Interest in employee ownership is rising, in part due to the positive benefits that these firms have both in terms of firm productivity and for workers, such as impressive effects on asset building for workers of color and reducing the racial wealth gap, and for their potential to preserve quality jobs even as the nature of work changes. For example, the Institute for the Study of Employee Ownership and Profit Sharing at Rutgers University recently found that people of color in ESOPs frequently built up considerable wealth in their ownership accounts, often above $100,000, even for workers of color with low-to-moderate annual incomes (median wealth for Black women workers was lower at $32,000, but all other groups were above $140,000). By contrast, the median wealth (net worth) of a black household in the US is, according to 2016 Federal Reserve data, a paltry $3,400. (Latinx households have median wealth of $6,300.)
There is an enormous opportunity to expand the number of individuals who benefit from employee ownership. As NPQ noted two years ago, citing data from the Oakland-based nonprofit Project Equity, “Baby boomers own 2.34 million businesses, employ 24.7 million people, and have combined annual sales of $5.14 trillion.” It is estimated that 80 percent of these businesses lack a succession plan. When these owners retire, one of the best ways to preserve these jobs is to sell their companies to their employees. But too often this option is ignored, and every year many people needlessly lose their jobs as a result.
Business Succession, Private-Equity Style
What happens when advance business succession planning doesn’t occur? One route that often takes place when an owner retires is for the firm to be sold to a competitor. Or, it gets bought out by a financial investor, typically a private equity (PE) fund, using a “leveraged buyout”—that is, a combination of the PE fund’s own investment money with a significant loan from an outside entity, such as a bank.
The PE fund, as new controlling owner of the company, retains firm ownership typically between three and eight years, during which time PE fund managers serve on the board and steer the company toward growth and improved profitability. Often, this process threatens workers’ wages and job security. A PE fund might break up the company to sell its parts or recombine them with other companies it owns, or relocate it, with a total loss of the local economic activity. The fund typically “exits” the investment—that is, gets its money back and realizes its profit—by selling the company to a strategic buyer, another PE fund, or by “going public” and selling stock.
The Employee Ownership Alternative
If the selling owner wants to keep the company in its community, converting the firm into an employee-owned firm is often a superior choice. One common mechanism is using an employee stock ownership plan, or ESOP. Most often, the workers do not have the money to buy the company outright, so the owner sells the company shares to a newly established ESOP trust, but instead of receiving the selling price in cash, the owner essentially extends a loan to the company for the purchase of the shares. This loan from the selling owner is repaid over time using the company’s own free cash.
This can work very well. NPQ recently wrote about Yankee Publishing, owner of Old Farmer’s Almanac, which started the conversion process this year. But it doesn’t work if the seller needs to cash out quickly. In this seller-financed model, the owner remains tethered to the company because of the financial stake that comes from having essentially lent the shares to the company. Full repayment to the selling owner can take up to ten years. Many retiring owners, not surprisingly, say, “Thanks, but no thanks.”
Can Private Equity Assist with ESOP Conversions?
It seems like a ridiculous idea. The logic of private equity is to maximize profit, often at the expense of workers. The logic of an ESOP is to generate value for the workers, who are also the owners. Why would you ever combine the two?
Yet it is possible to use the three-to-eight-year typical investment period of private equity to provide a bridge that solves this cashing-out bottleneck. The owner still sells to the ESOP, but the private equity investor acts as an intermediary purchaser, enabling the exiting owner to get paid now, and, then, as it exits, turning over its shares to the ESOP trust.
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The PE + ESOP model, in short, functions similarly to the seller financing model, except that an outside investor enables the selling owner to “cash out” immediately. The selling owner usually reinvests 20 percent of the share value into the company to help facilitate the conversion (as opposed to up to 100 percent in the seller financing model). During the life of the investment, the vehicle creates the conditions for successful employee ownership, from the creation of a culture of ownership to the establishment of the financial parameters for a transition of the equity to the workers. Over time, company profits help the ESOP trust pay back the investors, the small portion of reinvestment from the selling owner, and any third-party bank financing. There are currently at least four PE groups that have used ESOPs in their transactions: Long Point Capital, Mosaic Capital Partners, Endeavour Capital, and New State Capital Partners.
This model has major incentives for the selling owners, investors, and the new company worker-owners. The selling owner gets most of her payment up front, leaving transition management to the investor group, which stewards the transition to employee ownership. The main benefit is felt by the workers, who now have ownership accounts that accrue over time, serving as a retirement fund that they receive upon leaving the company. ESOPs are heavily tax advantaged under federal law, which makes the transaction appealing to both the selling owners and investors.
There are risks, however, given the misalignment between traditional PE and workers. How do you square this circle?
In a recent report published by our organization, Transform Finance, called Financing Conversions Through a Private Equity Fund Model, we seek to address this conundrum. A desire to maximize PE returns could lead to the over-indebtedness of the business, or reduced reinvestment for growth. To truly benefit workers, investors need to act as stewards of the company and its workers. This, we note, can be done while still obtaining a healthy and just profit for the investors, but care is required to avoid hurting the interests of workers.
To avoid replicating the extraction of the traditional PE leveraged buyout model and to protect the interests of the workers, we suggest the following measures:
- Ensuring long-term employee ownership: Famously, a little over a decade ago, Samuel Zell used an ESOP at the Chicago Tribune as part of a complicated financing mechanism, structured with warrants (which gave Zell the ability to buy cheaply should the company become profitable), so that he would share in the gains, but workers would absorb all losses. Ensuring long-term employee ownership requires two things: (1) provisions for the ESOP trustee (who is hired to manage the funds in the ESOP) to vote in alignment with workers’ preferences on core issues, such as sale or dissolution of the ESOP, and (2) a company financial standing that is solid enough so that they are not saddled with high debt levels when the PE Group exits the investment. In other words, no Samuel Zells.
- Centering people of color and low-wage workers: Countering the racial wealth gap via employee ownership transactions requires an intentional focus on pipeline building, deal selection, and employee training opportunities. This can be done in multiple ways: referral networks of entrepreneurs of color (as piloted by the Legacy Business Fund), geographic approaches (The Fund for Employee Ownership), and pipeline development in industries that combine a significant workforce of low-wage workers and people of color with sufficient profit margins for building wealth for those workers.
- Measured impact: PE + ESOP investors must develop and track a set of metrics to measure wealth building, tenure and mobility, benefits, demographics, and other key impact areas. At the fund level, measuring such factors allows for an evaluation of how the conversion financing is contributing to improvement on its thesis (such as focusing on a democratic workplace or wealth creation). It also provides an opportunity for the fund manager’s compensation to be tied to impact performance, rather than solely financial performance.
- Employee participation and power: To strengthen worker voice and employee participation, PE + ESOP conversions should favor democratic structures (which are not required in ESOP companies, but are permissible), where workers nominate and elect the board of directors, and proactively build a culture of ownership. This provides structural accountability of the management team to the workers, and results in long-term alignment of the management with a pro-worker mission. Developing such structures and culture includes creating culturally relevant, accessible tools for capacity building with workers. Helpfully in this context, the timeline of the investment under the PE + ESOP model matches well with the period required for developing a culture of ownership vis a vis technical assistance.
- Non-extractive deal structures: If the deal is structured so that investors reap most of the value created by the transaction, as is typical in the traditional PE context, it is hard to see how the share of value for the workers is meaningfully improved. To have an impact, PE + ESOP funds must add more financial value for the affected stakeholders (in this case, the workers) than they take out—a notion developed and popularized as “non-extractive finance” by The Working World. This can take the form, for example, of establishing ceilings for investor returns that are commensurate with the risk they assume, of not structuring collateral in ways that could leave workers worse off in case of default, and in ensuring that the financial benefits to workers are not overshadowed by those to capital providers. While an investor may associate these practices with lower returns, such measures also encourage workers to give their all, lowering the risk of the transaction. In the context of the historical imbalance of power between workers and investors, a well-structured transaction must avoid (1) taking on too much debt in order to maximize payment to the selling owner, (2) reducing benefits or wages as a result of the transaction, and (3) creating profitability at the expense of ensuring quality jobs for the workers, including, for example, threatening the workers’ union status.
Millions of jobs are at stake within businesses that currently lack succession plans. Cooperatives, ESOPs, and other employee ownership structures provide wealth building opportunities and quality jobs for workers, especially workers of color and low-income workers. PE investors, if they are willing to accept potentially lower return (but also lower risk) investments, can play a very constructive role.
For these PE + ESOPs conversions to work, they must adopt the type of guardrails outlined above. If done so, ESOPs can provide stable, long-term employee ownership that centers not just the wealth-building qualities of the ESOP trust but also democratic ownership and other features of quality jobs, with the PE + ESOP model helping bring these transactions to scale. As Baby Boomers retire, over $10 trillion worth of businesses will be up for transition over the next five to 20 years. Imagine the impact on the economy if even a substantial part of those businesses could be successfully sold to the employees that built them.