Employees have the option to own a company through two common methods from an American perspective. There can either be a significantly large group of workers who own the business outright because they were part of the founding of the company or purchased shares independently, or the organization has an ESOP in place for those who have an interest in ownership.
An ESOP stands for an Employee Stock Ownership Plan. The first plans of this type became available in the United States in the 1970s thanks to the passage of federal legislation, with the goal to encourage lower worker turnover by offering an incentive to the success of the organization.
ESOPs have a structure which is relatively simple. The organization must first create a trust which provides for the distribution of shares, and then contributions are made to ensure access to the shares. Several different regulations can apply to the allocation of stock through this plan, including options that exclude specific positions, pay levels, or employment status. Workers have the opportunity to contribute to the trust, and then this tax-advantage option continues to build allocations until the time of distribution.
If you are thinking about joining an ESOP or own an organization and might want to offer this benefit, then these are the pros and cons of employee owned companies that you will want to consider today.
List of the Pros of Employee Owned Companies
1. It gives an organization the opportunity to rule by consensus instead of through dictation.
Goody Clancy started offering an ESOP in the early 1990s because the original owners were ready to move away from the business. There are over 100 employees who belong to the firm, and each one of them is also an owner. They have seven principals who also control a majority of the stock, but no one owns more than 10% of the shares of the firm.
One of the principals in the company, Geoffrey Wooding, told Architect Magazine that the benefit of this structure is an added level of consensus. “We govern by consensus, kind of like running Switzerland,” he said. “There is no titular head. We’ve done it this way for a number of years, and it works for us.”
2. You can take advantage of several tax and investment benefits.
ESOPs provide numerous benefits that are worth considering when comparing an employee-owned company to other structures. Whatever the principal amount is from a loan happens to be offers the potential of being tax-deductible. You can finance this lending option with pre-tax funds to improve your overall gains. When certain requirements are met, those who hold stock can sell it, defer their capital gains taxes indefinitely, and then pay it when it works best for their budget.
If you belong to an S-Corp and have the option for an ESOP, then the recognized earnings from this plan are also usually exempt from regular income taxes.
3. It offers employees a stronger initiative to achieve successful outcomes.
One of the biggest complaints that employees have today is that the success of their company doesn’t translate into a bigger paycheck. If there is an ESOP available, then that will not be the case. Every participating worker gets to take their equity share of the success. This outcome can improve the morale of workers, keep the organization more productive, and still encourage the growth of the brand and future scalability.
Most employees are more willing to share an idea, embrace change, or encourage innovation when they have a stake in the outcome. ESOPs make that possible.
4. You can get use an ESOP as an exit plan if needed.
When an organization is held closely by its owners, which is common for an S-Corp, then buying or selling shares in the company can be challenging. If you are ready to get out of the business, there might be specific rules that you must follow to transfer your shares to someone else. When there is an ESOP present, then the owner equity can become cash liquidity to help facilitate an exit.
The shares within the ESOP can gradually convert to liquid capital or become useful instantly. This process allows an owner to sell, increase the value of their equity, or gain more control over the company if the charter or law allows.
5. It can reduce the turnover rate for the organization.
You can be an employee-owned company and not be large enough to offer a formal ESOP. CO Architects in Los Angeles, which earned the award of being the ENR California Design Firm of the Year, uses ownership as a way to reduce their turnover. It is an 80+ member firm where about 20 of its workers have stock ownership. By using this option as a benefit, it becomes possible to lower the turnover rate in an organization because there is a tangible benefit to stay.
Businessing Magazine puts this advantage like this. “Employees today desire more than just a paycheck. They want to feel that they are contributing to something. By creating a culture of ownership, you can minimize employee turnover and motivate your staff to work harder.
6. You have more control over the internal mechanisms in play for the company.
ESOP structures offer the ownership group more control over their transition. Each transaction can be reviewed to determine if it should occur. The owners benefit from this process because it provides an increase in the internal structure of the company so that there isn’t too much power in the hands of a few or only one person. Workers can benefit from equity increases that they experience as well. That is why an employee-owned company is an excellent option to consider if you are trying to plan for a retirement.
7. It can help to offset the expense of wages when you first get started.
If you are struggling as a business owner to provide a fair wage to your workers in the early days of a startup, then an ESOP is an easy way to help manage this expense. By rewarding workers with stock, you can reduce the influence that salaries have on your bottom line at the exact time you need to start raising capital. Since your success becomes theirs as well through this process, you tend to see more innovation and early investment into the work that needs to get done.
List of the Cons of Employee Owned Companies
1. ESOPs can put the focus on profits over anything else.
Having a stake in the profits of a company can be a motivating factor that leads the organization to a successful outcome. It can also be the justification that some workers use to focus on the selling process instead of the relationship-building work that they need to do. When you take a sales-first approach, that means everything else comes second – including your innovation.
That makes the assumption that a worker qualifies for the program in the first place. Some employees may not receive an invitation to participate in the ESOP, so they don’t have the same motivation to find success.
2. There are no longer any benefits to strategic purchasing.
When there is an ESOP in place for an organization, then the stocks involved are sold at their fair-market value. Instead of seeking out strategic buyers who want a return through dividends or equity, it forces the company to look for financial buyers within the organization. That means you will have interest if there is a belief that the company will see robust opportunities for growth in the future, but there could be zero interest if earnings are static or decreasing.
Although this structure encourages long-term investments to keep workers around, any shareholders that stay put during the creation of an ESOP are likely to bail, taking their expertise with them out the door.
3. It can be challenging to finance ESOPs.
Most ESOPs end up using seller financing because there is too much risk in place for an outside investor to get involved with the plan. That is why businesses that use this structure have every employee as an owner instead of a VC or an angel pulling the purse strings. Unless an employee wants to put some cash up to get involved for a potential return, they might not want to participate. That’s why employee-owned companies usually offer this option as a benefit which is similar to a 401(k) plan. Workers can invest a little, receive a specific percentage match, and then see growth begin to happen.
4. Your financial growth can be limited by administrative fees.
If workers are contributing a small amount to their ESOP to maintain their ownership profile, then there is a chance that the administrative fees of the plan could wipe out all of the gains that the stock receives during the year. Should the performance of the organization slip and experience a financial loss, then you might find yourself paying into the plan just to continue with its participation.
Depending on the size of the ESOP in question, each worker might be required to pay several hundred dollars each year to continue administering the benefits. The only way to remove this disadvantage is to use an ownership structure that involves a different approach.
5. Some distribution restrictions may exist for some ESOPs.
When sellers are ready to turn their shares into cash through an ESOP, then there are some distribution restrictions which may be triggered by that process. If someone were to use a tax-free rollover for their transaction, then nothing could be allocated to a direct family member – even the employee’s kids. If there is a family-owned organization and the children are also part of the C-Suite or management structure, then they cannot participate in an ESOP whatsoever.
Any shareholders who own more than 25% of the stock are not permitted to participate is this form of employee ownership either.
6. It can sometimes cause cash liquidity issues for a business.
When a business sees a volatile earnings profile develop, then the presence of an employee ownership plan creates a higher level of financial risk. An ESOP requires that a specific amount of cash go toward this plan, which means there is less liquidity available to manage the other departments in the organization. It can reduce reinvestment opportunities, restrict innovation, and limit research.
If an organization encounters this disadvantage, then it typically sees lower earnings in the future. There can be restrictions on sales activities as well. Should someone experience a long-term disability or death as a shareholder, then the adverse impact to everyone could be immediate and severely negative.
7. Companies must have extensive employee ownership for a successful experience.
Unless there are a significant number of employees participating in an ESOP or another ownership plan, there are limitations to the amount of cash that is available for access at any given time. Key shareholders can utilize this platform to create personal liquidity as a way to exit the company, but that limits what becomes available for everyone else. That’s why there are usually restrictions on the equity percentages that shareholders can have with this structure. If one person could corner cash liquidity, then it would be impossible for anyone else to pursue the benefits of company ownership.
Conclusion of the Pros and Cons of Employee Owned Companies
When employees have ownership of a company, then they have an opportunity to pull the strings of their success. Each person can improve their net wealth when they create profitable benefits for their employer. It is a way to experience some of the benefits of self-employment and share investment without taking on a significant financial risk.
That doesn’t mean there are zero risks present with this opportunity. If the company goes out of business, then the ESOP is worthless. You would take a tremendous financial loss. Depending on your structure of ownership, there might be some liability issues to consider as well if something unexpected happens.
The pros and cons of employee-owned companies show us that with a stable financial picture and careful ownership planning, all parties can benefit from an ESOP or another structure. You will want to avoid the fees as much as possible but when this is done correctly, the success of the company becomes a benefit for each worker.
Natalie Regoli is a seasoned writer, who is also our editor-in-chief. If you have any questions about the content of this blog post, then please send our editor-in-chief a message here.