Policy Options for State Employee Ownership Legislation
Broad-based employee ownership plans, primarily employee stock ownership plans (ESOPs) and worker-owned cooperatives, are a bipartisan, effective means to help create an economy that is both more productive and more able to provide financial security for workers in all sectors of the economy. Federal law already provides substantial tax benefits to ESOPs and has the support of both parties, with essentially no opposition. Employee ownership companies generate 2.5% more new jobs year than would be expected if they were not owned by an ESOP, provide about 2.2 times the retirement wealth available to that 50% of the workforce fortunate enough to be in any retirement plan, and experience one-third to one-fifth as many layoffs as non-employee ownership companies.
Employee ownership plans are especially appealing to owners of closely held companies looking for a tax-effective, practical way to provide for business transition that preserves the legacy—and the jobs—they have helped create.
That is especially important now. Close to half of all privately held companies in the U.S. are owned by baby boomers, meaning 2.7 million American businesses are owned by someone age 55 or older.[i] In the coming decades, all of these business will either change owners or disappear. The median state has 34,000 businesses approaching an ownership transition. The effects of this generational shift will be felt in cities, small towns, and rural areas.
At the same time, state governments are struggling with the challenge of preserving jobs and stimulating local economies buffeted by larger economic trends. States currently spend an estimated $45 billion to $70 billion a year on efforts to attract and retain jobs.[ii]
If even a fraction of these exiting owners pursued an employee stock ownership plan (ESOP), worker cooperative, or other broad-based employee ownership model as their business exit strategy, the potential positive impact on workers, communities, and state economies would be substantial.[iii] Yet, many business owners are not even aware of employee ownership as an option. In light of this knowledge gap, many of these businesses will instead shut down or sell to outside investors who may not be interested in preserving and growing local jobs.
Addressing this knowledge gap can be a relatively cost-efficient way for states to preserve jobs, address wealth inequality, and increase retirement security. Specifically, states or local nonprofits at a state or regional level could set up outreach programs to inform and educate business owners about employee ownership as a transition strategy. Locally based outreach programs can draw upon existing networks of experts and infrastructures, such as colleges, universities, and successful employee ownership companies.
At the same time, state laws can make it more difficult for companies to become employee-owned. Some professional firms, especially in accounting, law, and medical services, cannot become majority-owned through an ESOP because the trust is not considered a qualifying owner under state laws requiring ownership to be held by members of the profession. Similarly, companies that qualify for set-aside programs because their owners are women, minorities, or veterans, lose their status if they become majority employee-owned through an ESOP, even if they continue to be controlled by qualifying individuals and/or most of their ownership, when considering shares allocated in the ESOP, go to qualifying individuals.
This paper outlines three legislative fixes to these problems:
1. Create a State Employee Ownership Center
Employee ownership centers already exist in eighteen states and the District of Columbia (Massachusetts and Colorado have state-funded programs; Pennsylvania, North Carolina, Vermont, and Ohio have active donor and activity funded programs; click here for a full list of state centers). These programs have proven very effective in helping business owners understand the employee ownership option or, in some cases, helping employees start worker cooperatives. Their costs are minimal relative to the impact they have.
In order to increase the effectiveness and penetration of local outreach and education, state centers can:
- Hold seminars statewide in conjunction with professional, business, and trade publications and organizations.
- Publish and disseminate brochures and other material.
- Work with the media to encourage stories on local employee ownership companies.
- Take advantage of the employee ownership community by facilitating peer-to-peer connections, where company leaders talk with their peers who have sold to an employee ownership plan. These connections are usually fostered based on location or industry.
- Provide references to qualified service providers.
These centers all have roughly the same mission—to encourage the adoption of employee-owned business models through education and outreach. That said, they differ in their funding, strategy, and methods. These centers range from being purely volunteer-driven to fully fledged organizations with an executive director and full-time staff support.
The models proposed here provide three alternatives:
Create a state agency: Here the state would create a capacity within an appropriate agency to perform these functions. Advantages include access to other state resources and the credibility attached to a government agency. Overhead cost can be higher, however. Colorado currently uses this model.
Create and fund a center in a state university: The longest-standing program is the Ohio Employee Ownership Center (OEOC), which was established in the 1980s at Kent State University. This has allowed the OEOC to take advantage of internships with students, research facilities, and the credibility that goes with the university imprimatur. To make this effective, however, there have to be people within the university who are eager to set a program like this up.
Fund a nonprofit: Vermont and Massachusetts have nonprofit organizations funded entirely or in part by the state. This may be the most cost-effective model, because these nonprofits can also seek grants and donations as well as generate income from services.
We believe that the minimum effective level of funding for these programs is about $150,000 to $200,000 per year. Any form of the program should be allowed to supplement its funding though income from sources such as event registrations and sponsorships.
2. Allow ESOP-Owned Companies to Qualify for Contacting Preferences
Most states have some form of contracting preference for minority, woman, and or veteran-owned businesses. Worker cooperatives owned by qualifying individuals could qualify, but ESOP-owned companies cannot. In an ESOP, the shares are held in an employee stock ownership plan trust and governed by a trustee, who may be an insider or insiders or, increasingly, an independent trust institution or individual. The trust does not qualify as an eligible owner, even if the ownership in the trust is mostly held by qualifying individuals, the company is run by qualifying individuals, and/or the company was historically qualified before becoming majority-owned by an ESOP. That means a company that, for instance, has most of its stock owned by ordinary employees through the ESOP who otherwise qualify under set-aside rules will not qualify, while a company owned by one, usually much wealthier, person will. Similarly, a company that shares ownership widely, is majority ESOP-owned, and run by a board and a CEO consisting of qualifying people will not qualify. One of the theories behind set-asides is that qualifying people getting the awards will be more likely to hire people who also meet the criteria. This does not change if the company is run by these individuals in an ESOP setting, but now the people they hire are also owners.
The set-aside issue has been especially problematic for companies that historically have qualified and are now considering an ESOP. If they ESOP ends up with majority ownership, some of their business will disappear.
There are two possible legislative fixes for this problem. One would provide a “look-through” that would require the company to provide evidence that the combination of shares allocated in the ESOP to qualifying individuals plus ownership outside the ESOP (if any) held by such individuals is greater than half the total ownership in the company. The second would be to allow ESOPs to qualify if the trustee and/or the chief executive officer and a majority of the board of directors are qualified individuals. The law could also require that both conditions be met.
3. Provide Assistance for the Costs of Considering an ESOP
In 2020, Colorado set aside $10 million per year for six years to cover a tax credit to cover up to 50% of the costs of an initial assessment of converting to employee ownership. The tax credit would be for up to $50,000 for an ESOP and up to $25,000 for a worker cooperative. The rationale behind the law is that many business owners may be reluctant to incur the substantial costs of using employee ownership for transtion when they at least perceive (albeit usually incorrectly) that a sale to a third party would not incur these costs.
4. Allow Ownership of Professional Corporations by ESOPs
A similar problem comes up in the context of certain professional firms, especially accounting, medical, law, and veterinary services, but also, in some states, engineering, architecture, and other professions. In many states, an ESOP can own up to 49% of these firms (over 40 states allow this for accounting firms), but the rules can be more restrictive for other firms. Some states, for instance, prohibit the corporate practice of medicine.
The simple solution to this problem is to allow ESOPs to own these practices, provided that the trustee or trustees of the ESOP are members of that profession. An exception should made for a transactional trustee hired for the purpose of making sure the purchase of shares by the ESOP trust from a non-ESOP owner is for not more than fair market value, as required by the Employee Retirement Income Security Act (ERISA). This transactional trustee would not have an ongoing role in making decisions about the shares in the plan and would be replaced after the transaction by a qualifying individual. The law could also require that the board be composed of a majority of qualifying individuals.
The appendix to this memo provides background on ESOPs and other forms of broad-based ownership.
How Do ESOPs Work?
ESOPs are a kind of employee benefit plan that can be used to buy out an owner and transfer ownership to employees in part or in whole, all while creating a qualified retirement plan at no cost to the employees. This is accomplished through the unique transaction structure that is available to ESOPs under law: the ESOP trust can borrow money to buy the shares of the departing owner(s), with the company making cash contributions to the plan to enable it to repay the loan over time. Alternatively, the company may contribute new shares of its own stock and/or use cash to buy existing shares without a loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.
Shares in the trust are allocated to individual employee accounts. Generally, all full-time employees are included after a year of service. When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares.[iv]
From the perspective of the selling owner, it makes sense to fund an ESOP at a higher rate than other benefit plans such as 401(k)s because the ESOP accomplishes multiple goals—in addition to being an employee benefit, it also provides a succession plan that fairly compensates the selling owner and introduces unique tax advantages for both the owner and the company. ESOPs have proven to be a sustainable form of company ownership. Not only do these employee-owned companies generally continue to thrive, this unique ownership structure often improves company performance.
Currently, there are around 6,660 ESOPs in the United States, holding total assets of nearly $1.4 trillion.[v] These plans cover 14.2 million participants.
At the company level, ESOPs have been associated with greater firm performance, productivity, and job stability. Employee ownership has been linked to greater employment stability in the face of an economic downturn, and firms with employee ownership were more likely to survive the last two recessions.[vi]
Privately held ESOPs generally intend their ESOPs to be permanent[vii] such that they have structural reasons to buck the trend of “short-termism” often seen in publicly traded companies and private equity firms that can have negative impacts on workers and communities.[viii]
First and foremost, these companies create retirement savings at a time when the median retirement savings among Americans without traditional pensions is zero.[ix]
ESOP companies tend to lay off employees at lower rates compared to other companies. National surveys show that among employees at private firms both actual layoffs and the perceived likelihood of being laid off are lower for employee-owners than for nonowners.[x]
This increased job tenure translates into quantifiable benefits for workers in ESOPs. An ongoing analysis of panel data from the National Longitudinal Survey comparing younger workers with ESOPs to similar workers without such a benefit finds the median job tenure of employee-owners is 5.1 years, 46% greater than the 3.5 years for those without an ESOP. This translates into appreciably higher median household wealth for ESOP workers.[xi]
Worker Cooperatives and Employee-Owned Trusts
Worker cooperatives and employee-owned trusts are the two other most important models for broad-based employee ownership. There are currently several hundred worker cooperatives, with the large majority employing fewer than 50 people. So they are much less numerous and employ far fewer people than ESOPs, partly because they do not have all the same tax benefits and partly because of their more restrictive rules. For the right company, however, they can be a very good (and less expensive and complicated) fit. Employee-owned trusts are common in the UK, but only starting to gain interest in the U.S. Project Equity, a nonprofit promoting these models, provides a good description of these approaches, which we have included here with its permission.
Worker-owned cooperatives are 100% employee-owned and are a popular choice because of their many benefits, a lower cost to set up, and the full range of democratic values they provide.
Worker-owned cooperatives are:
- Democratic: one-person, one-vote among employees (to elect board members and vote on major strategic decisions as defined in the bylaws), with employee-owners making up the majority of the board
- Equitable: employee-owners earn profit-sharing via patronage, based on hours worked
- Less expensive: lower setup and ongoing administration costs
- Tax-positive: profits shared as patronage are tax deductible to the business; also, some sellers may qualify for lifetime deferral of capital gains tax
- Equity stake: employees pay a small equity buy-in
- Universal: appropriate for companies of all sizes
A worker-owned cooperative is a company that is owned and controlled by the people who work there. The board of directors is made up of a majority of employee-owners who are elected by the full membership on a one-person, one-vote basis, and profits are shared based on hours worked. Their hallmarks are a highly participatory culture, with most having traditional management structures and “representative” democracy through the board and the annual general meeting.
Each employee purchases a single voting share, and their buy-in price is set relative to their earnings so that becoming an owner is a financial stretch, but still within reach of the entire employee base. Share value does not appreciate; this is one of the ways that worker cooperatives are designed to perpetuate employee ownership over the long term.
Worker coops have lower setup and ongoing administration costs, and qualify for some tax benefits (but fewer than ESOPs). In some circumstances, the seller can qualify for lifetime deferral of capital gains tax, and the profit that is paid out as patronage is tax-deductible to the worker cooperative business.
Employee Ownership Trusts
Employee ownership trusts (EOTs), sometimes called perpetual employee trusts, offer an option that safeguards the ownership over the long term by blending the trust structure with some of the democratic qualities of worker-owned cooperatives. EOTs are:
- Perpetual: safeguards the ownership of the business by its employees
- Flexible: offers more ability to design the trust structure to meet the goals and needs of the business
- Lower cost: lower setup and administration costs
- Free to employees: employees don’t pay for their ownership benefits
EOTs preserve the business over the long term for the benefit of the employees—not just their financial benefit, but also the preservation of their jobs and ownership. This contrasts with ESOPs, which, if faced with an acquisition offer, have a fiduciary responsibility to maximize the financial benefits to the shareholders. In an EOT, the employees benefit financially by receiving a share of the company’s annual profits rather than by owning an asset that changes in value based on an annual valuation. Company shares don’t circulate, as they stay in the trust.
Democratic voting by employees can be built in (through the power to direct the trustee), enabling strategic decisions to be in the hands of employees (for example, electing the board of directors).
EOTs have lower setup costs and negligible ongoing maintenance costs, but they are not eligible for the significant tax benefits of an ESOP.
One of the major benefits of the perpetual trust structure is its flexibility for companies that want to design the trust to fit their specific goals.
[i] NCEO analysis of the Annual Survey of Entrepreneurs, 2016.
[iii] Of course, this course of action is not suitable for every company. Generally, companies should have at least 20 employees to be able to absorb the transactional costs of an ESOP, have enough profits to purchase shares and still run the company, and have a culture open to sharing ownership.
[iv] See the booklet Employee Ownership: Building a Better American Economy for an overview of how ESOPs work in practice.
[vi] See A Guide to Research on Employee Ownership for a detailed summary of academic research findings.
[vii] For example, in the 2017 NCEO repurchase obligation survey, 72% of the ESOP respondents strongly agreed that they intend “our ESOP to be permanent.”
[viii] See for example, Measuring the Economic Impact of Short-Termism.
[ix] Author’s calculations using the Survey of Consumer Finances (2016). For additional data on the state of Americans’ retirement savings, see S Corporation ESOPs and Retirement Security.
[x] The General Social Survey (GSS) is a nationally representative, face-to-face survey covering a broad range of behavior and attitudes conducted by the National Opinion Research Center (NORC) at the University of Chicago. The General Social Survey does not break out ESOPs. Employee-owners are identified based on the GSS variable ownstock, which asks respondents whether they own any shares of stock in the company where they now work, either directly or through some type of retirement or stock plan.
[xi] See the full results at https://www.ownershipeconomy.org/.