Buying SMBs with the Co-op model

Our July Private Market Insights episode welcomes Eduardo Cabral, Corporate Development Manager at Obran Cooperative, to talk about the co-op model for acquiring a small business. The co-op model for acquisitions is one that has not historically gotten as much attention as the investor and debt-funded search methods popularized by the dominant literature in our industry. However, for many entrepreneurs, we believe the co-op model represents an opportunity from a financial and mission perspective, and we expect to see more employee-driven acquisitions going forward. 

At Private Market Labs, our goal is to unlock the potential of the small business M&A world. We’re thrilled to partner with Eduardo and Obran, and are excited to have them in the Spaces. 

Obran is a worker-owned cooperative conglomerate corporation. They exist to grow profitable, useful, and impactful businesses that serve their members, customers, and communities. Their business consists of sector strategies designed to leverage our unique cooperative advantage. 

As a Corporate Development Manager for Obran, Eduardo builds relationships with partner organizations to further the cooperative’s business and organizational goals. Eduardo developed business development skills at a Harvard Innovation Lab incubated/MassChallenge accelerated startup, as a capital markets analyst at Credit Suisse, and as an associate at Bengal Capital, a $40mm+ AUM cannabis-focused fund. Passionate about reducing wealth and income inequality, he also was an operator for campaigns such as Bernie Sanders for President 2016. Eduardo earned a bachelor’s degree in government from Harvard University. In his free time, Eduardo enjoys volunteering with local tenants’ unions, gaming, and ceramics.

Listen to the episode here or on your favorite podcasting app:

Different types of Co-ops

To start, let’s make a distinction: there are worker owned cooperatives, and then there are just cooperatives. If you think about REI, if you think about ACE hardware, these are all different kinds of cooperatives. In a traditional cooperative, the patron refund goes to someone. 

Let’s say you are buying corn from your farming cooperative. And because you’re buying corn from this cooperative they’re able to actually negotiate lower prices when producing the corn, because they have enough members and purchasing power. In terms of the difference between what you paid to the cooperative and how they’re able to source their materials, rather than going as some sort of dividend to the owners of a corporation, it goes back to the members of the cooperative as a refund.

A great example of a cooperative is the European Mondragon group, established after WW2. 

Co-op Patrons and Shareholders

Now let’s look at some definitions on how a worker-owned cooperative works – with patrons that are also employees. A patron is someone who has participated in the cooperative by paying to be a member, and then receiving some sort of service and return, in the form of a patronage discount or patronage dividend. This is money that is generated from the benefit of the cooperatives and members being together. 

Typically, in a cooperative, the patron is whoever’s receiving the service. In the case of Obran, the business is employment. They also have investors who own shares in the business, since they sell preferred equity, shares, things of that nature to raise capital. Depending on the fundraising structure, they may or may not be a patron. In that they’re, they may or may not actually be receiving a service and then also they may or may not be getting a vote at how the coop functions. 

But for any acquisition that Obran makes, any employee that is of that business can become a patron of the cooperative and become a member and have not only the patron dividend, but then also getting the voting privileges essentially. More on that in the governance section. 

So investor members own shares and the coop has a fiduciary responsibility to them in providing a return. The key difference here is that, rather than only having a fiduciary towards them, a coop has a double bottom line thanks to the patron kind of members. The other key difference is that in cooperatives patrons own one share, whereas investor-shareholders or employees with equity in startups own multiple shares and % of the business as a whole. 

Co-op Governance

The worker shares are more of a membership token that allow you to vote and then get a patronage refund. This is another key distinction from normally employee options pools, where you get some say, but you’re in another share class with diminished impact. 

One thing to be clear is that a cooperative is not a collective. So not every single action is voted on by the workers. Management is appointed by the board, voted on by the workers, and they would be making day-to-day business decisions as to what is retained earnings versus what it can move to be profit dividend. There is at least one step of separation where it’s not folks who are rank and file employees. 

There have been stories of operations that have become successful and turned into a collective, and then the workers vote to fire off the new young guy because he is working too hard. Yeah. That’s a clear cut example of misplaced incentives. With Obran being a worker-owned cooperative, their number one incentive is to make sure they continue to make acquisitions, because having a bigger patronage check will get more wealth into the hands of their worker owners. This way incentives are better aligned to the business while keeping democratic control,but having the ability to say: “Hey, we’re gonna prioritize these values over profit”, but then also at the same time, you have a structure that limits kind of the ability for an interpersonal group or a small group to be able to dictate the future of the business and all of the businesses on their own.

Making money as a co-op patron

In a worker-owned cooperative, the patron dividend is like a refund that is accrued under the management of the cooperative and shared benefits are accrued, or then given back to the members versus in a worker owned cooperative. 

Obran, for example, makes money by managing assets (businesses), and holding these assets. And so in this situation, a patron dividend or refund works a lot more like a dividend check. It’s usually a share of any excess profits that are generated by the underlying businesses. 

As a co-worker/co-owner of the business, there could be situations where your personal expenses are the business expenses, resulting in tax benefits. These benefits will be generated by optimizing folks’ expenses, and from financial management. For example, as a business owner, you can charge business meals or buy a car that you are using 50% for business, 50% for pleasure. As an employee, you would have to be either given a company car or be getting some sort of reimbursement. 

What’s more, 300 people coming together, they can probably borrow money more cheaply than they could on their own. The cooperative then becomes a financial layer that sits on top of what we do and lets our business be the business of managing our members  with the assets that we hold have kind of a dual purpose. 

Lastly, a key tax advantage is that when you sell a business to your employees or sell to a cooperative, you get to keep all that money tax free, as long as you reinvest it into American stocks, or qualified replacement properties. This is based on the 1042 IRS form, the same one that regulates ESOPs for startups (employee stock ownership programs), but without the setup costs associated with the latter. 

Obran Co-op Acquisition Example

We just completed an acquisition in Hawaii this year. It was our first acquisition of a Kaiser Permanente vendor, a relatively small deal, $3M-$5M. We went to this owner, we figured out the valuation of the business, and we went and took debt to borrow to buy the business because of this tax benefit, we’re able to borrow less right than we would otherwise. And then from there, managing the business, our number one priority isn’t necessarily profit. Our first priority is debt service. And then our second priority is essentially looking at all of our new members and looking at how we optimize their income. 

So for this first year at the newly acquired company, our goal is to make sure that the business stays stable and that we can pay off the debt, and we’re slowly transitioning to worker ownership. Step one is to make sure the job is stable, make sure we’re delivering the business. And then step two is optimizing the business so that people are making enough money to perhaps make larger patron investments into the business. Then you can focus on the divided piece. 

Starting a Co-op

The top two things to kind of keep in mind as you start:

  1. The legal complexity around it. In 2016 a new legal structure that was created in Colorado called a limited cooperative association. A limited cooperative association is kind of synonymous to a holding company, but the holding company is a cooperative. It allows for a governance structure of a cooperative but then you can go in and buy non-cooperative assets. Also make sure that you have kind of the right legal infrastructure put in place so that you can take advantage of the tax benefits, being that you can buy the business and have it be a tax free-transaction without the selling owner having a trust set up or anything like that. 
  2. The business model that you’re targeting is also critical, and needs to align with cooperative ownership. Ultimately, all business models could work under a cooperative lens, but today we are still operating in a competitive environment. Competitive business environment is great, but if you’re able to raise the wages of some employees, does that mean you have to raise costs? And does that make you less competitive and lose contracts? 

Be sure to check out the full episode for more details on each of the topics we discussed with Eduardo. Our goal is to ensure that entrepreneurs have access to the services and knowledge they need as they evaluate SMBs as part of their acquisition process. Tune in to our next episode on our Twitter Spaces every month, ask questions and let us know what topic and/or guest you would like us to bring to the next conversations.

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