The Democratic Firm

Chapter 6: Model of a Hybrid Democratic Firm

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Chapter 6: Model of a Hybrid Democratic Firm

Introduction: A Model for Transplanting

ESOPs and worker cooperatives have evolved in idiosyncratic ways in the United States and elsewhere. How can the “core” of these legal structures be introduced in rather different legal environments elsewhere in the West—not to mention in the transitional economies? For instance, worker coopera­tives have always been limited because they are all-or-nothing affairs. There is no intermediate stage that allows a company to ramp up to 100 per cent worker owner­ship over a period of years. This chapter presents a hybrid form of the Mondragon-type worker cooperative.

ESOPs do allow for that partial or hybrid interme­diate structure. But the American ESOPs require an external trust in addition to the corporation. How can the ESOP structure be applied in non-Anglo-Saxon countries which have little or no trust law? This chapter presents the idea of an “internal ESOP” which captures the basic ideas of the lever­aged ESOP transaction with no external trust.

The resulting models of a hybridized Mondragon-type worker cooperative and an internalized democratic ESOP turn out to be essentially the same—so that is the model of the hybrid democratic firm presented here.

A Hybrid Mondragon-type Worker Cooperative

The worker-owned cooperative has historically been an all-or-nothing creature. It tends to assume a workforce that al­ready understands and appreciates the rights and respon­sibilities of democratic worker ownership. A more practical compromise is a hybrid structure that can initially accommo­date less than 100 per cent or even minority worker ownership—but where that portion of worker ownership is organized on a democratic cooperative basis.

A hybridized Mondragon-type worker cooperative is a corporation where a certain percentage of the ownership rights is organized as a Mondragon-type worker cooperative, that is, with voting by an agreed-upon rule (e.g., equal or according to salary) to determine total vote of workers’ shares and with workers’ residual allocated among them ac­cording to labor (as measured, for instance, by salary).

An Internalized Democratic ESOP

The democratic ESOP is already a hybrid structure for demo­cratic worker ownership. Any percentage of the owner­ship could be in the ESOP, and that portion can be organized on a cooperative basis. However, the ESOP has evolved in an idiosyncratic way depending on the pecu­liarities of American law and the political process. In designing a new institutional form, it is best to think through the real function served by all the ESOP trust apparatus and then implement a streamlined version accomplishing the desired ends.

In particular, an external trust is a somewhat peculiar mechanism for worker ownership. The workers are, in fact, inside the firm. But an external ESOP trust is set up with the workers as beneficiaries. Then the firm issues external shares to be held by the trust. By this circuitous route, the workers have the ownership rights in their enterprise.

The external ESOP trust evolved in American law from a pension trust designed to hold shares in other companies. There is little need for the trust to be external if its primary purpose is to register ownership in the company itself. Corporate law could be modified or new corporate law drafted to, in effect, move the ESOP inside the corporation itself. The whole circuitous loop of worker ownership through an external demo­cratic ESOP could be simplified and streamlined by moving the ESOP inside the corporation.

In America, starting and administering an ESOP requires an army of lawyers, financial analysts, valuation experts, and accountants all resulting in sizable transaction costs. Indeed, a whole industry has developed for the “care and feeding” of ESOPs. Less of this would be necessary if the ESOP structure was internal to the structure of the corporation.

An internalized democratic ESOP is a corporation where a certain percentage of the ownership rights is orga­nized as a “democratic ESOP” within the company.

The Hybrid Democratic Firm

The interesting result is that a hybridized Mondragon-type worker cooperative is essentially the same as an internalized democratic ESOP—and that is the struc­ture we are proposing as a hybrid partial worker-owned democratic firm—which, for short, will be called a hybrid democratic firm.

Many useful ideas can be suggested by using the two ways of conceptually deriving the structure of a hybridized democratic firm (as a hybridized co-op or an internalized ESOP). How­ever, we will initially describe the structure in general terms.

The equity of the hybrid firm is divided into two parts:

(1) the workers’ portion of the equity which is the “inside ownership” and

(2) the external portion of the equity owned by outside parties such as organs of government, intermediate institutions, or private parties.

In a transitional economy, the external ownership might be public, that is, by the state, city, county, township, or village government.

There are two limiting cases: 0 per cent and 100 per cent inside ownership. With 0 per cent inside ownership, the firm would be a conventional corporation owned by public or private parties. With 100 per cent internal ownership, the firm would be a (non-hybridized) Mondragon-type worker cooperative which could also be seen as a 100 per cent demo­cratic ESOP (i.e. an ESOP with 100 per cent of the ownership) internalized to the company.

In an American corporation, there is a difference between shares that are authorized and shares that have been issued to become outstanding. A certain number of shares (assume all common voting shares) are authorized in the original corporate charter. Some of these shares are then issued to shareholders in return for their paid-in capital so those shares are then outstanding. If a company bought back or redeemed any shares, those shares would not be outstand­ing and would be retired to the company treasury until re-issued. Only the shares that are issued and outstanding can vote or receive dividends. The authorized but unissued or redeemed shares can neither vote, receive dividends, nor reflect any net worth.

In what follows, we assume the hybrid firm is organized as a corporation with common voting shares—although a simpler structure might also be used to implement the ideas. In a hybrid democratic corporation with shares, the inside owner­ship is a new category of issued and out­standing shares; it is not unissued or treasury stock. The workers’ stock is issued and outstanding but held in the firm for the inside owners, the workers. Each worker does not own a certain number of shares since the workers’ portion of the company is to be organized in a labor-based democratic fashion. The worker shares are held collectively and are unmarketable. The workers vote on an agreed-upon basis as to how the collectivity of the worker shares will be voted. The workers would elect a number of representatives to the board of directors proportional to the workers’ portion of the equity (e.g. one third of the directors for one third of the equity). The worker representatives on the board would form a natural subcommittee to control the shares in the workers’ portion of the equity in analogy with an ESOP gov­erning committee in the American external ESOP.

Some shares have a par or face value that is the value for which the shares were originally issued, but that value has no significance later on. Often shares are no-par shares with no par or face value; they simply have some original issued value. After a company has been in operation, the shares will have a book value (net book value divided by the number of common shares). If the shares are marketable, they will also have a market value. The book and market values are in general different from the face or issued values of the shares. The relevant valuation of the worker shares in a democratic firm is their net asset value or “economic book value”.




External Debt


External Equity


Real Estate

Internal ESOP:

Individual Capital Accounts

Suspense Account

Collective Account

minus Loan Balance Account

Hybrid Democratic Firm's Balance Sheet

The total book value of the worker shares is divided between several types of internal capital accounts in the internal ESOP:

(1) each worker has a value-denominated individual capi­tal account which would contain a certain amount of value (not a certain number of shares);

(2) there is a suspense account which serves as a temporary collective account or “holding pen” for value to be even­tually allocated to individual accounts;

(3) a permanent collective account, and

(4) there would also be a (debit-balance) loan balance account which could be treated as a contra-account to the collective account.

Company law could be redrafted so that the workers’ portion of the equity was a normal part of any corporation. A company typically runs several accounts such as total year-to-date wages or accrued vacation time. A worker’s internal capi­tal account would be another account maintained for each per­son in the company.

Each worker could have a membership certificate, but it would be quite different from a share certificate. The number of shares in the total workers’ portion might grow over time, but each worker only needs one membership cer­tificate to signify membership. Each year, the workers would receive Capital Account Statements showing the transactions in their accounts due to the year’s operations and the resulting ending balances.

Some details can be best illustrated by considering a concrete example. Consider a hybrid democratic firm where one-third of the ownership is inside or workers’ ownership. There could be, say, 960 shares issued and outstanding with 33 per cent or 320 shares held in the firm as worker shares. In a corporate election of (say) board members, there are 960 share-votes, 320 of which are controlled by the workers. The workers vote on a democratic basis as to how their 320 share votes should be cast.

A new worker might pay in a standard membership fee through payroll deductions. Shares with book value equal to the membership fee would be issued by the company to the total workers’ portion of the equity, and that value would be cred­ited to the new worker’s individual capital account.

The workers’ portion of the ownership would be exercised in not only a democratic but a labor-based manner. Workers would receive wages and salaries as usual, and then 33 per cent of the profits would be allocated among the workers according to their labor—after interest is paid on the capital accounts.

Profits will accrue to the workers in two ways. A firm-wide decision might be made for some of the profits to be paid out in dividends on the shares. Then, in the exam­ple, 33 per cent of the dividends would go to the workers collec­tively to be divided between them according to their labor (measured by salary or by hours). The dividends could be paid out in cash, or they could be added to the capital accounts and then used to pay out the oldest account entries according to the rollover plan. The remainder of the profits (not declared as dividends) would be retained so they would increase the net book value per share. The shares in the workers’ portion are valued at book value. Hence 33 per cent of the retained profit (= increase in net book value) would accrue to the workers’ individual accounts.

The allocation formula between worker accounts depends on whether the individual capital accounts bear interest or not. Accounting is simpler if interest is ignored, but interest is the only compensation proportional to the larger risk borne by large account holders (older workers). The interest comes out of the workers’ retained profit. The interest should be added to each account with the remainder of the workers’ retained profit (their one-third)—which could now be negative—allocated between the accounts according to labor. If there are little or no profits, the interest is still added to the workers’ accounts and the correspondingly more negative retained profits (i.e. greater losses) are allocated between the accounts according to labor.

It should be remembered that the workers do not have any individual ownership of shares; only the book value is represented in their individual capital accounts. In the hybrid firm, the shares still package together the three main rights in the ownership bundle (voting, profit, and net asset rights). But the workers’ portion of the ownership is organized in a labor-based democratic manner so the voting and profit rights (carried by the shares in the workers’ portion) are split off and assigned as personal rights to the workers’ role, while the book value of the worker shares is allocated between the capital accounts (individual, sus­pense, and collective accounts).

A worker’s account would be paid out in the regular rollover payouts (assuming the rollover plan is used) with the remainder paid out after termination or retirement. There are several ways to consider the payouts on the capital accounts when the firm is a hybrid instead of 100 per cent worker-owned. If a cash payout, in accordance with the rollover plan or upon termination, is from general funds of the company (and there is no proportional payout to the external shareholders), then worker shares with book value equal to the payout should be retired to the company treasury. Alternatively, if there was a cash dividend on all shares, then the worker portion of the dividend could be credited to the accounts according to current labor and then used to rollover the oldest account entries or to pay out terminated accounts. In that case, there would be no need to retire an equal amount of shares since the external shareholders received their proportional part of the dividend payout.

The ESOP Transactions with an Internal ESOP

The “Leveraged ESOP” Transaction

Consider a hybrid firm that starts off entirely or almost entirely government owned. Then a loan is channeled through the workers’ portion of the equity as an “internal ESOP” in order to increase the workers’ share of the company.

Let us suppose $300,000 is borrowed by the firm from a bank. There were previously 660 shares, 640 held by the government, 20 held by the workers, and the share book value was $1,000 each. With the loan channeled through the workers’ portion of the equity, 300 (= 300,000/1,000) new shares are issued to the workers’ portion of the ownership so the workers then have 320/960 or 33 per cent of the owner­ship. However, the share value is allocated to the suspense account.

Each loan payment is divided into a principal and interest portion. In many countries such as the United States, the interest portion is already an expense deductible from taxable corporate income. The principal portion is to be treated as a labor expense so that it would also be deductible as an expense from taxable corporate income. This procedure would need to be approved by the relevant tax authorities—as it has been approved in the United States.

A value amount equal to the principal payment is allocated from the suspense account to the individual accounts to be divided between them in accordance with labor. It is as if each principal payment is paid out to the workers as a bonus and then immediately reinvested in worker equity, and the money is then paid to the bank as the principal payment. In this manner, the hybrid firm internally mimics the leveraged ESOP transaction.

It should be remembered that changes in the worker accounts resulting from retained profits or losses are also taking place at the end of the fiscal year in addition to the credits relating to the principal payments. Those year-end profits or losses of the firm are computed with the principal payments treated as a labor expense.

When the loan is paid off, the principal amount of the loan will have been allocated between the individual accounts. The financial reward to the whole company for channeling the loan through the “internal ESOP,” the workers’ portion of owner­ship, is that the principal pay­ments on the loan were deducted from taxable income. The increased worker ownership should also reap other rewards through the greater motivation and productivity of the workers.

The “Leveraged ESOP” Buyout Transaction

In the previously described leveraged internal ESOP trans­actions, the loan money went to the company, and the worker shares were newly issued and valued at book value. An alternative leveraged transaction is to use the loan proceeds to buy externally held shares for the workers’ portion of the ownership.

The bank or financial institution loans money to the com­pany. The cash is passed through the company and used to buy back externally held shares from the government authority or other party holding the shares. However, instead of inter­preting this as a share redemption (which would retire the shares to the corporate treasury), it is viewed as the workers collectively buying the shares from the external owners. Hence those shares enter the workers’ portion of the ownership instead of the corporate treasury, and the workers would determine how those share votes are to be cast.

The Simplified Internal ESOP

It is also possible to have a simplified internal ESOP which removes some of the complications in favor of a minimal structure. The simplified internal ESOP is more appropriate for companies with all or substantially all of the ownership in the ESOP so that there is little point to differentiate between a loan channeled through the ESOP and a direct loan to the company. That allows considerable simplification in the ESOP structure. The suspense account, the loan-balance account, and the notion of special ESOP contribution (as opposed to an ordinary loan payment) can be eliminated.

What is left? With no special tax breaks (the typical situation when an “ESOP” is implemented on a firm-by-firm basis in a country with joint stock company law) and no special notion of an ESOP loan, what is left of the original ESOP idea? The basic idea of a manager/employee leveraged buyout is still there; indeed the insiders have substantially all the ownership. The trust aspect is also still there. The employee shares may not be freely sold, and the company will supply the market for repurchasing the shares. Thus the ownership is controlled as in a shareholders’ agreement in a closely-held company. In particular, it is controlled in order to maintain the correlation between ownership and working in the company.

Since there is no distribution of shares from the suspense account into the individual share accounts (there being no suspense account), all the more emphasis is put on the employees’ initial purchase of shares. The ESOP would impose a maximum number of shares that could be purchased by each employee where the maximum was proportional to salary (that is, a certain number of shares for each $100 of monthly salary). The ESOP might also impose a minimum purchase specified as so many month’s salaries. Employees who would not make the minimum purchase (even when offered installment payments out of salary) could either be terminated (hard version) or left unprotected when layoffs have to be made (soft version). Some distinction is usually necessary between existing employees at the time of buyout and new hires. The existing employees might be “grandfathered” into the ESOP while the minimum purchase of shares is made a condition of employment for new employees.

In the full featured internal ESOP, the periodic repurchase or rollover plan is designed to smooth out the liability to repurchase older worker shares instead of allowing it to build up and be triggered by termination or retirement. When the shares are repurchased with ESOP contributions in the periodic repurchase plan, the shares are redistributed to the current employees. But in the simplified ESOP, employees only get shares by purchasing them. There is no automatic redistribution of repurchased shares.

In the simplified ESOP, the functional equivalent of the periodic repurchase plan can be obtained by an appropriate dividend policy. There is little or no leakage of dividends to non-employees since we have assumed that all or substantially all the ownership is in the ESOP. Shares will only be repurchased upon termination or retirement but the dividends will keep share value down. The equivalent of the (say) five year wait for shares to be repurchased under the periodic repurchase plan could be obtained by declaring dividends in five year notes.

Implementation Questions

How can the hybrid democratic firm be imple­mented? There are questions involving both corporate struc­ture and tax benefits. The corporate structure of the hybrid democratic firm should at best be implemented by additions to existing corporate statutes authorizing the creation of the "workers’ portion" of the equity of a company. Legislation should be preceded by experimentation. The structure could be experi­mentally implemented (without legislation) in an enterprise by appropriately drafting the charter and by-laws of the enter­prise and obtaining the agreement of the present owners and the Workers’ Assembly. These could be developed as simple amendments to existing charters and by-laws to add the workers’ portion of equity onto an existing joint stock com­pany. After the development of a model sea­soned by experi­ence in a particular country, appropri­ate legis­lation can be drafted and passed.

The tax benefits of the "internal ESOP" transactions would require authorization from the tax authorities. This requires both allowing the principal payments on loans channeled through the workers’ portion of equity to be deducted as labor expenses and deferring any personal income tax incidence for the workers until the capital accounts are paid out.

There are reasonable arguments for both tax benefits as well as the strong American precedent. It is as if the principal payment was paid out as a deductible labor bonus and then immediately rolled over into equity shares in the company (the equity injection then being used to pay off the loan). Or one could think of the company as making the principal payment directly to the bank and simultaneously issuing an equal (book value) amount of shares to the workers’ portion of the equity as a deductible stock bonus. In either case, it should be a de­ductible labor expense to the firm. The workers have no in­crease in their disposable income so it is reasonable to defer personal taxation until the capital accounts are paid out.

ESOPs use American trust law. Trust law tends to be quite different, idiosyncratic, or non-existent in other countries. Rather than have the costly and bulky apparatus of the external ESOP trust as in current American law, the internal or workers’ portion of the equity should be a normal part of every company—with the workers’ percentage of ownership varying from the beginning of 0 percent up to 100 percent. Alternatively, a country could draft laws to create the machinery of trusts and then the machinery for the external ESOP trust.

Whether or not an external trust is used, it is key that the ESOP hold the shares in trust so that the workers cannot individually sell the shares. Each worker would like to have the benefits of working in a democratic firm and also have the cash from selling his or her shares (assuming everyone else does not do the same). But if everyone did likewise, the firm would no longer be a democratic firm. Hence there needs to be a collective decision to structure a firm in a democratic fashion, and thereafter individuals cannot sell their shares and remain in the company—anymore than citizens can sell their voting rights.

Management and Governance Structures

We turn now to some structural aspects of manage­ment (top-down use of delegated authority) and governance (bottom-up delegation of authority) in a democratic firm (hybrid or 100 per cent).

The usual governance structure in a corporation is for the shareholders to elect the board of directors, and then for the board to appoint the general manager and possibly other members of the top management team. Top management then appoints the middle managers who, in turn, select the low-level managers or foremen at the shop floor level. In a hybrid democratic firm, the workers should elect a portion of the board at least equal to their portion of the ownership.

Even in a majority or 100 per cent worker-owned company, it is not appropriate for workers to directly elect shopfloor managers. Those managers would then be in an intolerable position between middle management and the workers. They would have to “serve two masters”—to carry out the orders and management plans from above while at the same time being answerable to the workers who elect them.

Worker-owners also should not have the right to countermand management orders at the shopfloor level (except in the case of direct physical endangerment). There must be channels for workers to use to register their com­plaints. These could take two forms: (1) disagreements over policy questions or (2) grievances against managers or other workers for allegedly breaking enterprise rules.

For the workers to intelligently use their ultimate control rights (e.g. votes to elect representatives to the board or to vote on other issues put to the shareholders), they must have a flow of information about the company operations. In particular, worker representatives need timely information in order to have an input in management decisions. There should be a number of forums where information can be communicated, questions can be asked of management, and disagreements can be expressed.

There is the annual meeting of the Workers’ Assembly but that can only deal with the larger issues of overall policy. There should be frequent shop meetings (weekly, bi-weekly, or at least monthly). It is important that at least part of each meeting is not chaired by the shop foreman or any other representative of management. There should be another non-managerial elected shop or office representative such as a “shop steward.” In part of the shop meetings, the shop steward should preside, disagreements should be voiced in a respectful manner (perhaps by the steward) without fear of recrimina­tions, and the shop managers should have to explain actions and decisions which are called into question.

Another forum for communication and discussions could be the company newsletter or newspaper. Ordinarily, this would be controlled by management. But there should be a column given over to the shop stewards who collectively want to bring an issue before the company as a whole. There could also be letters to the editor, questions to managers with their answers, and brief interviews with randomly selected workers on the topics of current interest.

There should also be a grievance procedure for workers who feel they have been wronged by managers in terms of the company rules, regulations, and policies. The shop steward would function as the spokesperson for the worker with the grievance (who may otherwise be intimi­dated by the whole procedure). The political doctrine of “separation of powers” argues that abuses of power are best held in check if there is some separation of powers and authority between the different branches of government such as the legislative, executive, and judicial branches. The board of directors is the legislative branch and the manage­ment team is the executive branch in a company. A separate judicial branch would be an elected grievance committee that would function as the court of last appeal in the grievance procedure. However, since the grievance committee would be elected by the shareholders, the board of directors could also play that role as the court of last appeal. That would involve some loss in the separation of powers, but it is hard to imagine a grievance committee having much autonomy if the board and management are already in agreement on an issue. If the workers were convinced that major injustices or abuses had occurred with the concurrence of their board representatives and if the workers could not wait until the annual meeting of the Workers’ Assembly, then they should use a recall procedure to change their representatives on the board of directors.

One general principle in any democratic organization is that those who are not in direct positions of power should have the organizational ability to voice and discuss their concerns. This is the idea of the “loyal opposition” (see Ellerman, 1988b discussing the inside role of a union as the loyal opposition in a democratic firm). “Opposition” is not always the right word since the idea is not to always oppose current management but to have enough independence so that opposition could be voiced whenever deemed necessary. That, for example, is why there should be some worker-elected representatives, herein called “shop stewards,” who are not part of management’s line of command, and that is why the shop stewards should chair at least part of the shop meetings. The need for some such loyal oppositional structure is obvious when workers only have a minority ownership position in a hybrid firm, but it is also needed when workers have majority or 100 per cent of the ownership. Periodic election of directors is often insufficient to keep management accountable so the watchdog role of the oppositional structure is still needed in the majority worker-owned company.

The American ESOP is a separate external trust with its own governing committee. It sometimes has its own decisions to make—independent of company decisions. For example, the ESOP might accumulate contributed funds and use them to buy back the shares of departing workers. In the simplified hybrid structure recommended here, the ESOP is internalized as part of the company so there is no separate trust with its governing committee. Nevertheless, there will be some “ESOP decisions” that are decisions of the collectiv­ity of workers, not decisions of the board or management of the hybrid firm. The suggested structure is that the worker representatives on the board form the subcommittee to function as the “internal ESOP” governing committee. They would decide, for example, whether divi­dends would be passed through to current workers, or whether the accounts would be credited and the cash paid out to rollover the old­est account entries.

An important program in a hybrid democratic firm is the internal education program [see Adams and Hansen, 1987]. The whole idea of being part of a democratic decision-making organization might be new to the workers. The workers might be accustomed to taking orders from an authority figure. The workers have stepped out of their sub­ordinate “employee” role to become worker-owners in a horizontally interdependent organization. They have a whole new set of rights, responsi­bilities, and concerns. They need to develop skills for discussion and participation in meetings, to learn something about the business side of the enterprise, and to read simplified financial statements and capital account summaries.

Responsibility should be pushed down to the lowest feasible level through worker participation and quality-of-working-life (QWL) programs. Worker owner­ship creates the possi­bility of substantial increases in moti­vation and produc­tivity, but it is not automatic. Ownership must be realized at the shopfloor level through worker participa­tion in order to deliver the maximum effect on productivity.

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