Rescuing and resetting the UK economy after COVID-19 via debt-to-equity swaps
Dr Jonathan Preminger from Cardiff Business School and Dr Guy Major from Cardiff University’s School of Biosciences tackle the problem of loans and debt finance facing organisations when the UK emerges from the COVID-19 pandemic.
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Government-backed loans and 80% wage grants may ease many companies through COVID-19. But there are two fundamental problems with loans and other kinds of debt finance, which will become increasingly apparent as companies emerge from the crisis: First, most obviously and seriously, loans have to be repaid. Second, the interest payments are a fixed burden, which does not take into account the financial success or difficulties of the company going forward.
To stop large numbers of firms going bust, what the economy could do with now is an injection of explicitly risk-sharing, non-repayable financing: equity investment, i.e. share capital, with variable dividends depending on success. But many firms may be reluctant to cede control of their businesses to external holders of traditional voting shares. And potential investors will be wary of risky investing without the protection provided by some kind of control.
This risk/control dilemma has long been faced by worker co-operatives and employee-owned companies, whose growth can be restricted – or even fail – due to under-investment. However, a viable solution to this dilemma is available which could now be applied to the wider economy as it emerges from the pandemic.
We argue that all companies should be given the option to swap government-backed debt for initially government-held, tradeable equity shares. This could be combined with other complementary forms of debt relief and risk-sharing, such as temporarily accepting a higher rate of corporation tax in exchange for part of the debt being written off.
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’ and workers’ 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’s value-added (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.
How would it work? The firm’s value-added would be split into a number of ‘slices’. Each worker gets a pre-agreed number of slices, effectively their variable pay, and each share gets one slice as its dividend. Workers would have an incentive to increase profit, thus increasing their variable pay, but in doing this, they would also be maximising earnings per share, and would thus automatically work in the interests of investors as well (see Figure 1 and Appendix for details).
Figure 1: Value-added (surplus) sharing scheme.
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 £’s of total variable pay there would have been, running the scheme retrospectively with last year’s numbers, divided by the number of full-time equivalent workers, W.
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 and participation in management (thus improving working conditions and job satisfaction), one can both protect jobs and improve the performance and prospects of companies.
In the uncertain times ahead, it will be unacceptable to keep most workers’ wages fixed at reduced levels but allow owners/directors to reward themselves additional pay and perks unrelated to performance. Senior executives would have to have their remuneration pegged to performance in the same way as workers’ wages. This would also work to protect external investors’ interests.
A great many companies will need all the help and risk-sharing they can get 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.
External investors may be wary of company directors taking bad decisions, although most founder-entrepreneurs know their own businesses and sectors far better than most ‘generalist’ investors. Bad-decision risk can be mitigated by giving investors ‘voice’ rights (feeding in expertise, advice and suggestions), but without normal voting rights. Voting rights could, however, kick in, temporarily at least, after a period of sustained losses, to help get a firm back on track.
A step towards a fundamental reset of the economy
It will take time to convert firms to value-added (surplus) sharing. A viable path would be to add debt-to-equity conversion – including value-added sharing to protect investors – as a flexible medium-term exit strategy from government-backed Corona-loan schemes. This will give firms more survival and growth options as the time approaches to pay back their loans, including much-needed risk-sharing.
Surplus-sharing shares would have prescribed standard form rights including that they are tradeable, which would also give investors themselves – initially banks and the government – a natural exit strategy: they could sell their shares to other investors via secondary markets, which the government could help set up and facilitate. It would be better if such sales were staggered, to avoid massive discounts. The current control structure of the companies concerned, including any benefits from employee ownership and workplace democratisation, would not be undermined or diluted by ‘vulture capitalists’, as surplus-sharing shares are normally non-voting: ownership is separated from control, while investors are protected via the explicit value-added sharing formula. Firms or federations of firms may choose to organise their own secondary share markets, perhaps via trusts, which could allow potential share buyers to be vetted: an additional firewall against corporate predators in the event that emergency voting rights were triggered.
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.
In short, debt-to-equity swaps as firms emerge from this crisis could constitute an important part of a much-needed fundamental reset of our economy – a silver lining for the current cloud.
Dr Jonathan Preminger is Lecturer in Work and Labour Relations at Cardiff Business School.
Dr Guy Major is a Senior Lecturer in the School of Biosciences at Cardiff University.
Thanks to Fieldfisher partner Graeme Nuttall OBE for his comments on a previous draft.
This article was originally published on the Cardiff Business School blog.