cross-posted with permission from Jason Wiener | p.c., copyright reserved.
Many businesses are looking at the possibility of selling their companies to their employees through a worker cooperative. They have crunched the numbers, gotten the employees interested, have figured out the financing, but now want to explore the timing of a potential sale. Often there is a misconception that the owners have to sell 100% of the business in one lump sum, in one transaction to the worker coop. Often this is exactly what happens, but it is not the only way to sell a business to employees using a worker cooperative model.
There is another time frame that can be used to slowly sell your business to your employees. This may be needed or wanted for a variety of reasons, such as you want to stay in charge for some time, or the value of the business cannot feasibly be financed in one transaction, or the employees need more time to be trained as owners or entrepreneurs. One method for selling a business to a worker cooperative over time involves creating a separate worker cooperative and selling portions of the business to the cooperative over a period of time, say 3 to 10 years (or more). Here are the potential steps that could be taken. For ease of reference, let’s call the company “ABC”. The “Sellers” will be the current owner(s) and the “Buyer” will be the worker cooperative (“New Co-op”):
- Those employees who are interested in becoming coop members and eventual owners of ABC would create a separate worker cooperative, a separate entity from ABC.
- All interested employees would become member-owners of the cooperative and would be employed by the cooperative. Any other employees who have no interest in ownership of either the cooperative or ABC would remain employees of ABC.
- The cooperative would “lease” its member-owners to ABC as employees to provide the services that ABC is providing its customers. In the first year or two, this might mean that 10-20% of the ABC employees would become member-owners of New Co-op, leased out to ABC. Over time, more of the ABC employees might want to join the cooperative.
- Each year, a percentage of the Seller’s interests in ABC would be sold to the cooperative so that New Co-op becomes a partial owner of ABC over time. That percentage can be whatever amount is decided between the Sellers and the Buyers. For example, 10% of the company could be sold each year for 10 years. Or 20% per year for 3 years and then the remainder in one amount.
- A formal purchase and sale agreement (“PSA”) would be used between the Sellers and the New Co-op. The actual sale in any given year of a percentage interest described in the purchase and sale agreement could be made dependent on the continued positive cash flows of ABC and the New Co-op.
- The management of ABC could remain with the Sellers until the parties agree otherwise, or until the cooperative owns more than 50% of ABC, or some other formula. Again, as defined in the PSA. The management of New Co-op would be in the hands of its member-owners.
- New Co-op would then have a contract with ABC for the lease of its member-owners to ABC. The leasing of member-owners to ABC will generate income for New Co-op which will be used to pay salaries or wages as well as employment benefits to the member-owners. The member-owners of would be paid as employees of New Co-op, not ABC, with all employment and related taxes being handled by New Co-op. ABC might continue to have employees who are not members of New Co-op but it would have a lump sum expense payment for employee leasing with New Co-op.
- New Co-op could be taxed as a Subchapter T company, with profits distributed to the member-owners based on their patronage of the cooperative (number of hours worked as leased employees to ABC or for the cooperative). The income to the cooperative from leasing member-owners to ABC would be considered patronage-sourced income and available for favorable tax treatment under Subchapter T.
Another issue to think about when selling over a period of time, are the tax advantages of utilizing Section 1042 of the Internal Revenue Code (“IRC”). This section of the IRC allows the owners of a company to sell to a worker cooperative and defer capital gains. The Sellers must own stock in either a C-corp, an S-corp or an LLC taxed as either a C-corp or S-corp for at least 3 years prior to the sale. Then the Sellers must sell at least 30% of their stock in ABC in year 1 to get the deferred capital gains tax advantage. The remaining 70% of the stock can be sold to the cooperative over a period of years. Of course, if the 30% in year one amount is a barrier, the parties can go back to talking about selling a small amount each year, over time. For more information about 1042, see our blog post about the subject titled: Updated Section 1042 Tax Benefits.
This is just one example of a possible structure for a “slow sale” to a worker cooperative. Because the needs of both the Sellers and the Buyers have to be taken into consideration, as well as the industry and what type of cooperative is desired (including multi-stakeholder coops), there is a great deal of design that goes into this type of transaction. Please contact us if you have any interest in exploring your options to sell your business to a cooperative.