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Limited Cooperative Associations and Early Stage Financing

Cooperatives are the original social enterprise business model and Colorado is emerging as the “Delaware of cooperative law,” thanks in no small part to limited cooperative associations (LCAs), authorized by C.R.S. Title 7, Article 58. The limited cooperative association is a relatively new entity type, adopted in Colorado in 2010.  It offers a balance of flexibility, self-determination, cooperative identity and fundamental protection for the cooperative principles and economic structure. As of 2017, LCAs can also elect the protections and privileges of the Colorado Public Benefit Corporation Act.

LCA’s, like traditional cooperative corporations, are for-profit member-owned business structures that also subscribe and adhere to seven widely recognized cooperative principles.

Benefits

The cooperative and LCA model leverage certain unique theoretical and empirically proven advantages (see references one, two, and three), including:

  • Stickier relationship between user-customer-members and platforms
  • Greater user trust, based on data protection, user-member centricity
  • Higher success rate (lower failure rate) over long-term
  • Higher customer retention rate when ownership is shared
  • More resilient business models through economic cycles
  • Lower workforce attrition rates and higher employee morale
  • More stable governance
  • Alignment of interest between members and investors
  • Tax efficient as primarily pass-through entity for tax purposes
  • Leadership focused more on producing long-term value to co-op’s various stakeholders
  • Distributed capital and equity base creates motivated network of user-members
  • Stabilize and increase positive economic impact in communities
  • More transparent and democratic decision-making processes de-risks strategic maneuvers
  • Longer-term horizon and non-liquidity based options available for equity redemption and planning purposes

Investments and ROI

Like traditional corporations, public benefit corporations, or LLC’s, LCA’s can generate returns for investors.  LCA’s operate with pluralistic purpose, for the benefit of members, to generate a profit, and to tend to the interests of other stakeholders, including investors.  LCA’s distribute profit to their members on the basis of “patronage”; the value of goods or services contributed to or purchased from the LCA, and to investors based on the relative amount invested.  Subject to certain limitations, LCA’s can generate returns for investors based on profitability, distributions on profitable asset sales, refinancing, or through a liquidity event.  LCA’s, as member-owned and democratically-governed entities, seek to grow and operate sustainably for the benefit of their members, and thus do not set out with the objective of demutualizing or undergoing a liquidity event. Consequently, the primary mechanism for generating a return on investment is through sustainable operations and profitability.

 

Financing Examples

Traditional and mature cooperatives have tended to finance operations and growth using a preferred share that earns a target, non-cumulative, non-guaranteed dividend over a minimum holding period of between five to ten years.

More recently, multi-stakeholder start-up LCA’s have been using revenue-based financing mechanisms to raise capital, offering investors a return of up to a multiple of 1-5x the original investment, or a fixed percentage of profit for a fixed duration of time.  Once the cap is reached, the shares are treated as automatically repurchased. These instruments are sometimes called demand dividends.  Even Silicon Valley and New York VC’s are catching on to revenue-based financing and alternative business models as a way of helping to build a more sustainable and healthy business.

Non-exhaustive list of examples of seed-stage investment terms based on recent offerings.

Equity equivalent investment type:“Capped Return, Self-Redeeming”“Profit Share, Self-Redeeming”“Hybrid Profit Share – Capped Return”“Target Dividend”
Original investment (e.g.)$500,000$500,000$500,000$500,000
Return3x cap, no pre-set profit allocationX% of profit for 5-years.Greater of Cap or X% of profits for 5-years, with true-up within 90-days of 5-year anniversaryTarget 5-8% annual dividend (non-cumulative)
LiquidityPriority distribution of Cap, less prior distributions before any distributions to membersX% of positive proceeds after debt.Greater or Lesser of Cap or X% of positive proceeds after debt.Priority distribution of original purchase price plus declared but undistributed dividends.
RedemptionAutomatically redeemed at CapAutomatically redeemed as of 5-year anniversary, subject to true-upPut option at 5-year anniversary. Call option by Cooperative at any time.
Transferability/

Resale

NoNoNoNo
“Bandwidth” for realized ROIDiscretionary cash flowX% of profitGreater of discretionary cash flow or X% of profitAfter-tax net income

 

Creating the Workplace We Want

Management and operation of a law firm has taken many forms over the years and we are exploring new, innovative ways to run our firm. We are experimenting with the use of democratic principles, Teal, and self-management to develop a style that works for us and our clients. Earlier this week, Jason sent an article around to the team that highlighted The Wellington Community Law Centre (WCLC), a New Zealand law firm that went from a traditional hierarchical management system to fully self-managed in six months. Our firm has been discussing and implementing self-management techniques and it was inspiring and encouraging to read about WCLC’s journey. While reading the article I was tripped up by the reference to “advice process.” I had never heard the term before and we haven’t formally chosen a decision-making process to adhere to, so I did a little research. In a nutshell, advice process is an alternative to top-down and consensus decision making. Instead of executives or leaders making decisions, the employee who notices the problem or opportunity is empowered to act on that knowledge and becomes the decision-maker. The decision maker must seek input and advice from the relevant team members, leaders, and stake holders, but is ultimately responsible for creating a proposal and deciding what action to take. The process resonates with me because even as the least experienced member of our firm, I feel empowered to make decisions and suggestion for improving processes or creating new ones. I’m comfortable approaching the more senior attorneys to discuss my ideas and get their feedback and I’m able to pursue projects that interest me and be an active participant in my career development.

My favorite quote from Geoffrey Roberts, the general manager of WCLC, was, “When you treat people with high levels of trust, then they will live up to that. They will give you much more than you can imagine. Anecdotally, I argue that high levels of trust result in high levels of engagement and flexibility.” Perhaps more than anything else discussed, I feel that building trust is critical. For me, feeling trusted makes me feel like I can make mistakes and that I will get productive feedback that will help me grow as a lawyer. Having trust also means that I’m not afraid to come forward when I have made a mistake or to be held accountable for a decision I made. One way our firm fosters a trusting environment is through quarterly retrospectives. Retrospectives give us the chance to reflect on what is and isn’t working – they also help remove the negative connotations from accountability. Instead of accountability being scary, it simply becomes an opportunity to celebrate a win or learn from a decision that didn’t work out.

As a member of a law firm that is treading an unconventional path, I love seeing what WCLC has been able to accomplish. It gives me hope for the future of the profession and it’s nice to know our firm is in good company.

Choosing the Right Entity for Your Business

Last week our team held its first legal café at Green Spaces in Denver. We welcomed a group of approximately thirty entrepreneurs and discussed the nuances of entity choice. Our team was excited for the launch of what we hope will become a mainstay for the firm and a valuable resource for our community. We selected entity choice as our first topic because this early decision can often have far-reaching consequences for businesses. The right entity is critical for many aspects of the business, from protecting the social mission to attracting outside capital. Our hope is that we can help early stage entrepreneurs avoid the pitfalls of choosing an entity not well suited to their long term vision. To that end we created this presentation with an overview of entity types and strategies for choosing the right entity. Those who attended the legal cafe also had the opportunity to participate in an hour of small group Q&A with our team.

The event exceeded our expectations and our team is looking forward to hosting future legal cafes that provide useful information to entrepreneurs at all stages of developing their business.

Electing Public Benefit Corporation Status as a Limited Cooperative Association: Limiting Director Liability

All certified Colorado B-Corps, organized as Colorado Corporations or Cooperatives, are required to become Public Benefit Corporations (PBCs) by April 1, 2018. Since a number of our clients are B-Corps, we’ve been immersing ourselves in the finer points of the Colorado Public Benefit Corporation Act (PBCA), particularly as applied to Limited Cooperative Associations (LCAs). As originally enacted, the PBCA did not allow LCAs to elect PBC status despite Article 55 and Article 56 cooperatives being able to do so. It appears that the omission was simply an oversight by the drafters that was recently corrected in an amendment that allows LCAs to elect PBC status. While this was a needed amendment to the PBCA, the PBCA is not as cleanly applied to LCAs as to Article 55 and Article 56 cooperatives.  Unlike Article 55 and 56 cooperatives, the Colorado Business Corporation Act (CBCA) is not used as a gap filler for the Uniform Limited Cooperative Association Act (ULCAA), which governs LCAs. This presents a challenge to limiting director liability for LCAs under the PBCA. The PBCA is written with the corporate form in mind and references the CBCA with regards to director liability, but is silent as to how use of the PBC form will affect director liability when the entity is an LCA.

Section 7-101-506 of the PBCA lays out the duties of the directors of a PBC:

(1) The board of directors shall manage or direct the business and affairs of a public benefit corporation in a manner that balances the pecuniary interests of the shareholders, the best interests of those materially affected by the corporation’s conduct, and the specific public benefit identified in its articles of incorporation.

(2) A director of a public benefit corporation:

     (a) Does not, by virtue of the public benefit provisions of section 7-101-503 (1), have a duty to any person on account of an interest of the person in the public benefit identified in the articles of incorporation or on account of an interest materially affected by the corporation’s conduct; and

Additionally, it permits a PBC to expressly state in its articles of incorporation that a “disinterested director’s failure to satisfy this section does not, for the purposes of section 7-108-401 or 7-108-402 or article 109 of this title 7, constitute an act or omission not in good faith or breach of the duty of loyalty.” The problem for LCAs is that this provision only contemplates a corporation using the PBC form as evidenced by its reference to “articles of incorporation” and the statutory references to the CBCA. The concern for an LCA organized using the PBC form is that its directors may not be protected by the limiting language as it is currently written in the statute. Further, simply altering the express language provided in the PBCA to reference the analogous sections in the ULCAA could render the language unenforceable because it does not track the statutory language of the PBCA. This is not a concern for cooperatives organized under Article 55 or Article 56 because both Articles use the CBCA as a gap filler. ULCAA, on the other hand, was enacted as a stand-alone statute and there was no intent to use the CBCA as a gap filler.

The ideal solution is an amendment to the PBCA that makes the limiting language inclusive of LCAs. In the interim, it is prudent for LCAs using the PBC form to include the limiting language as it is written in the PBCA and include another provision that clearly expresses the intent of the LCA to apply the ULCAA provisions that are analogous to those CBCA provisions regarding limiting director liability. This statement of intent should be drafted to give parties, a court and other interpreters clear guidance to resolve conflicts of interpretation between the PBCA, ULCAA and the Articles of Organization. As a firm, and a PBC, we are invested in the implementation of this statute and look forward to following and participating in its evolution to meet the needs of the businesses that are utilizing the PBC form.