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The Need for NOVARS (NOn-voting Value Added Residual sharing Renewable Shares)
By Guy Major

Editor's note: In this article, Guy Majors describes NOVARS, an alternative to the individual capital accounts pioneered by the Mondragon cooperatives. The author proposed the formation of clubs to invest in worker co-ops and trade in NOVARS. GEO readers interested in the investment club idea can contact him at <guy.majors@physiol.ox.acuk> Phone: 44(0) 1865-282 507 (w) 44(0) 1865-714 505 (h)

Why Are Democratic Firms Rare?

Numerous academic studies show that a firm's performance can be improved substantially by the combination of:

* profit-sharing

* meaningful employee involvement in decision-making

* a significant degree of employee ownership

* accountability to external investors.

Let us define a `democratic firm' as one controlled by its workers, with directors being

elected by one worker one vote (pro rata for part-timers). Why are such firms so rare?

There are many theories for this:

* intrinsic inefficiency

* self-extinction tendencies

* poor support structures

* institutional bias and cultural intertia

* risk aversion of unwealthy workers

* bad management

* underinvestment

* degeneration' back to capitalist control.

The latter two explanations are recurrent themes in the academic literature on the subject.


There is a certain amount of theoretical and anecdotal evidence that one breed of  democratic firm, the common ownership workers' co-operative, is particularly prone to this problem. A worker leaving such a co-op ceases to earn any money from his or her past efforts within that firm, and cannot extract the principal or the future earnings of any "sweat equity" (foregone wages ploughed back into the company). Conversely, a new worker can "free ride" on older workers' sweat equity . The value to a worker of a pound invested is higher

* the longer the worker expects to stay in the firm (which may lead to `horizon clashes'), but

* lower than in a firm with indvidual ownership shares (predisposing to underinvestment).

Suppose an investment project yielded $1,000 per year per worker, and that the firm's risk-adjusted discount rate was 10%. If the firm was a common ownership co-op, the project would be worth the following amounts to five different workers who expected to stay in the firm for the following periods:

A (1 year): $ 909

B (5 years) $ 3,791

C (10 years) $ 6,145

D (20 years) $ 8,514

E (for ever) $10,000

Suppose the investment project cost $4,000 each in foregone wages. It would not be in A or B's interests, but would be in C, D and E's. If the average worker, like B, expected to stay only 5 years, then the project would not go ahead if workers voted in a self-interested way, although it would probably proceed in an equivalent capitalist firm.

If the earnings from the project were paid as dividends on non-voting shares representing the sweat equity, and if those shares were easily marketable and could be held indefinitely after leaving the co-op, then the project would be worth $10,000 to all workers, irrespective of how long they expected to remain in the co-op. The project would probably then be funded, and the above horizon clash between short- and long-term workers would not occur.

However, if

(a) there were any restrictions on share transfers (such as a requirement for at least 51% to be held by the workers), or

(b) the secondary (second-hand) market for the shares was inadequate, so that they could not be sold for their full present discounted value, then underinvestment might still occur.

Restricted transfers can be particularly troublesome when most workers are too poor to buy out those wishing to sell their shares. Secondary markets can be ineffective when trading is infrequent ("thin"), when there are insufficient buyers or sellers or when the present discounted value of single shares is too high (as often occurs with marketable membership shares, such as those used in U.S. plywood co-ops).

Democratic firms often seem too risky to attract external (non-worker) investment. Equity collateral is generally required to secure debt financing - a firm suffering from inadequate reinvestment may find it hard to borrow. Fixed dividend preference shares are probably even less attractive to investors than debt financing (what is the security?). Nor do they share in the firm's income risk, making them less attractive to the workers. Equity in the form of ordinary voting shares would undermine work-place democracy. Non-voting profit-sharing preference shares are not attractive to would-be investors: what is to stop the workers ripping them off by raising pay to reduce profits?


If a democratic firm is `too' successful, and the older members are unable to extract the full market value of their past efforts, investments, risk- and decision-taking, for any of the reasons outlined above, then pressure may grow either

* to hire non-voting labour (`founderitis'), or

* to sell out to capitalist control.

Both types of degeneration can be prohibited by the firm's rules, but this may have the unintended side-effect of reducing innovation and imaginative risk-taking, because workers must bear the risks of failure, but cannot gain the full fruits of success. Banning degeneration may place the firm at a long-term disadvantage to capitalist ones.

Debt vs. Equity

Debt and equity are extremes along a spectrum of finance.

Debt has one advantage for democratic firms: it is non-voting (although usually not without influence). It has numerous disadvantages: its value is fixed (doesn't vary with the firm's success), the principal must be repaid and interest payments do not depend on the firm's success; aside from the risk of default, debt does not share in the risks of the business.

Equity in the form of ordinary shares has numerous advantages: its dividends and market value are variable, going up and down with the success of the firm, and it never has to be repaid (it is`locked in'). There is one big disadvantage for democratic firms - ordinary shares are usually voting shares, which undermine work-place democracy.

To avoid underinvestment and degeneration, democratic firms need fully tradable investment which like debt is non-voting, but like equity is locked in and shares both income and capital value risk.

In a capitalist or investor-controlled firm, most ordinary shareholders don't vote, but their interests are protected by

* an activist minority with similar goals

* the possibility of voting

* the ability to sell shares, reducing the price and leaving management vulnerable to a take-over

* shareholder agreements.

How can equity investors be protected in a worker-run firm? Pay ceilings and dividend floors may stop workers ripping off investors, but cannot cover all long-term contingencies.

Value Added Sharing

Value Added is sales minus all non-labour costs and is also equal to pre-tax profits + wages + perks. Splitting a firm's value added in a pre-defined way between workers and shareholders prevents the workers ripping off the investors.

Suppose each worker in a firm has a minimum wage (capital doesn't starve, but people do). Define the firm's `surplus' as its value added residual - its total minimum wages bill.

Let a fraction (the `bonus fraction') of the surplus be allocated to pay bonuses for workers, and the rest (the `profit fraction') be pre-tax profit (so that bonus fraction + profit fraction = 1). If a firm had a surplus of $1 million, and a bonus fraction of 0.7, the total pay bonus would be 0.7 x $1 million = $700,000. The pre-tax profit would be 0.3 x $1 million = $300,000.


Circumstances change with time: the number of workers or the amount of capital in the firm, its value added residual, wage rates in other companies, interest rates, technology, etc. The bonus and profit fractions could be complex formulae attempting to account for all conceivable circumstances, but this is unlikely to be flexible enough. It is simpler to `renew'each share yearly:

* renegotiate bonus and profit fractions

* if no agreement, reset both by comparing the firm's rate of return on capital with agreed benchmarks.

In this way, if the firm does well, the workers can force the bonus fraction up, but if it does badly, the investors can force the profit fraction up instead, to improve their future returns.

NOVARS combine these ideas into one financial instrument.

Non-voting: except limited consultation rights and emergency voting rights if firm `underperforms seriously'

(e.g. losses for 3 years in a row).

Value Added sharing: surplus = value added residual - minimum wages

pre-tax profit = profit fraction x surplus

total dividend = `dividend fraction' x pre-tax profit (if sufficient funds in profit and loss account)

Renewable: specified renewal period [1 year] after whichrenegotiate or forcibly reset profit fraction to push returns on capital towards target

Shares: last claim on residual assets

tradable - price can rise or fall

voice (speaking at meetings) and information rights

holder may propose resolutions or be elected a director

Shareholders and workers have to agree depreciation allowances, perks, expenses, advances on bonuses, appointments of independent experts, the share price for newly-issued NOVARS and changes in the dividend fraction, rules or minimum wages.

The voice and information rights, and the right to propose resolutions or to stand for election as a director would allow investors with business experience to persuade workers to make strategic changes and to strengthen the firm's management, if required.

Forced profit and bonus fraction resets

Each NOVARS firm has a fixed target rate of return on equity, which is higher for riskier enterprises and lower for `green' or `social' businesses.

Whenever negotiations on a new profit fraction fail, the profit fraction is multiplied by a `reset factor' equal to target/actual rate of return, but constrained to between 0.9 and 1.25 (say), to keep changes gradual while allowing the profit fraction to rise faster than it can fall. This asymmetry compensates equity investors for the fact that they are bearing more risk than the workers (because of the minimum wage). The new bonus fraction is 1- new profit fraction.

Secondary markets

Without a credible `exit' route, most investors will not `enter' into an investment. A democratic firm, however, like others, need investment which is locked in. To reconcile these two conflicting needs, and to prevent underinvestment and degeneration, an effective secondary market is required, where existing bonds and shares in the firm can be traded. A primary or new issue market is also required, to allow the firm to raise new capital as cheaply as possible from multiple investors. How can this be achieved for small NOVARS-based firms?

Three options, reaching progressively wider audiences (but not the general public) are:

* the company itself circulating buy and sell offers to its shareholders and creditors

* a trust to buffer supply and demand and act as an informal market maker

* a `work-place democracy investment club' to arrange deals and circulate investment advertisements among members, making use of the Internet and exemptions from financial services regulations to keep down costs.


* Democratic firms are rare in part because of underinvestment, degeneration and poor management.

* To avoid these problems, they need freely tradable non-voting equity shares and effective second-hand markets in these shares.

* Instead of routine voting rights, equity investors can be protected by value added sharing, share renewal (moving the rate of return on capital towards some target), information, voice and consultation rights, the right to propose resolutions and to stand for election as directors, and emergency voting rights.

* NOVARS combine these features, and a work-place democracy investment club based on the Internet could provide the secondary market.

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