What is Employee Ownership?
Employee ownership financing is equity or debt capital that supports businesses transitioning to employee ownership.
Employee ownership provides owners an exit pathway, working capital to businesses to rebuild post-COVID, and workers access to business ownership.
Employee ownership models have been around for decades and can help rebuild a more equitable and resilient economy. They can shift ownership to workers of color and transition to diverse leadership to close the racial wealth gap. Employee-owned businesses are an overlooked and tiny segment of the U.S. with only 6,000 Employee Stock Ownership Plan (ESOP) businesses, 460 worker-owned cooperatives (co-ops), and Employee Ownership Trusts (EOTs). Employee-owned businesses have higher productivity, more committed workers, less firings, wealth that stays in communities, and better wages.
However, there is still limited financing available to US small business owners looking to transition their businesses to employee ownership. Expanding the number of financing opportunities available for transitioning businesses to employee ownership structures would create more opportunities for equitable business ownership.
Here are the three major forms of employee ownership:
- Employee Stock Ownership Plans (ESOPs) are qualified retirement plans used to transfer all or part of the company’s shares to a trust, administered on behalf of the employees. Employees earn their shares as a retirement benefit. ESOPs come with significant tax benefits, which, coupled with regulation, mean they can be a fit for companies with more than 30 employees, given higher set up and ongoing costs.
- Worker Cooperatives (Co-ops) are 100% employee-owned and governed by the people who work there. Employees pay a small equity buy-in and the board of directors is made up of a majority of employee-owners who are elected by the full membership. Profit-sharing is built into the model and is based on hours worked. Worker cooperatives have lower transaction and ongoing administration costs than ESOPs. Co-ops can be the right structure for companies of all sizes, but they are primarily used by smaller companies with fewer than 30 employees.
- Employee Ownership Trusts (EOTs), sometimes called Perpetual Employee Trusts, preserve the business over the long term for the benefit of the employees. Employees don’t pay for their ownership benefits, and they receive a share of the company’s annual profits. EOTs have lower transaction and ongoing administration costs than ESOPs.
An employee ownership buyout offers full cash proceeds for the acquisition of the target company. In this style of transaction, a private equity firm such as Apis & Heritage Capital Partners raises all of the capital to acquire the business and lends it through the company to a newly formed ESOP Trust, which then purchases the company from the selling shareholders. In effect, it is similar to buying a house with a 100% mortgage. Over the next three to five years, the company creates equity value by paying down the acquisition debt, including the private equity firm’s investment. Once this debt, which is similar in structure to any company that has recently been acquired through a leveraged buyout, is fully paid-off, the company is free of external stakeholders and can remain an ESOP-owned company in perpetuity.
Employee ownership financing from private equity, lenders, and other capital providers helps fund these business conversions. Typically, the employees do not have enough savings or access to capital to purchase all or the majority of the shares from the small business owner(s). Beyond whatever the employees can afford to contribute, they need to raise outside financing from a local bank, venture capital, private equity, etc. to acquire the business.
Here are the basic components of a worker co-op conversion:
- Business Entity Creation: The creation of a business entity that is a worker-owned cooperative. This can be accomplished by converting the existing business, or forming a new cooperative entity.
- Sales Transaction: A sales transaction executed between the current owner(s) and the new worker co-op to sell the existing business to the worker co-op and execute a Purchase & Sale Agreement. Each worker-owner “buys in” to the co-op and receives a single voting equity share. The sales transaction is typically financed by a group of lenders.
- Governance & Cultural Shift: A transition of roles and culture among the new worker-owners to take on the ownership responsibility of the new entity and run it under democratic governance.
There are financing nuances depending on the employee ownership model. Worker co-ops must avoid raising equity and selling controlling shares of the company to anyone who is not an employee-owner. This means venture capital, private equity, and common stock offerings are typically off-limits. However, co-ops can raise preferred equity with non-voting stock that does not include any ownership or control rights. Given the equity restrictions and smaller nature of worker co-ops, they are usually funded by a group of lenders like banks and CDFIs with a mix of secured and unsecured loans.
Unlike worker co-ops, ESOPs can actually raise equity from investors like VC and PE to finance the business conversion.
Here are the basic components of an ESOP conversion:
- Trust Creation: In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan.
- Sales Transaction: Owner(s) use an ESOP to create a ready market for their shares and sell their shares directly to employees. The company can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares. In the borrowing scenario, the employees then make tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.
In almost all ESOP transactions, the seller finances the ESOP’s acquisition by taking the majority of proceeds in the form of a Seller Note, which is paid down out of the company’s cash flow over the next five to 10 years. Compared to a traditional acquisition event, business owners are sacrificing cash upfront at exit to share ownership with their employees. The owners’ liquidity event is spread out across five to 10 years.
However, a private equity-backed ESOP offers full cash proceeds for the acquisition of the company. A PE firm such as Mosaic Capital Partners or Apis & Heritage Capital Partners raises all of the capital to acquire the company and lends it through the company to a newly formed ESOP Trust, which then purchases the company from the selling shareholders. Over the next three to five years, the company creates equity value by paying down the acquisition debt, including the PE’s investment. Once this debt is fully paid off, the company is free of external stakeholders and can remain an ESOP-owned company in perpetuity.
- Employee Vesting: Shares in the trust are allocated to individual employee plans. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account or vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once or gradual.
- Employee Departure: When employees leave the company, they receive their vested stock, which the company must buy back from them at its fair market value. Private companies must have an annual outside valuation to determine the price of their shares.
Benefits vs. Costs
- Tax Advantages / No Federal Taxes for ESOPs: A small business that is 100% owned by workers and structured as an S-Corp ESOP does not pay federal income taxes. This meaningful tax savings generates immediate capital that can build cash reserves or be reinvested for growth. The small business owner will have significant federal tax benefits by selling at least 30% of the business to the ESOP; he or she can then defer capital gains indefinitely, and other tax benefits kick in as the ESOP ownership increases. For example, an S-Corp ESOP with 100% ownership pays no federal income tax. ESOPs are also free to workers who receive gifted shares as a retirement benefit.
- Wealth Creation / Workers Become Owners: Employee ownership buyouts provide business owners with a cash exit and higher wages and job preservation for workers. It offers owners a clear succession plan and exit pathway without giving up ownership to a private equity firm or larger corporation outside their community. Employee-owned businesses incentivize workers to create value for the business because their ownership stakes can increase in value as the business sustainably grows over time. Workers can sell their stakes back to the business for cash when they either retire or leave the business. This model can build more resilient local economies and help close the racial wealth gap with a path to business ownership for workers of color.
- Access to Capital / Resilient Jobs & Communities: Employee ownership buyouts offer growth capital for small businesses that face significant barriers to accessing capital from VCs and lenders. This growth capital can help businesses rebuild from the COVID-19 pandemic and preserve local jobs in underserved communities.
- Regulations – Complex & Regulated ESOPs: There are a number of benefits for owners, workers, and investors with an ESOP business transition, but ESOPs remain complicated and highly regulated. This complexity and regulation comes with higher set up costs, starting at $40K, and administrative costs.
Capital Product Fit
When is employee ownership financing a good fit for businesses?
- Annual Revenue: $2M+
- Employees: 30+ for ESOPs; <30 for co-ops and EOTs
- Financials: 2+ years of financial statements
- Business Entity: C Corp or S Corp for ESOPs; more flexibility for co-ops and EOTs
When is employee ownership financing not a fit for businesses?
- Too Young: If a business does not have at least two years of financial statements, then it is difficult for an employee ownership investor to underwrite and make an investment.
- Too Small: For ESOPs, businesses need to have at least 40 employees and $2M in annual revenue to take advantage of the tax benefits compared to the legal and regulatory costs.
- Blitzscalers: Businesses that require rapid growth to take over an entire market or create a new market and need large amounts of VC funding to scale. These “Blitzscalers” typically focus on speed and growth over cash flow and profits.
Why would business owners want to choose an employee ownership deal?
- Community Succession Plan: Small business owners looking to retire or take a step back from their business have the opportunity to transition and sell it to employees. Employee ownership can keep these businesses and jobs in local communities and enable the next generation of leaders.
Project Equity: Employee Ownership Case Studies
Project Equity curated case studies from employee ownership transitions from across the nation — both from their work and the work of others. Discover employee-owned businesses in your industry, explore their map by region and gain insight on best practices.