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Sharing Ownership, Part 2: The ESOP or the Co-op—Which Way to Go?

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Sharing Ownership, Part 2: The ESOP or the Co-op—Which Way to Go?

by John Abrams

Among small and medium-size businesses considering employee ownership, one of the most common questions is: Which makes more sense, the ESOP or the co-op? In Part 1 of this series—“Sharing Ownership: A Succession Strategy Proves Out” (October)—I mentioned that most employee-owned companies are ESOPs, but more companies are exploring and choosing the cooperative alternative.

As an employee-ownership consultant with the ICA Group in Boston, Jim Megson did comparisons to analyze the benefits and drawbacks of each option. The specifics will vary, but here is an adaptation of his summary report for one company.

Sale to a Worker Cooperative

Advantages:

relatively inexpensive to set up

no annual maintenance fees

can use IRS 1042 rollover to defer capital gains under certain conditions

owner can retain oversight until note is paid off

members buy a membership share, which makes ownership “real”

democratic structure involves all employees

shares can be held only by employees

Disadvantages:

owner sells 100 percent immediately and therefore does not gain from future increases in company value

owner must finance transaction since cooperatives are not well understood by bank

employees must find cash to buy a membership share

Three-Phase Sale to an ESOP

Advantages:

ESOPs are highly regulated and understood by banks

selling company in stages makes transaction more manageable for company

can use IRS 1042 rollover to defer capital gains under certain conditions

value of stock should increase over time; therefore price for subsequent portions of stock would be higher

after first one-third transaction, owner still retains full control and can see how system works before turning over control to employees

if things do not work out after first transaction, option remains of selling to different buyer

employees are not required to invest any of their own money

Disadvantages:

more expensive to set up ($25,000–$50,000)

annual maintenance costs of $10,000–$20,000 (annual appraisal, plan administrator, etc.)

formal valuation of what employees are receiving will be lower because they do not have controlling interest

owner may be required to provide personal guarantee for bank loan to ESOP

shares can be passed on to heirs, who can vote the shares, potentially diluting company culture

employees are not required to invest any of their own money

This is, of course, very subjective and company-specific. Under “Sale to a Worker Cooperative,” one of the advantages listed is the democratic structure, but if you don’t want a democratic structure, or don’t think it will work well in your company compared with the more traditional corporate structure of an ESOP, it doesn’t qualify as an advantage. And, as you probably noticed, the fact that employees are not required to invest any of their own money is listed as both an advantage and a disadvantage with an ESOP. It’s an advantage because employees often do not want to invest; it’s a disadvantage because they are therefore less invested.

Each company must do its own soul-searching and financial analysis. There is no one-size-fits-all in the world of employee ownership. Whether or not an owner is planning to use a tax deferral under IRC Section 1042, the choice between sale to an ESOP or sale to a worker-owned cooperative will yield different tax and cost consequences for the business and a dramatically different employee experience in subsequent operation of the business.

Size and Its Implications

Is the cooperative approach applicable only to very small companies? The conventional wisdom among most employee-ownership experts is that co-ops are best for businesses with 25 to 30 employees; beyond that, it makes sense to use the ESOP approach. But that may be changing.

Many feel that there is no cap on size; if a democratic organization is the goal, a co-op can work at any scale. John Logue of the Ohio Employee Ownership Center thinks the co-op approach is going to take off and become very popular. “There are many people out there,” he said to me, “besides eccentric businesspeople like yourself and idiosyncratic academics like me, who will find this idea appealing for a variety of reasons.”

But all this, as Megson reminds me, must still be looked at in terms of size. The “governance difference between running a relatively small democratic company and a larger one,” he says, “is the difference between direct democracy and representative democracy with all its implications and complications.”

There is normally some adversarial tension between the employees and management in a company. Both employee cooperatives and democratic ESOPs must overcome this conflict and the natural reluctance of employees to assume responsibility. Democratic companies are most appropriate when the employees recognize their common interest in working together to sustain the business and, therefore, their jobs and careers; when they believe they will create and gain greater value—of whatever kind—from their work in a collectively owned and managed workplace; and when they are willing to engage in the process of decision-making and learning the skills of business ownership.

The hope is that with equity comes trust, and adversarial tensions succumb to collaborative bonds. When the employee owners share both profits and control, there’s no separation. The group is vested with both the benefits and the burdens of distributed power.

The Promise of Employee Ownership

I often wonder why the socially responsible business movement in the United States has not embraced employee ownership more fully. This movement has popularized ideas about commerce as a means of implementing people-centered human resources programs, pursuing environmental sustainability, encouraging participation in local community life, and promoting social and economic justice. As far as I can tell, though, there’s only a faint murmur (but gradually increasing in volume) about distribution of ownership.

Entrepreneurs are risk takers, but perhaps—and I am only speculating here—giving up control seems like too great a risk to these pioneers who have already risked so much to build businesses that embody their personal values.

I’ve come to believe, however, that giving up control is the business risk that has the greatest potential to generate positive returns. It’s not unlike choosing to have a baby. There can’t be anything we do in life more risky than having children, but for most people the perils are apparently outweighed by the potential pleasures and fulfillments. That’s how it felt to me—a worthy gamble. Not to mention that offering ownership without control seems like selling someone a car without turning over the keys.

Employee ownership is clearly coming into its own. Corey Rosen says in his book Equity, “What’s interesting about employee ownership isn’t only that it’s widespread. It also turns up in a disproportionate number of influential and innovative companies. Nearly 80 percent of the corporations on Fortune’s ‘100 Best Companies to Work For’ list had some kind of broad-based ownership plan.”

And he continues: “The extent to which high-tech firms that are focused on the Internet have granted ownership to their employees has no precedent in modern American history. No other industry has ever attempted, much less achieved, the depth, breadth, and extent of wealth sharing found among these firms.”

It sounds like we’re learning something—that companies offering ownership and control to their entire workforce have the potential to unleash an explosion of entrepreneurial activity. They are offering a share in capitalism itself.

Steve Magowan, a Vermont employee-ownership attorney with Steiker, Fischer, Edwards & Greenapple—a firm with offices in four cities—said to me recently, “We feel like employee ownership is expanding for two reasons: (1) baby boomers reaching retirement age, and (2) bad experience with private equity firms.”

Many business owners have experience with private equity buying the firm, taking control, cutting costs and personnel or taking the company lock, stock, and barrel overseas—whatever it takes to maximize return, without regard for the employees, the community, or any of the other real stakeholders.

Employee ownership and democratic governance are not for everyone. The conversion to employee ownership of any kind is complicated and difficult. And some people don’t believe in making their businesses employee-owned. For them it will never work.

For us, it does. I have come to the conclusion that the profound ethic of employee ownership and all that spills from it and gathers around it constitute the foundation, the fuel, and the inspiration for the modest successes we have had at South Mountain Company. The employee-owned workplace is, in my view, the spawning ground for a restorative future.

John Abrams is co-founder and president of South Mountain Company, an employee-owned design and building firm committed to responsible business practice. This article is derived from his new book, Companies We Keep: Employee Ownership and the Business of Community and Place, which includes a longer reading list and a list of consultants, among other resources. To learn more and/or order the book, visit www.chelseagreen.com.

A Transition Agenda

Organizing a worker-owned business, or restructuring an existing one, is daunting. It brings up endless questions, and they don’t all have easy answers. There is no single set of rules to guide the process, and this is a dynamic, growing movement; therefore, new approaches and understandings are constantly being created. The following is an attempt to outline an agenda to help you move through the process, and provide some helpful resources for you and your company.

1. First and foremost, you—the owner(s) or a group of people in the case of a startup—must be interested in examining the possibilities, the benefits, the drawbacks, and the obstacles of a democratic workplace, and have at least a philosophical commitment to it.

2. Given that interest, identify a few key employees to work with in the exploratory phase. In an existing business, if it is not possible to identify at least one or two, this might not be the right thing, or the right time.

3. Remember, there are no right answers, and there is no business exactly like yours. This is an inquiry to discover how your business might transition to a new form, and whether this is an appropriate direction.

4. Read whatever you can (or whatever appeals to you) from the Reading List below and spend some time on relevant Web sites. Distill the nuggets—the ones that seem to fit your sensibility and your situation. Talk with your key employees about the readings. What have you (all) learned that may be useful?

5. At this point, it is important to hire a consultant with employee-ownership knowledge and experience to help you navigate. The consultant can help you undertake an internal examination and do a preliminary feasibility assessment and risk analysis. Dig deep. When short on knowledge, use common sense to work through as far as you can. These are some of the questions you’ll need to answer:

What does the owner (or owners) want? When?

What do the key employees want?

Where do the needs intersect? Where are there tensions?

What is your initial sense of the value of the company?

What does the future of the company look like?

How committed are the key employees to the future of the company?

How committed is the owner (or owners) to taking this step?

How will the purchase be financed?

How much can the business afford to pay out to the owner(s)?

What form of ownership seems most appropriate to current company realities:

—cooperative corporation?

—employee stock option plan/cooperative hybrid?

—limited employee stock option plan?

—simple expanded partnership (for those not ready for—or inclined to—employee ownership)?

—other?

How will decisions be made?

What will be policy decisions and what will be management decisions?

What kind of ownership training will be needed?

What kind of management training will need to occur to prepare for the departure of the owner(s) (if this is part of the plan)?

6. If the results of this inquiry are generally positive and indicate that it may make sense to move forward, summarize all findings and draw conclusions about the following:

Here’s where we think we’re at right now.

Here are the remaining questions we have.

7. It can be very valuable, at this stage (or earlier), to talk with people at a few other employee-owned companies, of roughly your size, about your findings, and your specific questions, and get their reactions.

8. With your consultant’s assistance, and with the assistance of an accountant and attorney:

Conduct a company valuation analysis and prepare a financial buyout scheme.

Prepare corporate bylaws.

Prepare a formal business plan.

Prepare an offering statement and legal agenda for reorganization.

9. At this point you should be prepared to initiate the restructuring and birth the new company.

Go through the steps. Live happily ever after (maybe). Adjust as necessary.

On Sharing Ownership: A Reading List

Frank T. Adams and Gary B. Hansen, Putting Democracy to Work: A Practical Guide for Starting and Managing Worker Owned Businesses. San Francisco: Berrett-Koehler, 1992. The primary focus is worker cooperatives.

John Logue, “The 1042 Roll-Over Cooperative in Practice: A Case Study of How Select Machine Became a Co-op.” Northcountry Cooperative Development Fund, 2006. Available atmncooperate.org/1042_rollover_co-ops_MN_case_study.pdf. An excellent article about the nuts and bolts of an employee-owned cooperative restructuring via an important IRS tool.

John Logue, Richard Glass, Wendy Patton, Alex Teodosio, and Karen Thomas, Participatory Employee Ownership: How It Works. Worker-Ownership Institute, 1998. A well-organized analysis and how-to book.

Peter Pitegoff, “Worker Ownership in Enron’s Wake: Revisiting a Community Development Tactic.” Journal of Small and Emerging Business Law 8, no. 2, Summer 2004. Abstract (and link to full text at Westlaw.com, subscription required) at lclark.edu/org/jsebl/vol8no2.html. An up-to-date analysis of the state of employee ownership.

Cory Rosen, John Case, and Martin Staubus, Equity: Why Employee Ownership Is Good for Business. Boston: Harvard Business School Press, 2005. The big picture, primarily about ESOPs.

 

 

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