In this series so far, we have analyzed the potential for a sistered for-profit entity and cooperative entity to separately optimize for financing and member-orientation. Since publishing this series, I’ve received some good feedback from readers. Some have asked about additional terms and benefits that could be designed into the TechCo – Cooperative “pre-nuptial” agreement. Feel free to go back and re-visit Part 4, where I’ve supplemented with new ideas.
Need to go back and read prior episodes?
In this episode, I’m going to unpack the notion of reciprocal ownership or equity interest between TechCo and Cooperative.
More and more, we’re seeing innovative legal constructs (disclosure: our firm represented one of the investors in the financing that consummated this transition) brought to bear to address mission protection, stakeholder governance and other ills created by our historical cultural obsession with shareholder primacy (disclosure: the author is a former attorney with our firm). For more about mission protection, my colleague, Francisca has created a wonderful blog series on the topic.
While I laud the creativity and rigor applied to the development of purpose trust ownership of business enterprise, I remain skeptical of the durability and flexibility of the trust model for such purposes. I really do prefer corporate forms for business ownership. I have come to appreciate, however, that purpose trusts can be a great alternative to a traditional tax exempt non-profit, which is highly regulated by the IRS.
Back to our TechCo – Co-op hybrid structure. In addition to creating a contractual framework to align incentives and leverage differentiated entity design, creating and marrying two separate legal entities provides an opportunity to further enmesh the two by conferring reciprocal ownership. TechCo can be issued membership in Co-op, and Co-op can be issued common or preferred shares in TechCo. Let’s unpack this.
In the limited cooperative association (“LCA”) form, membership is divided between “patron” and “investor” membership. Patron members use, contribute to, or purchase from the cooperative. Investor members furnish capital to the cooperative, but do, in this capacity, patronize or use the services of the cooperative.
LCAs can offer investor-memberships with or without voting rights. The LCA Co-op could offer TechCo investor-member shares as recognition of in-kind service (licensing fees, development services or other in-kind support)), for capital contributions or for other consideration. Alternatively, the LCA Co-op could create a class of membership for the TechCo, presuming that TechCo intended to patronize the Co-op in some way, be it by offering a software license, or by providing management or other back-end support. The benefit to TechCo holding either a patron-membership share or investor-membership shares include:
- Aligns TechCo’s individually with the Co-op’s collective strategy and mission.
- Provides TechCo with an additional revenue stream, through patronage dividends.
- Provides a mechanism to defer Co-op’s payments to TechCo, in the form of those patronage dividends.
- Offers the possibility of having TechCo or its interests represented on Co-op’s Board of Directors.
- Offers the possibility of giving TechCo voting rights, either as a patron-member, an investor-member or possibly both (subject to tailored LCA governance design).
At the same time, TechCo could reserve, sell, award or otherwise issue shares of its common or preferred stock to Co-op. This could be in many forms:
- Issue common shares to Co-op as if it were a co-founder.
- Sell or gift vesting common shares to Co-op as a retention tool.
- Sell or gift preferred shares as part of a financing.
- Reserve shares or issue a warrant to purchase shares as part of an upside guarantee for the Co-op.
TechCo’s issuance of equity to Co-op serves a reciprocal purpose to Co-op offering its version of equity to TechCo; to align incentives, to reward early risk with upside, to give Co-op meaningful governance rights in an around TechCo’s Board, to retain Co-op’s business. Further, having Co-op on TechCo’s cap table may assuage concerns of any outside investor that the Co-op would “go rogue” on TechCo and put investment at (additional) risk. Investors may even see Co-op on the TechCo cap table as a risk mitigation device, thereby reducing return expectations. It’s as if a start-up had a large institutional customer on its cap table as a show of commitment and validation.
