How Traditional Accounting Hinders Worker Co-op Start-Ups

Mike Leung

 

Abstract

This paper provides an explanation of why worker cooperative startups are rare. If true worker ownership is to be maintained in the startup period where losses occur, members face either a 'pay to work' or 'expected investment loss' problem. Founding members must either pay money to cover the losses resulting from their labor, or make investments upfront which will be expected to decline in value as losses occur. These two issues are completely foreign to modern finance and current labor practice, and also ignored by the worker coop community. Under the current worker cooperative model financially rational entrepreneurs will not structure a new business as a worker cooperative. These issues trace back to inconsistencies in the third cooperative principle, which in the case of worker cooperatives translates to profits in proportion to labor. Solutions to this startup problem constitute a class of loss based returns that are independent of labor, in violation of the cooperative principles.
 

Introduction

Worker cooperatives are worker-owned, democratically-managed businesses. The definition of worker ownership in this context means the members of the cooperative are the residual claimants who acquire the profits or losses of the firm. The members of the worker cooperatives collectively divide the firms earnings (or losses) between themselves, while non-member investors are limited to a fixed return on their investment.

The ownership concept applied to a worker cooperative startup has trivial result:

Early members of a worker cooperative will lose money before it becomes profitable.

This follows directly from the definition of worker ownership and the fact that most modern startups endure a period of losses in the initial stage. However, the implications arising from founding members of a worker cooperative losing money are non-trivial, even if the concept itself is.

In all doctrinal systems certain concepts are forbidden in the sense that they don't exist within the given framework. And since people use that framework to contextualize and categorize information, concepts that lie outside of that framework are either ignored or incorrectly described. The failure of the current framework, the implications for worker cooperatives, and possible solutions are described below.
 

Investment Framework

Founding members of a worker cooperative lose money during startup phase. They own the business so they appropriate the losses. But the implication of members of a worker cooperative startup losing money is that they must make an investment that is expected to decline in value. And the concept of an investment that is expected to lose money does not exist in modern finance.

Why is an investment that is expected to decline in value such a novel concept? Because investments in a non-cooperative business are never expected to decline in value. Were there an expectation of loss, the investment would not be made.

Investments in a non-cooperative startup can be expected to appreciate, despite negative earnings during startup. The difference is that equity in a non-cooperative business includes ownership of the future profits of the business. So long as profit steams are predicted to be higher at a future point in time, equity investments can increase in value despite business losses being incurred. In a cooperative business where the future profits are appropriated but the future members, they can't be owned in the present. Thus losses in a cooperative business will always result in members losing money. Note that this is an issue for all types of cooperative startups, not just worker cooperatives. Worker cooperatives just happen to concentrate those losses in a relatively smaller number of individuals (and not businesses) making the effects more financially significant.

To summarize, losses in a worker cooperative startup are immediately realized by the members, while losses in a non-cooperative startup are not necessarily realized by anyone, ever. This is because non-cooperative firms are traded based on their market value, while worker cooperatives transact based on their net asset value.
 

Labor Framework

The member losses in a worker cooperative startup can be described equivalently from a different perspective. The implication of members of a worker cooperative startup losing money is that they must pay to work. And the concept of an paying money to work does not exist conceptually in modern labor framework. While people have worked for minuscule compensation and even for free as slaves or by volunteering, nowhere do we hear of people paying money to work.

The 'pay to work' situation describes the case where founding members of a worker cooperative make no upfront investment (zero buy-in), but instead pay for the losses as they are generated. Since the members are the owners, it is their obligation to bear the losses. Note that this 'pay to work' issue is not mitigated by any salary or wage the member may be receiving. Any member compensation would directly increase the loss the members had to cover, with the net effect of transferring money from one pocket to the other.
 

Current Practice

An accurate description of the transaction founding members of a worker cooperative engage in is naturally lacking. The founding members of a worker cooperative are typically told and probably in many cases believe that their investment does not decline in value as a result of the startup losses. The technical reason for this is simple, the accounting does not reflect it. When the founding members of a  worker cooperative buys-in initially, this is credited to their internal capital account which tracks the value of their investment in the cooperative. And the value of the internal capital account is typically held fixed during the startup period, despite the losses.

There are three ways the losses bypass the members' internal capital accounts. First, a 'negative equity account' is created which absorbs the losses in the startup period. Second, a 'collective reserve account' is used to fulfill the same loss absorbing function. And third, the losses are pushed forward in time (recognized at a later date), a result of an accounting system designed for non-cooperative businesses.

The negative equity account is used to store the startup losses until they are offset by future profits. After that point profits are distributed to the members based on their labor contribution. The sole purpose of the negative equity account is to hide the startup losses. And the losses are sometime hidden from more than just the members. To the extent that the startup losses exceed the cumulative investments of the members, the losses are being hidden from outside investors as well.

The collective reserve account was designed to buffer worker cooperative members from earnings fluctuations. Typically, rules are established for adding a portion of the earnings or losses to the account. But when a worker cooperative starts, the balance of the collective reserve account is zero and if some fraction of the losses go into the account the value will become negative. In some instances when there is no negative equity account, worker cooperatives will choose to put all startup losses in the collective reserve account.

The accounting issue is different in substance and form. The effect of Generally Accepted Accounting Principles (GAAP) is to spread out the earnings which in the startup phase means pushing the recognition of losses forward in time.  For a non-cooperative business, if all future profits are owned in the present, it can be reasonable for the accounting to smooth the earnings. But in a cooperative where profits and losses are distributed immediately, a different accounting assumption is needed. The 'going concern' GAAP accounting assumption (that the business will continue to operate) leads to smoothed earnings and needs to be replaced with a 'snapshot' assumption that accurately reflects the current state of financial affairs in a cooperative, particularly with respect to the net asset value. The effect of the current accounting is to understate the startup losses. This takes place whether or not the cooperative uses a negative equity or collective reserve account. In the case where a negative equity or collective reserve account is used the accounting understates the losses going into these accounts.
 

Growth Implications

Ironically, the first two mechanisms consisting of the negative equity account and collective reserve account were developed by the worker cooperative community with the aim of helping cooperatives grow. While there may have been some minor benefit to hiding the losses and making worker cooperatives appear more conventional to potential founders, the negative consequences are much more severe. Independent of their perception, worker cooperative founders are required to be financially irrational by incurring guaranteed losses. Since potential future profits that can cover the loss have less than perfect probability of being generated, the transaction has a negative expectation value. This means that statistically speaking, creating worker cooperative startups will be a losing financial proposition. While it is possible that founding members may subsequently earn additional profits in excess of their recouped loss, they are based on their provision of future labor and not tied to the initial transaction.

The treatment of these startup losses are the fundamental barrier to the generation of new worker cooperatives. This is true regardless of whether the transaction is accurately described.

[I]t is...already the case that outside investors bear losses in worker cooperative startups.

With the members' losses exposed, several other issues become apparent. If we are to maintain worker ownership during startup, founding members must have sufficient assets or secondary income to bear the losses. Only a small minority of the population who can sustain negative personal cash flow from what is likely their primary occupation. Worker cooperative with anything but smallest startup losses are impractical for most groups of people, prohibiting startups in a wide range of industries and sectors. Any capital intensive, research and development dependent, or long time frame startup is infeasible under the current worker cooperative model. This is especially true in the absence of cooperative funding networks (Spain and Italy), or large gifts (donations and non-profit assistance).

The types of worker cooperative startups observed provide empirical confirmation of this thesis. Bakeries, coffee shops, restaurants, books stores, bike shops, cleaning services, home healthcare, graphics design, and printers typify the scale of new worker cooperatives today.

These fundamental questions concerning the cooperative principles also influence the broader landscape for worker ownership. There is much more activity converting existing businesses to worker cooperatives or transitioning businesses to partial or full worker ownership through Employee Stock Ownership Plans (ESOPs) than starting worker cooperatives.
 

Solutions

How could worker cooperatives properly compensate for the financial losses of the founding members? It can be as simple as providing founding members a loss based return that is greater than the original loss. For example a new worker cooperative could decide to provide early members a claim on profits equal to a loss factor times their incurred loss, where the loss factor is greater than one. While the fairness of any particular loss factor can be debated, the important point is that it shifts the situation from one that is financially adverse to the founding members, to one that is potentially neutral or positive.

Loss based returns have the effect of shifting profits from later members of the cooperative to the earlier members. This would be an explicit claim on profits that was not based on the labor of the members, violating a dearly held cooperative principle: “Benefiting members in proportion to their transactions with the co-operative”. However, worker cooperative startups in practice already violate the third cooperative principle by distributing profits after the startup period in exact proportion to the loss (not labor). This whole transaction is then incorrectly described as a fixed value investment that didn't lose value, so the fundamental issues regarding the internal consistency of the cooperative principles can be conveniently ignored.

The second and certainly more contentious issue concerns situations where the startup losses will exceed the cumulative capital investments of the founding members. If these types of medium and larger scale businesses are to be accessible as worker cooperative startups, the member ownership criteria will have to loosened further. If outside investors are bearing the losses they will need to receive similar loss based returns as proposed for the members (though likely with a reduced loss factor). This would provide them a fixed return (claim on profits) based on the amount lost. While this proposal will likely be viewed as sacrilege and the end of worker cooperatives (as we know them), it will provide for democratic startups which will naturally transition to traditional worker cooperatives, while limiting the return to outside investors.

It is worth pointing out that it is also already the case that outside investors bear losses in worker cooperative startups. They then receive future profits (should they arise) equal to their loss. This transaction is again incorrectly described as a fixed value debt like investment, in the same way the founding members investments are treated. This is the case with the Arizmendi Association where the losses are about five times the cumulative founding members' investments in a new bakery/pizzeria. As outside investors are already partial owners of worker cooperative startups in certain cases (by covering the losses), the proposal is not a so radical, merely bringing theory in line with current practice. The only radical part is stating the transaction accurately.
 

Implementation Issues

The recognition of the member losses during startup has internal and external components. The negative equity account and collective reserve account are internal issues of a trivial technical nature that could in theory be addressed with sufficient will. However, the usual social, financial, political, and ideological barriers remain.

From a financial perspective, in any competitive environment (businesses startups for example) there will be limited resources with which to challenge the status quo. Those challenges tend to be expensive in terms of time and money, thus low priority. Also, ideas outside of the given framework are by definition considered radical. When a business must interact with other entities and individuals, a different structure puts it at a disadvantage. This is especially true when financing is necessary as financial entities and investors tends to favor conservative ideas that are familiar and well understood.

[A]n honest and critical discussion of the cooperative principles will reveal both the model and values that will guide worker cooperatives in the future

From and ideological standpoint, acknowledging the founding members' startup losses undermines the cooperative principles by demonstrating the third principle on member economic participation is routinely violated in practice. Profits distributed exclusively on patronage along with member democracy are the defining features a cooperative. Demonstrating cracks in one of the cooperative principles creates an identity crisis many ardent worker cooperative supporters probably wish to avoid, perhaps even at the cost of sacrificing the growth of the community.

From a political and social standpoint, people in any field generally find it hard to acknowledge the model they have been advocating may have some fundamental flaws. Fundamental flaws, as opposed minor technical ones, infringe on the ability to promote the model in good conscious, raise funding, advance legislation, and so on. The safe move is usually to bury or ignore the offensive ideas.

The accounting issues are a tricker problem involving factors external to worker cooperatives. Deriving the proper cooperative accounting system is a major task which will require substantial effort but is nonetheless straightforward. The harder task will be the acceptance and implementation of that accounting system. Since the current accounting system is required to be used for tax purposes, it is basically the only choice businesses have.

The present accounting system serves as a major bulwark of capitalism. Through its assumptions, it protects the ability to capitalize labor by owning future (labor produced) profits in the present. This is enshrined in the market value of a business. Due to the preponderance of non-cooperative businesses there will be relatively little support for drastic changes to the accounting system. An accounting system can be appropriate for either cooperative or non-cooperative businesses, but not both.
 

Conclusion

The losses in a worker cooperative are fundamentally different than in a non-cooperative business because they are always realized losses. The losses are realized by the founding members because they are the current, but not necessarily future owners of the cooperative. In non-cooperative business ownership, the present value of future profits are owned, meaning losses are not necessarily realized immediately. This creates an unprecedented situation in worker cooperatives where early members in the startup phase must either make an investment that is expected to decline in value or pay money to work. These concepts do not exist within the current capital or labor framework. With respect to addressing these basic worker cooperative transactions, modern finance has failed.

In practice cooperatives incorrectly describe the losses and potential future profit distributions that cover the losses, in order to nominally adhere to the cooperatives principles. The faulty description applies to the founding member investments, and in instances where their investments don't cover the losses, to outside investments as well. The problem is not with the underlying transaction or its implications, but with usual interpretation of the third cooperative principle of profits in proportion to labor. As expected of a principle that is not internally consistent, it is routinely violated in practice. Unfortunately, capital in a worker cooperative cannot be reconciled with the cooperative principles.

While there are social, political, and ideological barriers to recognizing and addressing this situation, its resolution is essential if we ever wish to see worker cooperatives proliferate. To achieve substantial growth, worker cooperatives have to be a reasonable option for entrepreneurs, and that cannot happen when the model creates adverse financial consequences for the founders, even if they are hidden. The goal of professional cooperative developers and their associated funding sources should not be to disguise these adverse financial consequences through the accounting, but rather illuminate and rectify them.

Hopefully, a great deal of experimentation by entrepreneurs and an honest and critical discussion of the cooperative principles will reveal both the model and values that will guide worker cooperatives in the future. The path toward growth is clear, but it may be a long journey.


References

Ellerman, D. (1992) Property & Contract in Economics: The Case for Economic Democracy. Cambridge: Blackwell.

Ellerman, D. (1997) The Democratic Firm, Xinhua Publishing House, Beijing.

Financial Accounting Standards Board (2010).

Samuelson, P. (1976) Economics, New York: McGraw-Hill.

 

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Citations: 
When citing this article, please use the following format: Mike Leung (2016). How Traditional Accounting Hinders Worker Co-op Start-Ups. Grassroots Economic Organizing (GEO). http://geo.coop/story/how-traditional-accounting-hinders-worker-co-op-start-ups
Publication Date: 
Wednesday, October 19, 2016