The Democratic Firm



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The Democratic Labor-based Firm

Definition of the Legal Structure


In a capitalist corporation, the membership rights (voting and profit rights) are part of the property rights attached to the shares which are transferable on the stock market or in private transactions. In a democratic firm, the membership rights are not property rights at all; they are personal rights assigned to the functional role of working in the firm, i.e. assigned to the workers as workers (not as capital suppliers).

In particular, the democratic principle states that the right to elect those who govern or manage (for example, the munici­pal government) should be assigned to the functional role of being governed or managed (e.g. living in the municipality). Hence the democratic principle assigns the voting rights to elect the board of directors to the workers as their personal rights (because they have the functional role of being managed). After an initial probationary period, it is “up or out”; a worker is either accepted into membership or let go so that all long-term workers in the firm are members. Upon retiring or otherwise leaving the firm, the member gives up the mem­bership rights so that the votes always go to those being governed.

In a similar manner, the labor theory of property states that the rights to the produced outputs (Q) and the liabilities for the used-up inputs (K) should be assigned to the functional role of producing those outputs and liabilities. Hence the labor theory assigns the residual rights to the workers as their personal rights (because they have the functional role of producing those outputs and using up those inputs). If a worker left enterprise A and joined firm B, then he or she would forfeit any share in the future residual of A (since he or she ceased to produce that residual) and would gain a residual share in firm B.

The democratic principle and the labor theory of property are thus legally institutionalized in a corporation by assigning the two membership rights, the voting rights and the residual claimant rights, to the functional role of working in the firm. When membership rights are thus assigned to the role of labor, then the rights are said to be labor-based. When membership rights are owned as property or capital, the membership rights are to be capital-based or capital-ist even when those rights are owned by the employees. In the democratic labor-based firm, the workers are the masters of their enterprise—and they are the masters as workers, not as “small capital-ists.”

The third set of rights in the conventional ownership bundle, the net asset rights (i.e., the rights to the net value of the current assets and liabilities), are quite different. They represent the value of the original endowment plus the value of the past fruits of the labor of the firm’s current and past members reinvested in the firm. The rights due to the members’ past labor should be respected as property rights eventually recoupable by the current and past members.

The job of restructuring the conventional ownership bundle to create the legal structure of a democratic firm (also “democratic labor-based firm” or “democratic worker-owned firm”) can now be precisely specified.

Restructured Ownership Bundle in a Democratic Firm

Membership rights (#1 & #2) assigned as personal rights to worker’s role.

1. Voting rights (e.g., to elect the Board of Directors),

2. Net income rights to the residual, and



Net asset rights (#3) are property rights recorded in internal capital accounts.

3. Net asset rights to the net value of the current corporate assets and liabilities.

The first two rights, the voting and residual rights, i.e. the membership rights, should be assigned as personal rights to the functional role of working in the firm. The third right to the value of the net assets should remain a property right recoupable in part by the current and past members who invested and reinvested their property to build up those net assets (see the later discussion of internal capital accounts).


The Social Aspects of Democratic Labor-based Firms


The democratic labor-based firm does not just supply a new set of owners for the conventional ownership bundle of rights. It completely changes the nature of the rights and thus the nature of the corporation.

Who “owns” a democratic labor-based firm? The question is not well-posed—like the question of who “owns” a freedman. The conventional ownership bundle has been cut apart and restructured in a democratic firm. The membership rights were completely transformed from property or ownership rights into personal rights held by the workers. Thus the workers do hold the “ownership rights” but not as ownership rights; those membership rights are held as personal rights. Thus it may be more appropri­ate to call the workers in a democratic firm “members” rather than “owners.” Nevertheless, they are the “owners” in the sense they do hold the “ownership rights” (as personal rights), and it is in that sense that we can call a democratic labor-based firm a “worker-owned firm.”

The change in the nature of the membership rights from property rights to personal rights implies a correspond­ing change in the nature of the corporation itself. No longer is it “owned” by anyone. The “ownership” or membership rights are indeed held by the current workers (so they will self-manage their work and reap the full fruits of their labor) but they do not own these rights as their property which they need to buy or can sell. The workers qualify for the membership rights by working in the firm (beyond a certain probationary period) and they forfeit those rights upon leaving.

Since those membership rights are not property which could be bought or sold, the democratic labor-based corporation is not a piece of property. It is a democratic social institution.

It is useful to contrast the democratic labor-based corporation with a democratic city, town, or community. It is sometimes thought that, say, a municipal government is “social” because it represents “everyone” while a particular set of workers in an enterprise is “private” because that grouping is not all-inclusive. But no grouping is really “all-inclusive”; each city excludes the neighboring cities, each province excludes the other provinces, and each country excludes the other countries. Only “humanity” is all-inclusive—yet no government repre­sents all of humanity.

Governments are “all-inclusive” in that they represent everyone who legally resides in a certain geo­graphical area, the jurisdiction of the local, state, or national government. But the management of a democratic firm is also “all-inclusive” in that it represents everyone who works in the enterprise. It is a community of those who work together, just as a city or town is a community of those who live together in a certain area. Why shouldn’t a grouping of people together by common labor be just as “social” as the grouping of people together by a common area of residence?

The genuinely “social” aspect of a democratically governed community is that the community itself is not a piece of property. The right to elect those who govern the community is a personal right attached to the functional role of being governed, that is, to legally residing within the jurisdiction of that government. Citizens cannot buy those rights and may not sell those rights—they are personal rights rather than property rights.

In contrast, consider a town, village, or protective association (see Nozick, 1974) that was “owned” by a prince or warlord as his property, a property that could be bought and sold. That would be a “government” of a sort, but it would not be a res publica; that “government” would not be a social or public institution.

The democratic corporation is a social community, a community of work rather than a community of residence. It is a republic or res publica of the workplace. The ultimate governance rights are assigned as personal rights to those who are governed by the management, that is, to the people who work in the firm. And in accordance with the property rights version of the “labor theory of value,” the rights to the residual claimant’s role are assigned as personal rights to the people who produce the outputs by using up the inputs of the firm, that is, to the workers of the firm. This analysis shows how a firm can be socialized and yet remain “private” in the sense of not being government-owned.

Capital Rights in Democratic Firms

What About the Net Asset Value of a Corporation?


We have so far focused most of our attention on the membership rights (the first two rights in the ownership bundle) in our treatment of the democratic firm. Now we turn to the third right, the right to the net asset value. That is the hard one. One of the most important and most difficult aspects of enterprise reform is again in the treatment of those property rights.

The value of that third right is the net asset value, the value of the assets (depreciated by use but perhaps with adjustments for inflation) minus the value of the enterprise’s liabilities. The net asset value may or may not be approxi­mated by the net book value depending on the bookkeeping procedures in use [see Ellerman, 1982 for a treatment of such accounting questions]. Of more importance, the net asset value is not the same as the so-called “value of a [capitalist] corporation” even if all the assets have their true market values. The “value of a corporation” is the net asset value plus the net value of the fruits of all the future workers in the enterprise [see Ellerman 1982 or 1986 for a formal model]. In a democratic firm, the net value of the fruits of the future workers’ labor should accrue to those future workers, not the present workers. Hence our discussion of the capital rights of the current workers quite purposely focuses on the net asset value, not the “value of the corporation.”

The net asset value arises from the original endowment or paid-in capital of the enterprise plus (minus) the retained profits (losses) from each year’s operations. Thus it is not necessarily even the fruits of the labor of the current workers; the endowment may have come from other parties and the past workers who made the past profits and losses. Hence the third right, the right to the net asset value, should not be treated as a personal right attached to the functional role of working in the firm.

There is considerable controversy about how the net asset value should be treated. One widespread socialist belief is that the net asset value must be collectively owned as in the English common-ownership firms or the former Yugoslav self-managed firms; otherwise there would be “private ownership of the means of production.” To analyze this view, it must first be recalled that the control (voting) and profit rights have been partitioned away from the rights to the net asset value. The phrase “private ownership of the means of production” usually does include specifically the rights to control and reap the profits from the means of production. But those rights have been restructured as personal rights assigned to labor in the democratic firm. Hence the remaining right to the net asset value does not include the control and profit rights tradition­ally associated with “equity capital” or with the “ownership of the means of production.”

Let us suppose that it is still argued that any private claim (for example, by past workers) on the net asset value of a democratic firm would be “appropriating social capital to private uses.” This argument has much merit for that portion of the net asset value that comes from some original social endowment. But what about that portion of the net asset value that comes from retained earnings in the past?

In a democratic firm, the past workers could, in theory, have used their control and profit rights to pay out all the net earnings instead of retaining any in the firm. Suppose they retained some earnings to finance a machine. Why should those workers lose their claim on that value—except as they use up the machine? Why should the fruits of their labor suddenly become “social property” simply be­cause they choose to reinvest it in their company?

Consider the following thought-experiment. Instead of retaining the earnings to finance a machine, suppose the workers paid out the earnings as bonuses, deposited them all in one savings bank, and then took out a loan from the bank to finance the machine using the deposits as collateral. Then the workers would not lose the value of those earnings since that value is represented in the balance in their savings accounts in the bank. And the enterprise still gets to finance the machine. Since the finance was raised by a loan, there was no private claim on the social equity capital of the enterprise and thus no violation of “socialist principles.” The loan capital is capital hired by labor; it gets only interest with no votes and no share of the profits.

Now we come to the point of the thought-experiment. How is it different in principle if we simply leave the bank out and move the workers’ savings accounts into the firm itself? Instead of going through the whole circuitous loop of paying out the earnings, depositing them in the bank’s savings accounts, and then borrowing the money back—suppose the firm directly retains the earnings, credits the workers’ savings accounts in the firm, and buys the machine. The capital balance represented in the savings accounts is essentially loan capital. It is hired by labor, it receives interest, and it has no votes or profit shares. Such accounts have been developed in the Mondragon worker cooperatives, and they are called internal capital accounts.

One lesson of this thought-experiment is that once the control and profit rights have been separated off from the net asset value, any remaining claim on that value is essentially a debt claim receiving interest but no votes or profits. “Equity capital” (in the traditional sense) does not exist in the democratic firm; labor has taken on the residual claimant’s role.

Capital Accounts as Flexible Internal Debt Capital


Internal capital accounts for the worker-members in a demo­cratic corporation are a form of debt capital. Labor is hiring capital, and some of the hired capital is provided by the workers themselves and is recorded in the internal capital accounts. These internal capital accounts represent internal debt capital owed to members, as opposed to external debt owed to outsiders. Instead of debt and equity as in a conventional corporation, a democratic firm with inter­nal capital accounts has external and internal debt.

How does internal debt differ from external debt, and how does an internal capital account differ from a savings account? Any organization, to survive, must have a way to meet its deficits. There seem to be two widely used methods: (1) tax, and (2) lien. Governments use the power to tax citizens, and unions similarly use the power to assess or tax members to cover their deficits. Other organizations place a lien on certain assets so that deficits can be taken out of the value of those assets. For instance, it is a common practice to require damage deposits from people renting apartments. Damages are assessed against the deposit before the remainder is returned to a departing tenant.

A free-standing democratic firm must similarly find a way to ultimately cover its deficits. Assuming members could always quit and could not then be assessed for possible losses accumulating in the current year, the more likely method is to place a lien against any money owed to the member by the firm. Each member’s share of the losses incurred while the worker was a member of the firm would be subtracted from the firm’s internal debt or internal capital account balance for the member. This pro­cedure would be agreed to in the constitution or ground rules of the democratic firm. Losses, of course, may not be subtracted from the external debts owed to outsiders. Hence internal debt in a democratic firm would have the unique characteristic of being downward flexible or “soft” in comparison with external “hard” debt. It is thus also different from a savings account in a bank which would not be debited for a part of the bank’s losses.

In the comparison between a democratic firm and a demo­cratic political government, the firm’s liabilities are analogous to the country’s national debt. The internal capital accounts, as internal debt capital, are analogous to the domestic portion of the national debt owed to the country’s own citizens. The differences arise because of the two different methods of covering deficits. The firm uses the lien method while politi­cal governments rely on the power to tax.

The firm’s lien against a member’s internal capital account also motivates the common practice of requiring a fixed initial membership fee to be paid in from payroll or out of pocket. Then there is an initial balance in each member’s account to cover a member’s share of losses during his or her first year of work.

Profits or year-end surpluses, like losses or year-end deficits, would be allocated among the members in accordance with their labor, not their capital, since labor is hiring capital and is thus the residual claimant. The labor of each member is commonly measured by their wage or salary, or, in some cases, by the hours regardless of the pay rate. In worker cooperatives, that measure of each member’s labor is called “patronage” and net earnings are allocated in accordance with labor patronage.

When the net earnings are negative, the losses are allocated between the capital accounts in accordance with labor. Thus the system of internal capital accounts provides a risk-absorbing mechan­ism with a labor-based allocation of losses.

The Internal Capital Accounts Rollover


"Allocation” is not the same thing as cash distribution. There are good practical arguments for not paying out current profits as current labor dividends. The immediate payout of current profits pro­motes a “hand-to-mouth” mentality and fails to tie the workers’ interests to the long term interests of the enterprise. By retaining the profits and crediting that value to the capital accounts, the workers need to insure that the enterprise prospers so their value can eventually be recovered.

When should the accounts be paid out? One idea is to leave the account until the worker retires or otherwise terminates work in the enterprise, and then to pay out the account over a period of years. There are several reasons why that termina­tion payout scheme is not a good idea.

By waiting until termination or retirement for the account payout, the accounts of the older workers would be much larger than those of the younger workers and thus the older workers would be bearing a grossly unequal portion of the risk. Risk-bearing should be more equally shared between the older and younger workers. Moreover, it would create an incentive for the older and better trained workers to quit in order to cash out their account and reduce their risks. For young workers, retirement is too distant a time horizon. Current profits would be an almost meaningless incentive for them if the profits could not be recovered until retirement. And finally cash flow planning would be difficult if the cash demands of account payouts were a function of unpredictable terminations.

These problems with the termination payout scheme are alleviated by an “account rollover scheme” wherein the account entries are paid out after a fixed time period. The allocations to the accounts are dated. Cash payouts should be used to reduce the older entries in the capital accounts. If an account entry has survived the risk of being debited to cover losses for, say, five years, then the entry should be paid out. That is sometimes called a “rollover” (as in rolling over or turning over an inven­tory on a first-in-first-out or FIFO basis) and it tends to equalize the balances in the capital accounts and thus equalize the risks borne by the different members.


Internal Capital Account Rollover


Current retained labor patronage allocation adds to all members’ accounts (equal additions assumed in the above illustration), and then the cash payouts reduce the balance in the larger and older accounts—thereby tending to equalize all the accounts. The incentive to terminate is relieved since the account entries are paid out after the fixed time period whether the member terminates or not. And cash flow planning is eased since the firm knows the payout requirements, say, five years ahead of time.

Instead of receiving wages and current profit dividends, workers would receive wages and the five-year-lagged rollover payments. New workers would not receive the rollover payments during their first five years. They would be, as it were, paying off the “mortgage” held by the older workers—without being senior enough to start receiving the “mortgage payments” themselves.


A Collective Internal Capital Account


In a socialist country, some of a democratic firm’s net asset value might be endowed from a gov­ernmental unit, and there is no reason why that value should ultimately accrue to the workers of the enterprise. Hence there should be a collective account to contain the value of the collective endowment not attributable to the members.


Assets

Liabilities

Cash

Inventory

Equipment

Real Estate



External Debts

Internal Capital Accounts

(internal debts)

Collective Account


Balance Sheet with Internal Capital Accounts


The net asset value (defined as the value of the assets minus the value of the external debts) equals the sum of the balances in the individual capital accounts and the collective account. Two other accounts, a temporary collective account called a “suspense account” and a “loan balance account,” will be intro­duced in the later model of a hybrid democratic firm in order to accommodate ESOP-type transactions.

There is another reason for a collective account, namely, self-insurance against the risks involved in paying out the members’ capital accounts. After retirement, the enterprise must pay out to a member the remaining balance in the worker’s capital account. In an uncertain world, it would be foolish to think that an enterprise could always eventually pay out 100 per cent of its retained earnings. Any scheme to finance that payout would have to pay the price of bearing the risk of default. One option is always self-insurance. Instead of promising to ultimately pay back 100 per cent of retained earnings to the members, the firm should only promise, say, a 70 per cent or a 50 per cent payback. That is, 30 per cent to 50 per cent of the retained earnings could always be credited as a “self-insurance allo­cation” to the collective account, and that would serve to insure that the other 70 per cent to 50 per cent could ultimately be paid back to the members.

The self-insurance allocation should also be applied to losses. That is, when retained earnings are negative, 30 per cent to 50 per cent should be debited to the collective account with the remaining losses dis­tributed among the members’ individ­ual capital accounts in accordance with labor patronage. Thus the self-insurance allocation would dampen both the up-swings and down-swings in net income.

The current members of a democratic firm with a large collective account should not be allowed to appropriate the collective account by voluntary dissolution (after paying out their individual accounts). Any net value left after liquidating the assets and paying out the external and internal debts should accrue to charitable organizations or to all past members.


Financing Internal Capital Account Payouts


In an economy where all firms were organized as democratic labor-based firms, there would be no equity capital markets since membership rights would not be property rights at all. However, there could and should be a vigorous market in debt capital instruments such as bonds, debentures, and even variable interest or “participating” debt securities.

How can democratic firms finance the payouts of their internal capital accounts? For a debt instrument with a finite maturity date, a company must eventually pay out the principal amount of the loan. However, a capitalist firm does not have to ever pay out the issued value of an equity share. A democratic firm could obtain the same effect by issuing perpetual debt instruments which pay interest but have no maturity date. Such a debt security is called a perpetuity or a perpetual annuity [see Brealey and Myers, 1984]. If the firm ever wants to pay off the principal value of a perpetuity, it simply buys it back.

A democratic firm could use perpetuities to pay out the rollover or the closing balance in an internal capital account. To increase the perpetuity’s resale value on debt markets, many firms could pool the risks by issuing the perpetuities through a government, quasi-public, or cooperative financial institu­tion or bank.

The pooling bank would pay a lower interest rate on the face value of the perpetuity than the firms pay to it; the difference between the interest rates would cover the risks of default and the transactions costs. The allocation to the collective account for the purpose of self-insurance would not then be neces­sary since the cost of risk would be borne by the firm in the form of the interest differential. Since the perpetuities would be guaranteed by the pooling institution (not the firm), workers could resell them with­out significant penalty.

The balance in a worker’s internal capital account is a property right, not a personal right. For instance, if a worker-member dies, his or her vote and right to a residual share are extinguished but the right to the balance in the account passes to the heirs. Since the balance in the account is a property right, why can’t the worker sell it? The only reason is the lien the enterprise has against the account to cover the worker’s share of future losses (while the worker is a member). But if the balance is large enough (in spite of the rollover) or the worker is near enough to retirement, then part of the account could be paid out in salable perpetuities (in addition to the rollover payouts). Internal capital accounts could also be paid out using variable income or “participating” securities.

Participating Securities


Since democratic organizations can only issue debt instruments, greater creativity should be applied to the design of new forms of corporate debt. Some risks could be shared with creditors by a reverse form of profit-sharing where the interest rate was geared to some objective measure of enterprise performance.

In a worker-owned firm, conventional preferred stock would not work well since it is geared to common stock. Ordinarily, common stockholders can only get value out of the corporation by declaring dividends on the common stock. Preferred stock has value because it is “piggy-backed” onto the common stock dividends. Dividends up to a certain percentage of face value must be paid on preferred stock before any common stock dividends can be paid. Preferred stockholders do not need control rights since they can assume the common stockholders will follow their own interests.



The preferred stockholders are like tax collectors that charge their tax on any value the common stockholders take out the front door. But that theory breaks down if the common stockholders have a back door—a way to extract value from the company without paying the tax to the preferred stockholders.

The Back Door Problem


That is the situation in a worker-owned company where the employees own the bulk of the common stock. They can always take their value out the “back door” of wages, bonuses, and benefits without paying the “tax” to the preferred stock­holders. Hence the valuation mechanism for preferred stock breaks down in worker-owned companies. For similar reasons, absentee ownership of a minority of common stock would not make much sense in a worker-owned company; the workers would have little incentive to pay common dividends out the front door to absentee minority shareholders when the back door is open. Discretionary payments won’t be made out the front door when the back door is open.

There are two ways to repair this problem in worker-owned companies:

— charge the preferred stock “tax” at all doors (front and back), or

— make the payout to preferred stockholders more manda­tory and thus independent of what goes out the doors.

The first option leads to a form of non-voting preferred stock that would be workable for worker-owned companies where the preferred “dividend” is required and is geared to some other measure of the total value accruing to the worker-owners.

The second option pushes in the direction of a debt instrument—perhaps with a variable income feature. The interest could be variable but mandatory, geared to the company’s “value-added” (revenue minus non-labor costs) to estab­lish a form of profit-sharing in reverse (labor sharing profits with capital).

The two resulting conceptions are about the same: a non-voting preferred stock with a required “dividend” geared to some measure of the workers’ total payout, and a perpetual bond with a variable return geared to value-added. Debt-equity hybrids are sometimes called “dequity.” This general sort of non-voting, variable income, perpetual security could be called a participating dequity security since outside capital suppliers participate in the variability of the value-added. Jaroslav Vanek [1977, Chapter 11] describes a similar “variable income debenture” and Roger McCain [1977, pp. 358‑9] likewise considers a “risk participation bond.”

A debt instrument where interest is only payable if the com­pany has a certain level of net income is called an “income bond” [see Brealey and Myers, 1984, p. 519]. Dividends on preferred and common stock is paid at the discretion of the board of directors whereas the interest on an income bond must be paid if the company has a pre-specified level of accounting net income.

There is also a special type of income bond with two levels of interest; some interest is fixed, and then an additional interest or “dividend” is only payable if the company has sufficient income. These partly fixed-interest and partly variable-interest bonds are called “participating bonds” or “profit-sharing bonds” [Donaldson and Pfahl, 1963, p. 192]. A partici­pating perpetuity would be a perpetual security with the parti­cipation feature.

Could large public markets be developed for such participating securities? Yes, such securities would closely approximate the dispersed equity shares in the large public stock markets in the United States and Europe. With the separation of ownership and control in the large quoted corporations, the vote is of little use to small shareholders. The notion that a publicly-quoted company can “miss a dividend” means that the dividend is sliding along the scale from being totally discretionary towards being more expected or required. Thus dispersed equity shares in large quoted corporations already function much like non-voting, variable income, perpetual securities, i.e. as participating dequity securi­ties. Thus public markets in participating dequity securi­ties not only can exist but in effect already do exist.


Mutual Funds for Participating Securities


It was previously noted that the market value of fixed-income securities would be enhanced if they were issued by a financial intermediary which could pool together the securities of a number of enterprises.

Pooling Participating Securities in a Mutual Fund

That application of the “insurance principle” would reduce the riskiness of the mixed-interest participating securities. There could be a “mutual fund” or “unit trust” that pools together the participating securities of enterprises it felt had good profit potential. Risk-taking individuals could buy securities directly from companies, while more risk-adverse individuals could buy shares of mutual funds that pooled together participating securities from many companies.

Workers receiving participating securities from their company could sell them directly for cash, hold them and receive interest, or could swap them for shares in the mutual fund carrying that company’s participating securities which could then be held or sold.

The participating securities also reduce risk for the com­pany. The variable interest portion automatically reduces the interest charges when the company takes a downturn. The security-holder then gets less so the security-holder has shared the risk. The interest charges go up when the firm does well—but not beyond the maximum variable-interest cap. Thus the participating securities work to reduce the variance or vari­ability of the net income for the company as a whole. Participating dequity securities allow democratic firms to utilize the risk allocative efficiency of public capital markets without putting the membership rights up for sale.

Aside from diversifying risk, the other major use of participating securities is to pay out the internal capital accounts of workers due to receive a “rollover” payment or who have retired or otherwise terminated work in the company. A public capital market in participating securities allows workers to capitalize the value of their internal capital accounts without the company itself having to “provide the market.”



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