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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

 

A View from an Outside General Counsel’s Perch

I was an in-house general counsel for more than 5 years at Namaste Solar. While in the role, I learned that rendering traditional legal advice was, as they say, necessary but totally insufficient to being successful or adding value. My colleagues consistently pushed me to add value by offering what I now call “legally informed strategic advice,” by which I gave actionable advice to make a decision in light of real world constraints and risk. No path was totally free of risk and no decision could be completely optimized for one variable at the expense of all others.  Law school, for better or worse, teaches lawyers to analyze a case with 20-20 hindsight and to evaluate the facts in light of black letter law. I was rarely pushed, or even inspired to go further and analyze what should have been the decision in light of broader circumstances.

So, when I became an in house counsel, I had to play a critical team role and advise a $20+M company through volatile and risky waters. We navigated a recapitalization, a turbulent and unpredictable policy landscape, layoffs, litigation, growth, scaling production capacity and massive industry consolidation. We had to act with poise, a watchful eye, but always with the clarity of knowing that unknowns lay just around the corner.

This experience has informed how we now offer general outside counsel to our clients today. We do this for more than 25 clients each year, and the number continues to grow. Increasing demand for our outside general counsel services tells us that (a) values and vision aligned legal counsel is rare and hard to find, (b) counsel willing to advise at the intersection of legal and business risk/opportunity is even rarer and harder to find, (c) adding value in multiple practice areas and legal topics involves constant adaptation and knowledge sharpening, and (d) offering “legally informed strategic advice” leads to better decisions.

Below are a few questions we ask ourselves and our clients to tune us for the task at hand:

  1. What is the context surrounding the issue we’re discussing?  Risk and opportunity do not present in a vacuum. Broader issues are at play. Are you facing a business cliff, or massive strategic opportunity? Is your back against a wall and you need this deal to go through? Are key relationships at stake and worth compromising to preserve? How is the business doing, overall?
  2. From what position are we starting?  Are we being asked to create a template that will scale up with a new offering? Are comparable transactional templates available? Are we able to red-line a draft from the counter-party? Different starting points present different cost structures and timelines.
  3. What are your high level concerns and objectives? This may seem obvious, however, I’m still surprised how seldom counsel checks in with the client to understand key concerns. Clients are most knowledgeable of the broader context, their own business and the dynamics of the negotiation. Without this information, the attorney is flying without instruments.
  4. Where are we in the negotiation timeline?  I like to ask this question as follows: “Are you asking me for an 11th hour review?” In other words, are we pulling up to the closing table and just looking out for major deal-breakers or red flags? Are we trying to raise awareness but we understand we’ll have little opportunity to request changes…at least not without jeopardizing the deal? This question fundamentally helps the attorney understand what, if any, bargaining leverage we have in requesting changes in a red-line. It’s a pet peeve of mine when an attorney red-lines each and every section of an agreement as if on a quest for technical and substantive perfection…one-party optimization.  This just does not reflect a balanced or real-world understanding of business negotiation. Parties interested in consummating a deal both give and take. It is the balance of compromise between the parties that determines how healthy a deal is and how likely both sides are to remain committed to it. I’ve seen time and again when a document replete with red-line edits grinds a negotiation to a halt, often over details that are esoteric and even academic to the parties business interests.
  5. Similar to the last question, are we “papering” an agreement already reached, or are we carving a statue from raw stone? In other words, have all material terms been discussed and negotiated by the parties or are we proposing terms for the negotiation that follows? The answer to this question fundamentally and significantly impacts how the attorney approaches her task and her perspective. Attempting to propose new terms in a negotiation that simply needs to be documented can lead to the breakdown of a negotiation. I’ve seen parties allege bad faith when the attorney for one party unwittingly raised new concerns and terms when the parties thought they had negotiated the 4 corners of the deal.

As always, clear documents support productive relationships. Good documents require clear, consistent and engaged communication between client and attorney. Clear strategic advice requires consistent communication even more so . Both sides need to develop trust between one another.  It’s neither an efficient use of client dollars, nor a good use of an attorney’s time to fly blind in supporting a client transaction. Offering value-add legal services requires that the attorney be kept in the loop and privy to the direct and indirect factors that influence negotiations.