulators or identifying an exemption to the registration requirement and completing any filings associated with such exemption.  Complying with securities regulations can be quite time-consuming and costly.

So, let’s say you and some buddies are starting a co-op – do you have to be concerned about securities regulation?

As you might guess, that depends on several factors!

First, what type of co-op is it?  Is it a worker co-op in which all of the members actively participate in the management and day-to-day operations?  In that case, arguably, membership in the co-op is not a security because the definition of a security requires that the profits to the investor must result from the “efforts of others.”

If it is a co-op in which members are not actively involved in the management, such as a consumer co-op grocery store, memberships may be considered securities.  This would depend on whether the members expect to receive a profit from their membership.  Do the members expect to receive patronage dividends at the end of the year?  If so, this type of membership would certainly seem to be a security and therefore subject to securities regulation.

But wait!  Before you panic, these memberships are likely to fall under some exemptions from securities regulation.  Let’s start with federal securities law.  There is an exemption from federal securities registration for offerings to residents of the state in which the co-op conducts most of its business and in which it is incorporated.  To rely on this exemption, you must make sure that all of your members live in the state in which you operate and are incorporated.  If even one membership is sold to someone outside the state, you could lose the exemption.  For a summary of federal securities law, see the SEC’s page on small business and securities regulations.

Now, what about state securities law?  Every state is different.  In California, there is an exemption from securities regulations for co-ops whose  members’ do not invest more than $300.  In Maryland, there is a blanket exemption of memberships in consumer co-ops from securities regulations.

It’s important to be aware of these issues before selling memberships in your co-op (or an investment in any small business)!

For some interesting observations about how securities laws stack the deck against small businesses, check out a recent article by Michael Shuman.

Over the past few years, IRS Examination (audit function) undertook correspondence “audits” of several members of worker cooperatives asserting the position that the member’s patronage dividends are subject to self-employment (SE) tax. Attorney Greg Wilson fought these cases asserting that patronage dividends were not subject to SE tax for various reasons. Eventually, an attorney for the IRS – IRS Counsel’s Office – in San Francisco, asked the IRS National Office for guidance on this issue. It appears that the IRS National Office concluded that patronage dividends paid by worker cooperatives are indeed not subject to SE tax and dropped the cases where it was asserting SE tax applied to worker coop patronage. But the IRS arrived at this conclusion because they determined the worker/members are employees of the cooperative and employees generally cannot receive both employment and self-employment compensation from the same entity. Continuing with this theme, the IRS then hinted that its position might be that patronage dividends paid by worker coops should be subject to employment taxes at the cooperative level – instead of SE tax – like a bonus paid to an employee. Where the IRS is going with this now is unclear.