{"id":2025,"date":"2020-05-06T10:08:19","date_gmt":"2020-05-06T09:08:19","guid":{"rendered":"http:\/\/blogs.cardiff.ac.uk\/business-school\/?p=2025"},"modified":"2020-05-27T15:51:23","modified_gmt":"2020-05-27T14:51:23","slug":"rescuing-and-resetting-the-uk-economy-after-covid-19-via-debt-to-equity-swaps","status":"publish","type":"post","link":"https:\/\/blogs.cardiff.ac.uk\/business-school\/rescuing-and-resetting-the-uk-economy-after-covid-19-via-debt-to-equity-swaps\/","title":{"rendered":"Rescuing and resetting the UK economy after COVID-19 via debt-to-equity swaps"},"content":{"rendered":"\n
\"\"<\/figure>\n\n\n\n

In our latest post, Dr Jonathan Preminger from Cardiff Business School, Dr Guy Major from Cardiff University\u2019s School of Biosciences and Jenny Rathbone Welsh Labour Member of the Senedd for Cardiff Central tackle the problem of loans and debt finance facing organisations when the UK emerges from the COVID-19 pandemic.<\/h3>\n\n\n\n

The problem<\/h3>\n\n\n\n

Government-backed loans and 80% wage grants\nmay ease many companies through COVID-19. But there are two fundamental\nproblems with loans and other kinds of debt finance, which will become increasingly\napparent as companies emerge from the crisis: First, most obviously and\nseriously, loans have to be repaid. Second, the interest payments are a fixed\nburden, which does not take into account the financial success or difficulties\nof the company going forward.<\/p>\n\n\n\n

To stop large numbers of firms going bust,\nwhat the economy could do with now is an injection of explicitly risk-sharing<\/em>, non-repayable<\/em> financing: equity\n<\/em>investment, i.e. share capital, with variable<\/em>\ndividends depending on success. But many firms may be reluctant to cede control\nof their businesses to external holders of traditional voting shares. And potential\ninvestors will be wary of risky investing without the protection provided by\nsome kind of control.<\/p>\n\n\n\n

This risk\/control dilemma has long been\nfaced by worker co-operatives and employee-owned companies, whose growth can be\nrestricted \u2013 or even fail \u2013 due to under-investment. However, a viable solution\nto this dilemma is available which could now be applied to the wider economy as\nit emerges from the pandemic.<\/p>\n\n\n\n

The solution<\/h3>\n\n\n\n

We argue that all companies should be given\nthe option to swap government-backed debt for initially government-held, tradeable\nequity shares. This could be combined with other complementary forms of debt\nrelief and risk-sharing, such as temporarily accepting a higher rate of\ncorporation tax in exchange for part of the debt being written off.<\/p>\n\n\n\n

How could debt-to-equity swaps benefit the range of different stakeholders? We propose a mechanism that locks together the interests of current owners, workers and investors (including the government), leaving control of the firm in the current owners\u2019 and workers\u2019 hands yet avoiding the risk of wages being raised at the expense of dividends to investors. In essence, this is a pre-agreed formula to split the firm\u2019s value-added<\/em> (sales minus non-labour costs, also equal to wages + profits) between workers\/directors and investors\/owners. This means a significant component of wages would be variable, and workers would share in the success (or otherwise) of their firm. But their jobs, hence livelihoods, would be far safer than if their wages were fixed.<\/p>\n\n\n\n

How would it work? The firm\u2019s value-added would\nbe split into a number of \u2018slices\u2019. Each worker gets a pre-agreed number of\nslices, effectively their variable pay, and each share gets one slice as its\ndividend. Workers would have an incentive to increase profit, thus increasing\ntheir variable pay, but in doing this, they would also be maximising earnings\nper share, and would thus automatically work in the interests of investors as\nwell (see Figure 1 and Appendix for details). <\/p>\n\n\n\n

Figure 1: Value-added (surplus) sharing scheme.<\/h3>\n\n\n\n
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An illustration of a version of the debt-to-equity swap value-added sharing scheme, which is further explained in the Appendix. The average number of slices per worker, k, is the number of \u00a3\u2019s of total variable pay there would have been, running the scheme retrospectively with last year\u2019s numbers, divided by the number of full-time equivalent workers, W. <\/figcaption><\/figure><\/div>\n\n\n\n

In exchange for more volatile or temporarily lower pay, employees could also be offered shares and, perhaps, more say in running the firm. According to a growing research literature, the combination of profit-sharing, employee shares and workplace democratisation is mutually reinforcing and highly effective at incentivising workers to innovate and improve productivity. So, by accepting variable pay, and sweetening it with a degree of employee ownership [1]<\/a> and participation in management (thus improving working conditions and job satisfaction), one can both protect jobs and improve the performance and prospects of companies. <\/p>\n\n\n\n

In the uncertain times ahead, it will be\nunacceptable to keep most workers\u2019 wages fixed at reduced levels but allow owners\/directors\nto reward themselves additional pay and perks unrelated to performance. Senior\nexecutives would have to have their remuneration pegged to performance in the\nsame way as workers\u2019 wages. This would also work to protect external investors\u2019\ninterests. <\/p>\n\n\n\n

A great many companies will need all the help and risk-sharing they can get <\/em>to have any realistic prospect of making it through this crisis. The substantial benefits of profit-sharing, employee ownership and workplace democratisation, coupled with external equity investment, could play a major role in maximising those survival chances.<\/p>\n\n\n\n

External investors may be wary of company\ndirectors taking bad decisions, although most founder-entrepreneurs know their\nown businesses and sectors far better than most \u2018generalist\u2019 investors.\nBad-decision risk can be mitigated by giving investors \u2018voice\u2019 rights (feeding\nin expertise, advice and suggestions), but without normal voting rights. Voting\nrights could, however, kick in, temporarily at least, after a period of\nsustained losses, to help get a firm back on track.<\/p>\n\n\n\n

A step towards a fundamental reset of the economy<\/h3>\n\n\n\n

It will take time to convert firms to\nvalue-added (surplus) sharing. A viable path would be to add debt-to-equity\nconversion – including value-added sharing to protect investors – as a flexible\nmedium-term exit strategy from government-backed Corona-loan schemes. This will\ngive firms more survival and growth options as the time approaches to pay back\ntheir loans, including much-needed risk-sharing. <\/p>\n\n\n\n

Surplus-sharing shares would have\nprescribed standard form rights including that they are tradeable, which would\nalso give investors themselves \u2013 initially banks and the government \u2013 a natural\nexit strategy: they could sell their shares to other investors via secondary\nmarkets, which the government could help set up and facilitate. It would be\nbetter if such sales were staggered, to avoid massive discounts. The current\ncontrol structure of the companies concerned, including any benefits from\nemployee ownership and workplace democratisation, would not be undermined or\ndiluted by \u2018vulture capitalists\u2019, as surplus-sharing shares are normally\nnon-voting: ownership is separated from control, while investors are protected via\nthe explicit value-added sharing formula. Firms or federations of firms may\nchoose to organise their own secondary share markets, perhaps via trusts, which\ncould allow potential share buyers to be vetted: an additional firewall against\ncorporate predators in the event that emergency voting rights were triggered.<\/p>\n\n\n\n

Persuasive working examples, tax breaks and affordable conversion experts (perhaps subsidised by the government) would help get the scheme off the ground. But the net result could be a game-changer: a massive increase in employee ownership, workplace democratisation, innovation and productivity, and tradeable non-voting external equity investment in small and medium businesses, bringing together a more optimal mix of capital, labour, good ideas and entrepreneurship, with fairer pay differentials and better-incentivised workforces, for the benefit of all. <\/p>\n\n\n\n

In short, debt-to-equity swaps as firms\nemerge from this crisis could constitute an important part of a much-needed\nfundamental reset of our economy \u2013 a silver lining for the current cloud.<\/p>\n\n\n\n

Dr Jonathan Preminger<\/strong><\/a> is Lecturer in Work and Labour Relations\nat Cardiff Business School.<\/strong><\/p>\n\n\n\n

Dr Guy Major<\/strong><\/a>\u00a0is a Senior Lecturer in the School of Biosciences at Cardiff University.<\/strong><\/p>\n\n\n\n

Jenny Rathbone<\/strong><\/a> is a Labour and Co-operative politician, who was elected as a Member of the Senedd for Cardiff Central in 2011. <\/strong><\/p>\n\n\n\n

Thanks to Fieldfisher partner Graeme\nNuttall OBE for his comments on a previous draft.<\/em><\/p>\n\n\n\n

Appendix: the details<\/h4>\n\n\n\n

a) The workable value-added sharing formula we propose, developed from an idea originally put forward by Professor Roger McCain of Drexel University, is as follows: Pay all workers a pre-agreed fixed \u2018base\u2019 pay. This may differ between workers, but the average per worker has to be pre-agreed and each worker’s base pay must be at or above the national minimum wage. Many workers have had to accept 20% salary reductions under the Coronavirus Job Retention Scheme or otherwise as a COVID-19 cost-saving measure and this could provide a benchmark for setting the new level of base pay.<\/p>\n\n\n\n

b) Calculate the \u2018surplus\u2019 remaining when total base pay costs (including all National Insurance contributions [NI]) are deducted from value-added.<\/p>\n\n\n\n

c) Divide the surplus (if positive) into equal \u2018slices\u2019, with one slice per share, and a pre-agreed number of slices (k) per average full-time equivalent (FTE) worker. Put simply, for the purpose of splitting the surplus, the average (FTE) worker is made equivalent to an agreed number of \u2018virtual\u2019 shares.<\/em> This is the central idea of the scheme, the main way equity investors are protected and workers incentivised.<\/p>\n\n\n\n

d) The number of slices can vary from one worker to another, as long as the average <\/em>slices per FTE worker is \u2018pegged\u2019 to the agreed k. Subject to this constraint, each worker\u2019s personal quota of slices could be chosen to keep their pay \u2013 now variable \u2013  close to when it was last fixed.<\/p>\n\n\n\n

e) The pre-tax profit per share is then (surplus\/total slices), and the average variable component of pay per worker is k x (surplus\/total slices). This includes all NI on that pay. Likewise, each individual worker\u2019s variable pay (including all NI) is their particular quota of slices x (surplus\/total slices).<\/p>\n\n\n\n

f) This scheme automatically allows optimal surplus sharing when the number of workers changes, or more capital is invested, without producing \u2018perverse\u2019 incentives as can occur in cruder schemes, such as those allocating fixed fractions of surplus to workers and\/or shares (see article cited at the end).<\/p>\n\n\n\n

g) Workers can be paid a monthly advance on their predicted annual variable pay component (their \u2018cut\u2019 of the predicted surplus), depending on the firm\u2019s predicted and actual income and outgoings to date. It would be prudent to allow a margin of error for unanticipated shortfalls (to avoid asking workers to pay back part of their advance).<\/p>\n\n\n\n

h) Up to a maximum pre-agreed \u2018reinvestment fraction\u2019 (say 1\/3) of any post-tax profit is then reinvested to boost working capital and fund new equipment, etc. The balance is paid out as dividends.<\/p>\n\n\n\n

i) Further reinvestment, if needed, can be achieved by part-paying dividends or variable pay using new shares, issued at a fair price, instead of cash \u2013 with the consent of recipients. <\/p>\n\n\n\n

j) Shares could be priced by an independent valuer, or by a pre-agreed standard formula such as the present discounted value = (projected dividend)\/(target rate of return), where the target rate of return is also pre-agreed, typically in the range 5 – 15%, depending on the riskiness, volatility and projected growth of the dividends. To keep things simple, one could use the interest rate on the company\u2019s government-backed loan as a guideline rate of return. If 7% were used, which is close to the average historical long-run rate of return on equity capital, then the share price would be (projected dividend per share)\/0.07 or about 14 x (projected dividend per share).<\/p>\n\n\n\n

The scheme could be set up initially as follows:<\/p>\n\n\n\n

  1. Calculate the pre-tax profit (P) and the total wage bill (including directors\u2019 pay and all NI) over the last year (could use median of last 3 years). <\/li>
  2. Add total wage bill to pre-tax profit, to obtain the value-added. <\/li>
  3. Subtract total agreed \u2018base\u2019 pay (including all NI), to get last year\u2019s notional surplus, had the scheme been running last year. <\/li>
  4. Set the total number of slices equal to the number of \u00a3\u2019s of notional surplus (\u00a31 per slice, i.e. each slice \u2018gets\u2019 \u00a31 of the surplus, to keep the numbers easy). <\/li>
  5. Suppose the number of FTE workers is W. Set the total number of worker slices (kW) equal to the (total wage bill minus total base pay) in \u00a3\u2019s (i.e. total variable<\/em> part of pay, had the scheme been running last year).<\/li>
  6. Set the total number of share slices (n1<\/sub> in Figure 1) to be the total pre-tax profit P in \u00a3\u2019s.<\/li>
  7. Thus, the total number of slices is the total notional surplus in \u00a3\u2019s, also equal to kW + P i.e. kW + n1<\/sub>. <\/li>
  8. Re-allocate the existing share capital of the company into P (i.e. n1<\/sub>) shares, so each gets one slice (i.e. \u00a31, with last year\u2019s numbers) of pre-tax profit (although no money is paid to the holder just yet). <\/li>
  9. The number of surplus slices per average FTE worker, k, is calculated as (total no. of worker slices)\/(no. of FTE workers), i.e. kW\/W. This slices-per-worker (k) is now locked into the scheme, as the principal means of protecting external equity investors. It can, if necessary, be renegotiated in the future.<\/li>
  10. Value the shares by an agreed method (see above). <\/li>
  11. If a debt-to-equity swap is needed, exchange debt for shares at that price. For example, ignoring taxes for illustrative purposes, if each share initially \u2018gets\u2019 \u00a31 of pre-tax profit (with last year\u2019s numbers, as outlined above), then each tranche of loan earning \u00a31 of interest could be turned into one additional share (giving a total of n2<\/sub> extra shares, as shown in Figure 1 above, where n2<\/sub> is the total number of \u00a3\u2019s of loan interest). Continuing with the 7% interest rate example, that is equivalent to a debt-to-share conversion price of \u00a31\/7% = \u00a31\/0.07 = \u00a314 roughly. So, at a 7% interest rate, every \u00a314 of loan, roughly, is converted into one share, as \u00a314 x 7% = \u00a31 interest (now potential dividend), near enough. (To account for 20% corporation tax[2]<\/a> on profits, and the fact that loan interest is not subject to this<\/em> company\u2019s corporation tax – it is deducted from profits beforehand – it might be fairer\/more tax-neutral to convert every tranche of loan earning 80p interest into one share, since \u00a31 pre-tax profit x 0.8 = \u00a30.8 post-tax profit, which is what each share actually ends up with. So that would be one share swapped for every \u00a30.8\/0.07 = \u00a311.40 of loan; \u00a311.40 x 7% = 80p).<\/li>
  12. The debt no longer has to be paid back. The new shares could be redeemable, at the company’s option, at a fair price as discussed above, after a set number of years to provide an exit mechanism for companies.<\/li>
  13. Instead of a fixed interest burden, the new shares pay a dividend according to the pre-agreed value-added sharing formula outlined above: higher in good years, none in bad years.<\/li>
  14. Some changes in law would be needed, for instance, to ensure shares issued under this scheme would not prejudice the controlling interest requirement applicable to an employee ownership trust, which otherwise requires, in particular, that the trustee of such a trust holds more than 50% of a company’s ordinary share capital and is entitled to more than 50% of the profits available for distribution.[3]<\/a><\/li><\/ol>\n\n\n\n

    Further background, details, references, diagrams and worked examples can be found in a peer-reviewed article, Major G. and Preminger J. (2019) \u201cOvercoming the capital investment hurdle in worker-controlled firms<\/a>\u201d, Journal  of Employee Ownership and Participation, <\/em>Vol. 2 (No. 2), pp. 133-150 (open access).<\/p>\n\n\n\n

    \n\n\n\n

    [1]<\/a> Well-known, successful examples of employee-owned (EO) firms\ninclude John Lewis + Waitrose, Riverford Organic Farmers, Aardman (makers of\nWallace and Gromit), Richer Sounds (hi-fi), Dulas (green energy, in Machynlleth), Aber Instruments (brewing + biotech, in Aberystwyth), Lush (10%\nEO) and Mooncup. There are around 370 (with at least 25% EO) employee-owned\nfirms in the UK, accounting for \u00a330bn of the economy (see employeeownership.co.uk<\/a>), together with a considerable number\nof worker co-ops (e.g. see wales.coop<\/a>).<\/p>\n\n\n\n

    [2]<\/a> Near enough the current rate of 19% for many companies: we keep the\nnumbers simple for illustrative purposes.<\/p>\n\n\n\n

    [3]<\/a> See: “Neat \u2013 Graeme Nuttall OBE sees employee ownership trust as the perfect succession solution<\/a>” (Sept 2014) Trusts & Estates Law & Tax Journal<\/em>.<\/p>\n","protected":false},"excerpt":{"rendered":"In our latest post, Dr Jonathan Preminger from Cardiff Business School, Dr Guy Major from Cardiff University\u2019s School of Biosciences and Jenny Rathbone Welsh Labour Member of the Senedd for […]","protected":false},"author":1654,"featured_media":2028,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_feature_clip_id":0,"_jetpack_memberships_contains_paid_content":false,"footnotes":"","jetpack_post_was_ever_published":false},"categories":[1431],"tags":[449,28,100,1429,1312,701,1313,1161,1427,115,1432,1433,121,1163,244,222,37,411,1425,128,642,1316,109,1419,980,1428,1436,1435,1426,32,1434],"class_list":["post-2025","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-covid-19","tag-capital","tag-cardiff-business-school","tag-cardiff-university","tag-co-operatives","tag-coronavirus","tag-corporate","tag-covid-19","tag-debt","tag-dividends","tag-economy","tag-employee-ownership","tag-employee-participation","tag-entrepreneurship","tag-equity","tag-finance","tag-government","tag-innovation","tag-investment","tag-loans","tag-management","tag-ownership","tag-pandemic","tag-productivity","tag-risk","tag-school-of-biosciences","tag-shares","tag-tax-breaks","tag-vulture-capitalists","tag-wages","tag-workers","tag-workplace-democratisation"],"jetpack_sharing_enabled":true,"jetpack_shortlink":"https:\/\/wp.me\/paOfaS-wF","meta_box":[],"jetpack_featured_media_url":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-content\/uploads\/sites\/620\/2020\/05\/Coronavirus-debt-finance.jpg","_links":{"self":[{"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/posts\/2025","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/users\/1654"}],"replies":[{"embeddable":true,"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/comments?post=2025"}],"version-history":[{"count":4,"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/posts\/2025\/revisions"}],"predecessor-version":[{"id":2060,"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/posts\/2025\/revisions\/2060"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/media\/2028"}],"wp:attachment":[{"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/media?parent=2025"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/categories?post=2025"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/blogs.cardiff.ac.uk\/business-school\/wp-json\/wp\/v2\/tags?post=2025"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}