By Jay Cumberland , Equal Justice Works Fellow Sponsored by the eBay Foundation
Read time: 15 minutes
DISCLAIMER: This is legal information, not legal advice. Please consult with your own attorney before taking action based on this information.
Small businesses confront a cash flow crisis without help on the horizon. Lenders aren’t helping enough. State governments aren’t helping enough. The federal government isn’t helping enough. Big businesses have the help they need, of course. When no one else has been willing to help, who can small business owners turn to? They’ve already been turning to their customers to raise funds. They can also turn to their workers. This is mutual aid--exchanging resources and services to satisfy needs without depending on the government. Providing workers with partial or full ownership can help small business owners and workers during COVID-19. Want to watch a video about this instead of reading? Check out the video below!
Small businesses face a massive cash flow crisis
Small businesses don’t have enough cash coming in to pay their expenses. The median small business will survive 27 days without income. As of this writing, the Bay Area’s shelter-in-place will be entering into its seventh week. Everywhere, small businesses have shuttered their windows and doors. Many have taken to some cost-cutting measure affecting employees, either laying off, furloughing, or reducing the hours of workers. Trimming expenses this way helps keep some income coming through the door. But while it extends the business’ life, it does so at the expense of workers. These cost-cutting measures puts workers and small business owners in conflict.
Image Source: J.P. Morgan Chase & Co. Institute, Executive Summary: Cash is King:
Flows, Balances, and Buffer Days: Evidence from 600,000 Small Businesses (Sept. 2016).
The federal government’s response has fallen direly short of this cash flow crisis. Really, the federal government has ensured big businesses will survive at the expense of small businesses. Small businesses needed $1 trillion to last the first 30 days. Instead, they received $300 billion. Moreover, Congress ensured that chains like Ruth’s Chris and Shake Shack could swoop in and take this money away from small businesses. Big banks, too, ensured funds would be disproportionately allocated to the larger businesses they already serve.
Image Source: Paul Blumenthal, Small Businesses Face Extinction-Level Event,
Congress Ensures Big Corporations Survive, Huffington Post (Mar. 31, 2020).
Small businesses laying off, furloughing, or reducing pay for workers are forcing them to depend on state governments. They imagine, I think, that state governments will have this handled. However, a large number of states have been significantly underfunding their unemployment insurance funds. Most can’t weather a new economic downturn, like this one, without going insolvent. California’s Unemployment Insurance Fund became insolvent approximately a year into the Great Recession in 2008. When this happens, California borrows hundreds of millions from the federal government to pay unemployment benefits. California still owes almost $8 billion from borrowing during the Great Recession. And it hasn’t accounted for another recession. As of April 4, 2020, the Tax Foundation estimated that California’s Unemployment Insurance Fund will run dry on May 2nd. I’ll hold my breath waiting to see what happens this time.
Small business owners should be aware that forcing workers to depend on unemployment insurance benefits comes at a cost. Unemployment insurance money borrowed from the federal government, at least in California, can be repaid only by raising taxes on employers or lowering already inadequate benefits paid to the unemployed. Either way, there’s no free lunch. And the more an employer forces employees to depend on unemployment benefits, the more it will pay in payroll tax in the future.
I know that’s a lot to take in. So, before moving on, take a breath. We’ll get through this together.
Businesses can weather this crisis by paying workers with equity
As I mentioned, small business owners and workers can help each other. Small business owners don’t have to help some workers at the expense of others.
Paying workers partially in equity during the COVID-19 crisis is one way to mutually aid each other, reduce expenses, and preserve income. This strategy will work in industries with highly paid workers. It requires that workers accept equity payment in lieu of part of their normal cash compensation. One third of Americans did not pay rent in April. Many simply don’t have enough cash on hand to make this option acceptable.
The shared equity option, like making workers depend on unemployment insurance, will ultimately reduce business profits. Paying workers in equity means reducing your own portion of equity. So, you’ll earn a smaller share of profits moving forward. Laying off, furloughing, or reducing wages and/or hours by more than 10% will likely also result in loss of profits moving forward. California already owes billions to the federal government that needs to be repaid through payroll taxes on employers or reduced unemployment benefits. It stands to reason that these taxes will increase significantly in the future. Small business owners will face a choice: accept a reduction in profits caused by increased payroll taxes or lower wages for workers.
Paying workers partially in equity should preclude workers from filing for the work sharing form of unemployment insurance in California, although this has not been tested, to my knowledge. Again, you should consult with your own attorney before acting on this information. At the very least, in California, a certain amount of hourly wages and salary must be paid in cash. For hourly workers, minimum wage and overtime wages must be paid in cash. For salaried workers, the amount required for exemption must be paid in cash. Anything above that can be paid in any acceptable wage, defined as “money or other value that is received by an employee for compensation for labor or services performed.” Cal. Labor Code Section 200(a). Generally, reducing wages and/or hours by more than 10% allows workers to file work sharing claims. However, if you reduce cash wages and pay the reduced amount in equity, you have not reduced wages. You have simply changed the manner of payment.
Why would workers take payment in this manner? It may help the business survive when it wouldn’t otherwise be possible. That ensures that workers will have their same job on the other side of this crisis. It might also help all workers retain their jobs when otherwise some workers would lose their jobs to help the business survive. It will entitle them to equity and also to profits in the business moving forward. Assuming the business survives this crisis, they will receive more money in the long run even though they are sacrificing cash at the moment. Small business owners can incentivize workers to accept this option by attaching voting rights to equity, by giving worker shareholders the exclusive right to appoint a certain number of board members, or giving workers a right of first offer and/or right of first refusal should the business be sold or closed.
Better yet, small business owners can sell to their workers to survive this crisis
Selling completely to workers and giving them all ownership and control achieves more for the small business, the small business owner, and the workers than paying partly in equity. It can bring working capital into the business, since most outside soft debt financing for worker co-op conversions comes with a substantial percentage of working capital. It gives workers not only a small portion of ownership but also full control of the business. It lets the owner stay on with the business while allowing the business to grow larger than them and outlive them.
Usually, this worker cooperative conversion process takes months if not years. The default process, detailed in a representative image below, must change for cooperative conversion to become a viable solution in this moment.
Image Source: https://institute.coop/sites/default/files/resources/co-op%20conversion%20timing%20chart.pdf
Below, I briefly outline a cooperative conversion process capable of moving quickly enough to allow cooperative conversion to serve as an answer in this moment. The viability of this process comes down to this:
(1) Is there a deal structure that allows small business owners and workers to trust each other? and
(2) Is it possible to quickly create a culture of change that enables owner and workers to continually modify an imperfect governance and management structure over time to fit their needs?
I think the answer to both questions is 'yes.'
Limit Time Spent on Feasibility Study and Valuation by Making the Price Reasonable
A feasibility study and valuation typically take around 8 weeks (approximately 2 months). This is not fast enough to respond to the present crisis.
Accelerating the feasibility and valuation of the conversion process is dependent on the business owner setting reasonable price. A reasonable price depends on two factors (1) a standardized valuation and (2) adjusting for valuation error by building substantial soft debt into the capital stack for the purchase.
A professional business valuation supplemented by a feasibility study analyzing the debt service capacity of the business primarily matters when hard debt is used to purchase a business. Hard debt requires mandatory payments. These may be mandatory and equal payments of $10,000 per month for 24 months to support a $240,000 purchase price. Alternatively, the payments may start small and then grow over time. When a seller or a lender finances a transaction with hard debt, they need to know that the business can make mandatory payments given existing debt loads and profits. Setting too high of a sale price is a recipe for disaster. It sets the purchaser up for failure. It puts the seller or lender in a position to foreclose if the purchaser can’t make the mandatory payments.
Soft debt with a bound repayment timeline essentially eliminates the need for a business valuation and feasibility analysis. Let’s say, for example, that you decide to sell your business for $1,000,000. With soft debt, the seller or lender will be repaid from a percentage of the business’ profits over time, perhaps on a 5 year timeline. There can even be a bonus if the business meets certain profitability standards. If the business can’t make enough profits to repay the loan, that’s fine. Nothing happens. The seller or lender overestimated the business valuation. The soft debt adjusts the price down to actual levels. This builds trust into the process. If the valuation is too high, the purchaser continues in possession and the seller / lender makes slightly less money. If the valuation was too low, the purchaser continues in possession and the seller / lender makes slightly more money. This allows the process to move at speed.
A ballpark business valuation using accepted methods should still be done quickly to ensure that if there’s a need to look for outside debt, the debt burden on the business is not too great for the business to bear.
Defer Business Plan by Staying On as Manager
Business planning usually takes 4 weeks, but this can be deferred by keeping on the business owner in a managerial or consulting capacity in the meantime. Business planning is generally necessary to ensure the business has the ability to increase revenues to pay off hard debt. Removing hard debt helps remove the need for a business plan. Having the business owner stay on for a while as manager or even in a consulting capacity helps ensure that operations will continue unaffected. Ultimately, it ensures that a new business plan can be developed at a later time. This also helps the owner be comfortable with the business paying back via soft debt. A common concern with soft debt is that profits will be artificially lowered to avoid paying back the soft debt.
Defer Funding Search by Using 100% Seller Financing or a Seller Finance Bridge
As for funding, this process can be expedited if the owner is willing to fully finance the conversion. The search for funding can take ~10 weeks, but it can be deferred until later so long as the business owner is willing to 100% seller-finance the deal from the beginning with soft debt or use 100% seller-financing as a bridge to more funding. An owner can seller finance immediately. There’s nothing restricting the pace of this kind of loan. If an owner doesn’t want to fully seller-finance the deal, they can use their seller-financing as a bridge loan. This bridge loan would require that the business obtain other debt to fully pay off the loan in a year or so. Alternatively, it could require that 50% of the loan be bought out by outside debt in a year or so. If that didn’t occur, 50% of the seller-financing could become hard debt in a year or so. Either way, the sale happens immediately, the owner is protected, and the business is incentivized to find working capital from an outside lender.
Defer Design of New Business Structure by Using Template Co-op Bylaws
The process of designing a new business structure, which lasts around 7 weeks, can, and I believe, should be deferred until after the conversion.
The common approach to restructuring attempts to fix every potential issue from the beginning. This process strives to create a system of government for the cooperative. It strives to make the perfect bylaws for the cooperative, and it makes them difficult to amend later on. This front-loaded process stems from fear of creating, accepting, and living within a culture of change.
This front-loaded process inhibits the cooperative’s ability to change and adapt in the future. The best organizations are not simply organizations with the best governance structure. A good governance structure makes an organization function well, but only for so long. One of my favorite organizational design and change practitioners is Rich Barlett. In the tweet pictured below, he notes that there is no perfect organizational structure. Things change, inevitably. Instead of trying to build the perfect governance and management structure, it’s better to start with what you have, then commit to learning how to create a culture of change, then enact that culture of change step by step. None of us have enough foresight to design the perfect system. It’s best that we stop thinking we do.
So, spread the 7 week business structure process across innumerable weeks in the future. Start with some simple, template collective board worker co-op bylaws or template representative board worker co-op bylaws. Then, commit to collective humility. Commit to the vulnerable work of personal and collective learning. Make this paid work. Block off hours for collective reading and study. Engage in collective design processes like appreciative inquiry to figure out the strengths of your organization and build on them. Establish 3 month or 6 month redesign check-ins. Rotate through one management or governance structure every year for four years, then choose the one that everyone likes best.
As a last resort, owners can give workers advance notice of closure so they can buy
If your business simply can’t survive during this time, it’s possible for you to continue with your business if you give your workers advance notice that the business will be liquidated through an assignment for the benefit of creditors, asset sale, Chapter 7 bankruptcy liquidation, or Chapter 11 bankruptcy reorganization. In general, this simply requires giving your workers as much advance notice as possible to allow them to line up financing to buy your business. If you’re putting your business through a Chapter 11 bankruptcy, it could still involve seller financing so long as you convince the bankruptcy court that a sale to employees will help the business grow, expand, and pay creditors what they are owed. So, if all else fails, don’t quit. There might still be light at the end of the tunnel.
About the Author
Jay Cumberland is an Equal Justice Works Fellow hosted by the Sustainable Economies Law Center. He started the project Anchoring Communities in order to help workers and tenants in the Bay Area resist displacement by taking collective control of their workplaces and buildings.
Jay believes political theory, social movement theory, and an international perspective must inform his work supporting housing cooperative conversions and worker cooperative conversions. These conversions are, after all, political exercises happening in social spaces around the globe. You can reach Jay at [email protected].