The Case for Investing in Employee Ownership

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(Photo by iStock/ljubaphoto)

For many years now, conventional solutions to income and wealth inequality—minimum wage, unions, progressive taxation, or guaranteed income—have failed to gain enough momentum to reverse the trend of greater and greater accumulation among the already well-off. What if we added a new approach, focusing on a primary source of wealth, business ownership, and how to transfer that wealth directly to the workers struggling today? A promising vanguard of institutional investors are doing just that, using their resources to support business transitions to employee ownership. If this nascent movement were to grow, it has the potential to significantly reduce the wealth gap overall as well as the racial equity gap.

Why Invest in Employee Ownership?

The COVID-19 pandemic further revealed the vulnerability of millions of workers in the US, who have seen wages stagnate for decades as work has become increasingly precarious. An already stark divide between the wealth of the top 10 percent and the bottom 90 percent became a chasm. The top 10 percent, who now own 89 percent of all US stocks, saw wealth grow significantly during the pandemic, while many low-wage workers lost jobs or risked exposure to a potentially fatal illness. The top 1 percent today own nearly a third (32 percent) of the country’s wealth.

As nonprofit, political, and business leaders concerned for the future search for new solutions, broadening access to wealth through employee ownership is gaining attention. It is a rare approach supported across the political spectrum, for it increases financial security for workers as it also increases the productivity and stability of businesses.

Employee ownership also has a role to play in preserving local economies. After two years of economic crisis, an unprecedented number of businesses are looking for new owners. A “silver tsunami” of business sales or closures loomed even before the pandemic, as baby boomer business owners approached retirement. The pandemic accelerated this trend. Employee ownership transitions for these businesses could be transformational, shoring up local economies while contributing to greater stability, civic engagement, and financial security for low- and middle-income workers who have been stretched to the breaking point.

Taylor Guitars: How Impact Capital Can Catalyze Employee Ownership Transitions

An inspiring example of what’s possible is Taylor Guitars, a manufacturer with $120 million in revenue, which recently transitioned to 100-percent employee ownership. The firm’s 1,200 workers in Southern California and Mexico will now benefit from the value of ownership shares via an Employee Stock Ownership Plan (ESOP).

The financing partner for this transition was the $100 billion Healthcare of Ontario Pension Plan (HOOPP). The pension fund was brought into the deal by Social Capital Partners (SCP), a Toronto nonprofit that tests strategies for addressing income and wealth inequality. Because Canada doesn’t have a similar ESOP structure, SCP became interested in the US ESOP model. After months of talking with leaders in the ESOP community—financial and tax advisors, researchers and advocates, trade associations, and business executives at ESOP firms—the SCP team reached the same conclusion that our organization, the US-based nonprofit research and consulting lab The Democracy Collaborative, did: Capital is the agent needed to significantly grow employee ownership. They also saw that ESOP transitions could meet the investment needs of large Canadian pension funds, which seek large, low-risk investments with moderate but steady returns.

In their explorations, Jon Shell, SCP’s Managing Director, met Ted Margarit from Chartwell Financial Advisory, who had worked with Taylor Guitars since 2013 on succession planning. Margarit and Shell agreed that the Taylor Guitars transaction offered a great opportunity for an employee ownership transition: The company was profitable, the founding owners agreed to remain in place for several years to support the transition, and there was room for growth.

The three organizations began discussing a deal that would primarily be financed by HOOPP, along with Social Capital Partners, with additional financing from the owners. These investments would be used to acquire the business from the founding partners. The twist is the company is in a sense acquiring itself on behalf of employees. Employees receive their shares free, as a company benefit, with their shares accumulating in retirement accounts similar to 401(k)s.  The company will pay back the cost of the financing through future profits, which provides a return to the pensioners. As the loan is paid, shares are released into the ESOP where they are allocated to employees based on a formula that takes into account tenure and salary.

This deal met HOOPP’s fiduciary responsibilities: HOOPP considered the investment relatively low risk, since the loan could be secured against the value of the business, and ESOP tax advantages would free up cash to grow the business and pay off the loan. The steady, moderate returns would be good for pensioners. Moreover, says Shell, “HOOPP loved the social benefit: The ESOP will generate considerable wealth for Taylor Guitars’ employees.”

Taylor Guitars’ factory workers—many of them people of color—stand to benefit handsomely. Research from the Rutgers University Institute for the Study of Employee Ownership and Profit Sharing shows that among lower-income workers, those at employee-owned firms are more financially secure than their peers, with those close to retirement (60 to 64 years old) having 10 times more wealth than the typical American in that age group (60 to 64). Moreover, the study found that Latinx employee owners have 12 times the median wealth of Latinx households nationwide, while Black employee owners have three times the median wealth of Black households.

Margarit describes the deal as the “NAFTA” of ESOP deals: A Canadian pension fund financed the first-ever ESOP that benefits both US and Mexican workers. He says working with values-aligned partners ensured a deal that was great for the business while also delivering the social impact all the participants sought.

Employee Ownership Investment Funds Attracting US Foundations 

HOOPP is not the only prominent institutional investor seeing employee ownership investment as a vital and financially prudent path to reduce inequality. US foundations are increasingly adding employee ownership investment funds to their portfolios.

Living Cities, a consortium of major US foundations and financial institutions, is an investor in the Employee Ownership Catalyst Fund recently launched by two California-based organizations, Project Equity, a nonprofit focused on business transitions to employee ownership, and Mission Driven Finance, a CDFI. The evergreen debt fund offers flexible financing to owners seeking an employee-ownership exit. Says Lauren Grattan of Mission Driven Finance, “Our investors see employee ownership as a powerful tool to close the racial wealth gap and create a more equitable world.”

Mission Driven Finance is also partnering with Apis & Heritage Capital Partners to manage the A&H Legacy Fund, which addresses the racial wealth gap by transitioning businesses with large workforces of color to employee ownership. Its first round of fundraising closed at $30 million, with major investments from Rockefeller, Ford, and Skoll.

Funds like these are typical of the dozen new and emerging employee ownership funds The Democracy Collaborative profiles in our report, Opportunity Knocking. As we researched why employee ownership had stagnated for decades and how to jumpstart the field, we identified organized capital as the solution. ESOP formation, which for sellers is a complex transaction, can’t compete with private equity funds knocking on company doors, ready to write a check. What’s needed are intermediary funds that simplify the conversion process for exiting owners and for investors. The growing number of intermediary funds, in effect, are the new knock upon the door. As more of these funds launch—and more investors support them—an exciting path to solving inequality is emerging.

Building a Capital Ecosystem to Grow Employee Ownership

While the dozen investment funds we identified show a shift in the employee ownership investment landscape, it remains a tiny segment of the market. To fully capitalize on this moment—with millions of businesses at risk and growing concern over inequality and racial equity—philanthropy is the player needed to catalyze the expansion of employee ownership investment funds.

The Kendeda Fund showed what’s possible, with its 2019 decision to seed several new employee ownership funds with $24 million in grants. The goal, says Diane Ives at Kendeda, was “to inspire the philanthropic and impact investment communities to see democratic employee ownership as a necessary—and profitable—strategy for business growth.”

Kendeda’s investment has shown promising results. One new fund, the Evergreen Cooperative Fund for Employee Ownership (FEO), for example, has already acquired and transitioned four businesses in Northeast Ohio to employee ownership. Among these is Phoenix Coffee with 37 employees, which FEO purchased in the midst of the pandemic, thus preserving jobs and helping the firm survive. The other funds supported by Kendeda have also catalyzed new transitions.

More broadly, the Kendeda investment is demonstrating the viability of employee ownership as an investment opportunity and a method of reducing inequality. Its seed capital helped funds attract other philanthropic investors, spreading the uptake of this new asset class.

Building on the catalytic role of philanthropy, the next growth phase will require action by government at local, state, and federal levels, playing a role in accelerating the movement of public and private capital into employee ownership. The federal government directly operates dozens of revolving loan funds, banks, and other investment vehicles, which could incorporate employee ownership. The same could be done at the state level, where many state-owned investment funds, including those run by development finance institutions, directly invest in economic activities.

One policy approach is to redirect existing government funds or set up new public funds that invest in employee ownership conversions. In 2019, for example, Senators Bernie Sanders, Kirsten Gillibrand, and others introduced a bill to create the US Employee Ownership Bank to provide $500 million in low-interest loans and other financial assistance for workers to purchase businesses through ESOPs or worker-owned cooperatives. Sen. Gillibrand was also the driving force behind the Main Street Employee Ownership Act (MSEOA), signed into law in 2018. That legislation bolstered federal support of ESOPs and worker cooperatives, in part through making it easier to finance employee ownership conversions with federal small business loans.

Building on MSEOA, the US Treasury recently announced that the State Small Business Credit Initiative (SSBCI), funded through the American Rescue Plan, will allow for capital investments in employee ownership transitions. States can use some of the $10 billion in Treasury funding to support funds that are working to buy businesses that were profitable before COVID but have been hurt by the pandemic and relaunch them as employee-owned enterprises once the economy recovers.

Beyond SSBCI, state and city governments can use their financial resources for loan guarantees or other credit enhancements, to attract private capital into employee ownership. One successful example is the Indiana ESOP Initiative (IEI), created in 2007 by then-Treasurer Richard Mourdock. The $50 million program incentivized lending to ESOPs by offering reduced interest on state funds if the recipient bank provided below-market-rate loans to ESOP companies. The program helped to create more than 900 new employee-owners. The city of Madison, Wisconsin, seeded a revolving loan fund, which is now managed by the local community development authority. It makes loans between $50,000 and $250,000 for cooperative development. 

The largest and most expansive policy idea for growing employee ownership finance involves the use of loan guarantees at a large scale by state and federal government. Investment banker Dick May of American Working Capital, along with colleagues Robert Hockett and Christopher Mackin, drafted a model policy called the Employee Equity Loan Act, suggesting that $100 billion in federal loan guarantees for employee ownership financing could create 13 million new employee-owners in a decade, add 1 million new jobs to the economy, and generate more than $1.7 trillion in new wealth for workers. Such guarantees would attract private equity dollars at scale by ensuring investor losses are limited.

Through approaches such as these, government can advance employee ownership by shaping the flow of capital, public and private. This role of government represents a well-trod path to scale: the private sector innovates, developing models, and the government boosts the best of these to scale through policy. This happened with finance for widespread home ownership, for example, with the development of institutions like Fannie Mae and Freddie Mac—and a similar path could create a robust capital ecosystem for employee ownership.

An Ownership Economy

The impact could be enormous. Thomas Dudley and Ethan Rouen, in a recent paper, Employee Ownership and Wealth Inequality: A Path to Reducing Wealth Concentration, calculate that if 30 percent of every US business were owned by its workers, the median household would see their net worth double from $121,760 to $230,076. The bottom 20 percent of households would see the largest gains, with their mean wealth increasing four-fold, from $10,060 to $40,000. Median wealth among Black households would increase from $24,000 to $106,000.

Despite this vast promise, the number of US firms converting to employee ownership continues to trickle along at 200 or 300 per year. Capital is the missing agent. As impact investors come to recognize employee ownership as a low-risk, high-impact asset class, they could catalyze conversions at scale, creating a movement that would be transformative for millions of low-income workers.

Read more stories by Marjorie Kelly & Karen Kahn.