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July 24, 2003
Hybrid LLC/Co-op Structure
Thanks to Walden Swanson, we have an outline on forming a hybrid LLC/Co-op business. Following is an edited amalgamation of an email thread we've had the last couple of days.
Minnesota has a new co-op law that has elements of an LLC. August 1 is the day the law goes into effect. This is the first state that has instituted a hybrid LLC/Co-op business organization.
http://www.revisor.leg.state.mn.us/cgi-bin/bldbill.pl?bill=H0984.3&session=ls83
Note this link points to the mark up bill rather than the final law, so it's a little hard to read. I don't think the final one is available yet.
The way we (Walden's company) are going to set up the initial structure has 3 classes of members: Investors, customers and Employees (employees include founders, developers, management, etc.).
The employees start out with 100% of the company and are diluted by the other shareholders. As you will see, this will eventually end up with 45% for the employee class.
The investors want a targeted IRR (Internal Rate of Return). We both agreed on an expected scenario for the income statement and then backed into their percentage ownership. (Notio note: That sentence right there defines the business issues at hand – what are the expected income and expenses and how much money is the investor willing to put in for how much of the business.) The key elements here, after agreeing on the expected scenario, were the dividend policy (you can distribute all of the profits like a Sub S rather than a Sub T - which is a slight advantage from the old co-op act), and the "terminal value". We agreed that the terminal value would be 1 X Sales at the end of 5 years. There would be a put and call at that time. This provides for the investor exit. At the end of 5 years, the co-op could choose, or be forced, to buy out the investor, but neither would have to happen. The exit was important for the investor. Say this formula gives them 20% of the company for their investment. This share does not dilute as new employees or customers are added.
The third class is customers. As new customers join, they dilute the workers - up to 35%. Additional consumer shares then start to dilute the other customers. In other words, the customers can own up to 35% of the company, but no more. We used the "value added" co-op model popular with many new Agriculture co-ops, so that customers that joined early were rewarded more than customers that joined later.
Most of the worker allocation will be based on classical ESOP parameters. You can find good info at www.nceo.org, the National Center for Employee Ownership. We're going to use hours rather than dollars since several of us have put in many hours and not gotten many dollars. We don't have this in place yet, but will be glad to share it when we do.
Excess earnings (profits) will be distributed by the shares each class owns. So the investors would get 20% of the dividend in our example. The employee class would get 45% and within that class the allocation would be by hours worked. Customers would get 30% distributed as patronage refunds in proportion to how much they purchased from the co-op.
Notio sez: This is obviously a lot more complicated than showing up at your lawyer's office with $750 and answering a few questions to file paperwork for an LLC. However, it attempts to deal fairly with the sweat equity of the workers, the avoidance of over-charging the customers, and providing a mechanism for investment capital (which is typically hard to get in ESOP and Co-op models).
A separate issue is that of governance. This is a key point of the structure because everyone wants to be well-represented and everyone has a different perspective on what's important. One approach would be to have representatives from each member class in proportion to the shares for that class. A nine-person board might have 4 worker reps, 3 customer reps and 2 investor reps. It wouldn't necessarily have to work this way though. Certainly in the venture capital world, the investors call the shots and the workers can go to hell. That attitude is what we're trying to avoid with a more complex pre-nuptial corporate structure.
Posted by Michael J. at July 24, 2003 03:57 PM