The Cooperative Hostile Takeover

Introduction

The routes through which workers typically gain ownership and control of their businesses are tightly constrained because they either require the consent of the owners or require the workers to start their own business. This paper proposes ways in which worker ownership and workplace democracy can be achieved on a broader scale through the restructuring of existing companies without the owners’ consent. This could drastically expand the scenarios in which employees of a business can achieve ownership and control and increase the formation of worker cooperatives.

There are several ways workers can acquire an ownership stake in their business, short of a full conversions to a worker cooperative. Shares of the business can be purchased by the employees directly, though this is limited to a small segment of the workforce with investable assets. Stock or options can be provided to employees as part of their compensation. An Employee Stock Ownership Program (ESOP) can be used to transfer the shares to the employees. Or the owners can gift the business to the employees, usually when they retire.

Worker cooperative startups are exceedingly rare. For worker ownership to be maintained in the startup period, the workers must bear the startup losses. This means they either have to ‘pay to work’ or make an investment that is expected to decline in value. An investment that is expected to lose money is unknown in modern finance. Shares of non-cooperative businesses can and do increase in many cases despite losses. Technology companies are common example.

Further, paying to work is contrary to contemporary labor norms. Unfortunately, these notions have been adopted by the worker cooperative community, leaving a situation that requires founders to engage in financially irrational behavior when starting a worker cooperative under the current model. In many cases, financial irrationality is required of outside investors, as well. This model leaves a scarcity of entrepreneurs and capital for worker cooperative startups. While there are technical solutions to this problem, various barriers continue to prevent worker cooperative startups from forming on any meaningful scale.

While worker cooperative startups of any substantial scale are impractical, the consent of the owners is required for employees to convert an existing business to a worker cooperative or gain some form of ownership. Since owners in most businesses do not consent to selling or diluting their stake, conversions to worker cooperatives are quite limited. In order for transformation toward worker ownership to take place on a large -scale, workers must be able to gain control of their business without the consent of the owners. As the present wealth distribution is highly skewed, workers must also do so with very limited financial means.

Valuation

What gives a business its value and under what conditions does that valuation hold? Modern finance provides one answer for what a business is worth: its future profits discounted to their present value. This is the market value of any non-cooperative business.

But how is a worker cooperative valued? If we believe in true worker ownership, only the current members of a worker cooperative are allowed to appropriate the profits in that period. Since the profits from the future periods cannot be owned in the present, the standard valuation methodology cannot apply to worker cooperatives. The only possible answer is that a worker cooperative is worth its net asset value, the price of its assets minus its liabilities. The market value only matters in demutualization, when the cooperative ceases to exist. While the net asset value of a worker cooperative is owned, the ownership only provides fixed interest-like payments, not the profits or control of the firm since those belong to the members.

There is a situation where a non-cooperative business has a valuation equal to its net asset value. This is the case when a business has no employees. A business with no employees has no future profits and can only be worth the value of its assets minus its liabilities. Note that by quitting simultaneously the employees of a firm can collapse its market price to the net asset value. This is the key to financing the transition to a worker cooperative.

The Transition

How do the employees of a business become owners of a worker cooperative? The first step is for the workers to organize themselves and agree to start their own worker cooperative business. Second, they would publicly state their intention to start their own business to avoid insider trading. Stating this in a small, print-only publication would create an informational asymmetry where the plan was not widely known. Even if the plan became widely known it would be impossible to judge the credibility of the statement. Third, the workers would decide to resign simultaneously on an agreed date. Before that date they would engage in financial transactions which would become profitable if a business suddenly lost its employees. These transactions could be carried out individually by the workers or through the new cooperative business entity they had created.

The workers would then simultaneously resign in a very public and visible way to generate a market reaction. After they quit they could exit their positions profitably. The proceeds from these transactions would then be used to finance their new business.

The workers would be able to roughly predict the profits from the transaction and know the cost of starting the business. Therefore, they could start their business fully financed and with an established workforce, allowing them to become operational in a short time frame. This would give them an advantage in the event that their former employer would attempt to rapidly hire and train new employees.

There are three different transactions through which workers could finance their business: equity put options, short sales, and credit default swaps.

For larger, publicly traded companies with an options market, equity put options can be purchased. Put options grant the right, but not the obligation, to sell shares at a certain strike price. The value of the put options increases as the value of a company declines. Purchasing puts is a convenient method because options are leveraged where a small change in price can result in a much larger return. The risk to the workers is limited to the price of the options.

Purchasing puts is the safest of the three methods and requires the least amount of capital. Buying puts will be more effective for companies with a higher price- to- book ratio.

Option premiums are poorly priced for a loss of employees risk. There are typically cheap ‘out of the money’ options available at the nearest expiration date. Out of the money put options are those whose strike price is lower than the current share value. Since the value of the business will be collapsing from the current market value to the net asset value when the workers quit, out of the money put options can be used to efficiently leverage limited capital.

Since profitable businesses typically trade at several multiples of their book value, proceeds from put options can easily cover the startup costs. If the workers wished to obscure the transactions in order to keep the options premiums low, they could purchase options with a variety of strike prices and maturities.

Short selling stock is possible for publicly traded companies with borrowable or shortable shares that lack an options market. While not all shares are shortable, the set of companies whose shares can be shorted is much greater than those with an option markets.

Short selling involves borrowing a stock, selling it immediately, and buying it back at a later time. If the price of the shares drops before the shares are repurchased, the transaction is profitable. However, this scenario is more risky because the workers would face potentially unlimited losses in the event the shares increase in value.

By short selling their stock, the workers would earn the difference between the market value and net asset value per share. Short selling would take significantly more capital than the options method since short selling is unleveraged. Unlike options, whose quantity can exceed the number of outstanding shares, short selling is limited to the amount of borrowable shares. The borrowable shares are only a portion of the outstanding shares.

Before committing to this strategy, workers would need to calculate whether the profits from short selling the available shares would be sufficient to start their own business. Since the profits from short selling shares would be proportional to the difference between the current market value and net asset value, the short selling method, like the equity put options method, would be more likely to work on companies with a high price- to- book ratio.

Credit default swaps can be utilized for privately held companies whose shares are not publicly traded, but issue publicly traded bonds. This strategy could conceivably be used to transition a private company with limited liquidity.

A credit default swap is a derivative that functions like insurance. It allows the owner of the credit default swap to be paid the face value of the debt (minus the market value of the debt) in the event of default. The underlying debt does not need to be owned to purchase a credit default swap. The risk is limited to the payments made for the credit default swap. A default does not need to occur for a credit default swap to increase in value. Only the perception of decreased credit quality is necessary. This perception can be aided by the reality of eliminated cash flows.

In a company with no employees, the primary method of generating cash flow used to pay the bondholders disappears. Since income-generating work is no longer being done, the only way to pay the bondholders is by selling assets, drawing existing lines of credit, or raising new financing. Cannibalizing the productive assets is harmful to the business, and raising new financing is likely difficult once all the employees have left. Provided that the existing cash and credit lines are small relative to the size of upcoming bond payments, the credit default swaps should show a sharp increase in value. Since typical credit default pricing assumes a stable workforce, a relatively small upfront investment in credit default swaps would be required to generate the returns needed to start a business.

Credit default swaps would be ideal for companies with limited liquidity, high fixed expenses, and high credit ratings. They would be more difficult in businesses with relatively high levels of cash and liquidity, low expenses, and low credit ratings.

Impediments

There are a host of factors that could make hostile takeovers difficult to implement in practice. A major organizing effort would be required, and an large majority of the employees, including a portion of the management, would need to agree to participate. It is unlikely that organizing on this scale could be carried out in secret, leading to adverse action from the current owners.

The new business would need to quickly acquire a customer base. Some of its customers would likely come from the old business. Transferring the customer base would be impractical if there were long-term contracts in place or customers were unable or unwilling to transfer their business. While individuals would probably be loyal to the workers instead of the business entity, business contracts might not transfer so easily.

Businesses that owned unique assets would also be problematic. Specific real estate assets might not be replaceable in a new business. This would pose a barrier in extraction industries if natural resources being extracted were present on land owned by the business.

Intellectual property rights held by the old company could also prevent the new business from being competitive. The intellectual property might not be replaceable or licensable by the new business.

Ownership Revisited

What happens to the ownership structure of the original business? That ownership stake still exists. By resigning, the employees have taken nothing from the owners of that business. What changed with the transition is the assumption about future profits once the original business no longer has employees.

The value of a firm above its net asset value is called goodwill. Goodwill is an intangible asset. Goodwill is typically associated with the reputation of the firm, its brand name, or customer loyalty which is assumed to enhance future profits. Whether these future profits will actually materialize is uncertain. Accounting practices are inconsistent on the issue of goodwill. Internally generated goodwill is not permitted as an asset on a firm’s balance sheet. This makes sense because a firm cannot record its future expected profits as a current asset. Yet purchased goodwill (when another firm is acquired for more than its net asset value) is counted as an asset. This is indicative of the valuation uncertainty where goodwill is involved.

The future profits of any company face a variety of risks. The company can be boycotted by its customers. It can face a divestment campaign and lose its access to capital. It could get sanctioned by a regulatory agency and be prevented from engaging in certain activities. Or it could lose its employees. None of these events change the actual ownership of the business, only the perception of whether future profits will be forthcoming.

Direct Purchase Futility

The problems with employees purchasing their business directly is that few businesses will be sold at or below their net asset value. The ones that can be purchased at those prices are usually not profitable and are typically either failing businesses or in declining industries. While there are some exceptions, they are rare.

With a market value (greater than the net asset value) purchase, the workers are engaging in a transaction where they pay up front for the entire future profits of the business. It is a financial transaction of precisely zero economic benefit in the event they stay with the firm indefinitely, and negative benefit if they ever leave. While there may be, and often are, other compelling reasons for purchasing a business for conversion, the financial component is dubious at best. It could be that the market has undervalued the business, or productivity gains and thus enhanced profitability after the conversion are expected, but it is unclear why the workers should be paying for their future profits at all. The negative financial component for the workers makes market value purchases a strategically flawed approach to creating worker cooperatives.

ESOPs do not involve workers purchasing shares of their business. The shares are purchased through tax breaks and dilution of the existing owners. ESOPs may not result in full worker ownership and may or may not be democratic, but the employees are getting shares for free. However, ESOPs are created at the discretion of the owners, often leaving workers little say in the process.

Conclusion

Understanding how labor is capitalized in modern firms allows workers to eliminate that capitalization at their discretion. The key is resigning instead of striking. Striking implies a desire to continue working under modified conditions, generating profits. The tools provided by modern finance allow workers to profit when labor capitalization disappears and use those proceeds to regain their sovereignty by financing their own worker cooperative business. By using put options, short sales, or credit default swaps, it is possible for workers with limited financial means to restructure their labor relations without the consent of the owners. This can shift the balance of power and perhaps lead to a proliferation of worker cooperatives.