Filling the finance gap to accelerate employee ownership
by Karen Kahn
Founded in 2001, Social Capital Partners (SCP) is a Canadian nonprofit organization that seeks to use finance to broaden economic opportunity. After years of focusing on improving job opportunities for those facing employment barriers in Canada, it has now turned its attention to capital ownership, the root of growing wealth inequality in Canada and around the globe.
In a recent interview, Jon Shell, who leads the nonprofit with founder Bill Young, spoke with me about SCP’s growing interest in employee ownership as a means to address the wealth divide. Though we think of wealth inequality as a uniquely American phenomenon, Shell points out that Canada too faces a stark divide. The top 1 percent of Canadians hold one quarter of the nation’s total wealth, while the bottom 40 percent own 1.2 percent of all wealth.
As Social Capital Partners makes the case for creating an ESOP-like structure in Canada, it is employing another strategy as well: investing in U.S. ESOP conversions.
The U.S., Shell explains, is far ahead of Canada in using public policy to promote employee ownership. The key vehicle for growing employee ownership in the U.S., the Employee Stock Ownership Plan (ESOP)—essentially a dedicated trust that holds the shares of a firm for its employees, who are its beneficiaries—has no similar counterpart in Canada. As a result, the barriers to employee ownership in Canada are steep, and only a few determined business leaders have structured firms with broad-based ownership.
Shell and his colleagues recently made their case for creating a Canadian-style employee ownership trust in a discussion paper, Building an Employee Ownership Economy. The paper points to the success of ESOPs in the U.S., where 14 million former and current employees of firms owned all or in part by an ESOP trust have accumulated $1.4 trillion in assets. And as the paper points out, improved employee financial security is not the only benefit of ESOPs. Overall, ESOP firms are more productive, pay higher wages, and are more resilient during downturns. The latter was recently confirmed in a survey published by the Employee Ownership Foundation that found ESOPs have laid off fewer employees than non-employee-owned firms as a result of the COVID-19 recession.
As Social Capital Partners makes the case for creating an ESOP-like structure in Canada, it is employing another strategy as well: investing in U.S. ESOP conversions. This strategy is designed to demonstrate that some of the barriers to ESOP growth—the number of U.S. ESOPs has not grown over several decades—can be overcome through better finance.
There was a really good match between the needs of pension funds for long-term investments with steady but modest returns and the capital needed for employee-ownership buyouts.”–Jon Shell, Managing Director and Partner at Social Capital Partners
As SCP explored employee ownership over the last few years, U.S. experts identified capital as one of the key barriers to growth. When the owner(s) of a private firm decide to sell their shares to an ESOP, that transaction is generally financed through a combination of traditional bank loans and debt from the owner themselves. This means it can often take a decade or more for owners to be paid the full value of their business. This is a significant disincentive to sell to employees—particularly in a situation where selling to a private equity or corporate acquirer would mean a lot more cash up front.
SCP saw an opportunity to intervene in a way that could even out the playing field, making employee ownership competitive with other buyout offers. As Shell explains it, “There is a sizable gap these days between what a private equity group might offer for a business and the size of a collateralized loan from a bank. That gap can be filled by a seller’s note, but essentially, in an employee buyout, the seller must be deeply committed because he or she is likely self-financing much of the deal.” What is needed to fill the gap and make the deal more enticing for the seller, says Shell, is an investment of mezzanine debt that reduces the size of the up-front cash gap and allows the seller to move on more quickly.
To prove the theory, SCP plans to invest its own money, but it also needed co-investors. For that, the non-profit turned to Canada’s largest pension funds. Says Shell, “There was a really good match between the needs of pension funds for long-term investments with steady but modest returns and the capital needed for employee-ownership buyouts.” While private equity, when it acquires firms, seeks to squeeze out value and then flip the firm in order to get a return on its investment, using debt from pension funds means there’s no need to re-sell the business, says Shell. The loan can be paid back from a company’s cash flow over a generous period of time.
The largest hurdle thus far has been finding the right deals in which to invest. Pension funds prefer to invest $100 million or more at a time, says Shell, so they need large deals. Though they have pursued several dozen leads, says Shell, with the pandemic reeking economic havoc, they have not yet completed a deal. Shell is hopeful, however. He says Canada and the U.S. both face severe business succession crises as baby boomer business owners begin to retire. Businesses will be changing hands—it is just a question of when. Shell’s experience is that after a severe recession—like the one we are in now—business owners aren’t apt to sell right away. They will try to hold on another year or two until the business regains value.
In the meantime, SCP’s goal is to sponsor some early deals to demonstrate proof of concept and help build a robust investment ecosystem for employee ownership. The goal is for Canada and the U.S. to have the structures and capital in place to take advantage of that wave of retirements when it comes, using the moment to grow a more equitable economy through employee ownership. “The ESOP is not, in and of itself, any less powerful of a tool than it was when it was created,” says Shell. But macro-economic trends and some shifts in policy have made it less appealing to sellers. “Those obstacles,” says Shell, “can be overcome. Our goal is to demonstrate how.”
Karen Kahn is a communications consultant and the editor of Employee Ownership News.