Scaling employee ownership requires dispelling common misunderstandings
by Bruce Dobb
A number of factors inhibit the growth of employee ownership, among them, common misconceptions among small business owners. The three most common myths we encounter at Concerned Capital when discussing employee ownership with small business clients preparing to sell are:
- Employee ownership means an ESOP.
- All employees must buy-in on the first day after the company is purchased.
- Employee owners will make day-to-day management decisions for the company.
None of these assumptions are true. The reality is that there are many ways to transition to employee ownership. One size does not fit all, just as no one management style works for every firm.
ESOPs Are Not the Only Option
Employee Stock Ownership Plans (ESOP) — highly regulated retirement plans in which the company is held in a trust for the benefit of the employees — are costly to implement. Legal fees and regulatory requirements drive up the first-year costs in Los Angeles, where we are located, to more than $100,000. For small businesses, where annual revenues are under $5 million, an ESOP isn’t feasible.
However, there are plenty of alternatives. Employees can buy a company in a variety of different ways, many with far lower legal costs than those associated with an ESOP.
Our company deals are often done with the owner carrying a note or with non-traditional lenders who have a social mission to encourage broader workplace ownership.
Most of our deals are with small companies that don’t have formal pension plans for employees and don’t qualify for traditional bank debt. Our company deals are often done with the owner carrying a note or with non-traditional lenders who have a social mission to encourage broader workplace ownership — for example, foundations, non-profit lenders, and community development financial institutions (CDFIs). With the Small Business Administration having recently expanded its definition of eligible ownership to include cooperatives, more lenders are now expected to enter the market.
Broad-based Ownership Is a Process, Not a One-Time Transaction
These types of deals often begin with a limited group of employee owners. This isn’t unusual. Many of the most well-known conversions from private ownership to broadly based worker ownership and control (such as worker cooperatives) didn’t start out that way. They may have started as a simple partnership among key employees.
Converting from a closely held company to broader ownership is a process.
Converting from a closely held company to broader ownership is a process. Most companies that convert to employee ownership are not fully employee owned on day one. A Yard and a Half Landscaping Cooperative in Massachusetts and Metis Construction in Seattle, Washington, are just two good examples of companies that took time to expand ownership.
Starting with a smaller, more responsive core group is often done out of necessity. There is strong demand for successful, well-run companies with great management. Foreign investors, larger competitors, or strategic buyers can move quickly to put a company in play even if it’s not listed. To protect the interests of all employees, a core group often needs quickly to secure a bid for the company with a “letter of intent.” There’s seldom time to organize everyone and build consensus, particularly when the seller isn’t interested in waiting.
Democratic Governance and Building an Ownership Culture
Employee ownership can take many different forms and involve different approaches to legal vesting. An initial group of insiders can take title through a Limited Liability Corp (LLC), a Partnership, a C Corp, a Social Benefit Corp or even a Sub-S Corp. But to be eligible for federal tax breaks for the seller, and favorable financing terms from social impact lenders, the conversion must demonstrate that the company will have the following characteristics when the conversion is complete:
- A path to ownership open to all employees — time period flexible
- Some sort of equitable profit-sharing mechanism for all owners
- Evidence of democratic control over governance decision making
This last one is commonly confused with day-to-day management control, which governance is not. Examples of governance issues are election of board members and officers, major investments with company assets, compliance with state and federal law.
Governance is not about who is in charge of shift scheduling or workplace hours or job assignments — those are management decisions.
Governance is not about who is in charge of shift scheduling or workplace hours or job assignments — those are management decisions that may not change, regardless of who owns or governs the firm.
Before the majority of employees can successfully play a role in decision-making and governance, the firm needs to build a culture of ownership, which includes elements such as:
- Building a common knowledge base regarding the process of transitioning ownership from an owner to an employee group: the legal and financial process, including how new members of the group buy in and how ownership is accounted for (i.e., shareholder interest and its value).
- Financial literacy regarding the company: its sales, competitors, how it makes money, and if it’s sustainable as a business.
- Understanding the risks as well as the benefits of ownership: how personal guarantees work and the difference between a limited personal guarantee vs. a general guarantee, if the lender requires it.
- Agreement on an open, democratic decision-making process: e.g., majority vote, consensus decision making, or delegation to a management group.
- Pride of ownership and mutual trust among the new owners.
This training, which is essential for a true, broad-based transfer of real ownership to employees, is often done by non-profit organizational and leadership development skill providers for a nominal or subsidized fee.
Opportunities Abound Once Myths Are Dispelled
Professional exit planners often recommend homegrown inside buyers as a seller’s best option. Saving time, avoiding having to train a new buyer on day-to-day operations, engendering good will, and leaving a lasting legacy are all good reasons for owners to sell to employees. Our job is to find the money to make it happen. That’s getting easier, but the misconceptions remain.
According to Forbes, FAST Company, the Wall Street Journal and Fortune, with so many retiring baby boomer owners, it should be the golden age of employee ownership. But it’s not as common as it could be because of these commonly held misconceptions — the need for an ESOP being the most prevalent. Once we dispel these myths, we can successfully help companies find their own, unique path to employee ownership.
Bruce Dobb is senior partner at Concerned Capital, a social benefit, investment banking firm in downtown Los Angeles that specializes in saving local jobs by helping employees buy the company they work for.
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