This blog post will explore two different employee ownership models – ESOPs and Cooperatives. It will discuss the distinctive features, advantages, and challenges of each model, and will briefly compare the two. Our hope is to help readers better understand these two models, and when either might be a suitable ownership structure for an organization based on the organization’s goals, culture, and employee dynamics. Please note, although only these two models are discussed, there are other employee ownership models that are also options for interested organizations.
Employee Stock Ownership Plans (ESOPs)
An employee stock ownership plan (“ESOP”) is a type of employee benefit plan that acquires company stock and holds it in accounts for employees. ESOPs enable employees to own, in a way, part or all of the company they work for, without having to pay for those shares. Employees accumulate shares of the company in their retirement accounts over time, and then cash in those shares when they retire or leave the company
So how does an ESOP work? First, there must be a business, which (typically through its owners) must make a decision to set up an ESOP for its workers. Next, an ESOP trust is set up, which is a trust that holds shares in the company on behalf of the employees. The trust is funded entirely by the company and is governed by federal rules that similarly govern 401(k) retirement plans. The company contributes money to the trust (or the trust borrows money), and the trust uses that money to buy some or all of the shares of the company from the company’s owners at a price determined by an independent appraiser. The trust then allocates shares to retirement accounts of employees, who now have stock in the company, as beneficiaries of the trust, without having had to pay for such shares individually. When employees leave the company, the shares are redeemed by the company with cash paid to the departing employees.
It is important to note, though, that ESOP benefits are subject to vesting, as laid out in the company’s ESOP vesting and distribution plan. This means that, for an employee to be entitled to the ESOP benefits, they must meet a minimum threshold of time worked for the company. Employees who terminate before meeting the vesting thresholds may forfeit benefits.
An ESOP company is governed similar to any other company (for example, likely by a board of directors). However, the company’s board of directors also appoints an ESOP trustee. The trustee is a fiduciary, responsible for overseeing the ESOP plan and acting in the employees’ best interests by making decisions that are aligned with the employees’ well-being. Further, the trustee manages the acquisition, allocation, and distribution of company shares and ensures the ESOP operates in compliance with relevant regulations.
The ESOP model originated as a defined contribution plan, a form of retirement plan under the Internal Revenue Code, and eventually became a qualified retirement plan (similar to a 401(k) plans, although they differ in significant ways as explained further here). Accordingly, because ESOPs are qualified retirement plans, they are notable for providing various tax benefits to companies and their employees. For example, contributions of stock and cash by the company to the ESOP trust are tax deductible, and employees pay taxes only on the redemption of their stock and distribution of their accounts (not at the time of the company’s contribution), at potentially favorable rates. Further, a company can use an ESOP for financing by borrowing through the ESOP and repaying the loan with pretax dollars. While these are some of the major tax benefits, other advantages exist depending on the company’s structure.
ESOPs offer various benefits, including:
- ESOPs can align employee and company interests by giving the employees a greater stake in the success of the business.
- They can be an effective way to buy out the owner(s) of a private company.
- Companies can use ESOPs to create, or to supplement the existing, benefit or compensation plans for employees.
- They can be used to acquire capital when the company borrows through the ESOP and repays the loan using pretax dollars.
- An ESOP can be used to acquire another company, or to divest a subsidiary, division, or product line through an ESOP buyout.
- As noted, they carry various tax advantages.
Challenges for ESOPs include:
- For the selling owner(s) using an ESOP as an exit strategy, the price that an ESOP can offer per share is limited to the fair market value of those shares, and thus, the seller may not get the same amount from the sale as it could from a strategic or private equity sale otherwise.
- Employees may not actually have control of the business. The extent of their control depends on the company’s governance and ESOP plan documents. So even though they will be invested in the business through their stock plan, their plan may not grant them extensive rights in the company’s decision making.
- ESOPs are very expensive for businesses to implement and administer.
- ESOPs are subjected to a high level of scrutiny and regulation by the IRS and Department of Labor.
- The company may experience a dip in cash flow because cash contributed to the ESOP can limit the availability of cash that would otherwise be available to reinvest in the business.
- ESOPs tie employees’ financial well-being to the company’s performance. If the company faces financial challenges, the employees’ retirement could be at risk. Additionally, their ESOP ownership may be an illiquid asset.
- There are many administrative requirements that come with selling the company to an ESOP, such as having a trustee to act as a fiduciary, annual regulated valuations, and a third-party administrator being engaged to maintain participant accounts.
Given their various features, ESOPs are obviously not for every business. Accordingly, certain features make companies better candidates for ESOPs than others. First, privately owned companies are better than publicly owned because ESOP contributions typically increase retirement expenses and reduce earnings, having negative market consequences. Strong cash flow and history of increasing sales and profits is helpful because earnings patterns will influence employee motivation (since they have more at stake now). Good candidates also have strong management. Since ESOPs involve a sale from the existing owners to the ESOP, good management is critical for ongoing success following that succession. Further, a diverse shareholder group is a positive because a wide range of retirement dates helps maintain balance between cash flow dedicated to the selling shareholders and a safety net for retention of cash in the business to invest in longer-term initiatives. Finally, if the company is in higher federal income-tax brackets, it will be able to take significant advantage of the tax benefits.
ESOPs will not be a right fit for some companies though. For example, very large or publicly traded companies are often too valuable for ESOPs to purchase, even over time, and thus are not ideal candidates. Similarly, very small companies with low revenue or few employees often are not good candidates for ESOPs because the cost of setting up and maintaining the ESOP can be too prohibitive. Finally, family-owned businesses that have been in the family for generations are also not great ESOP candidates unless the family wants to relinquish ownership of the business.
Cooperatives
Cooperatives are covered extensively on this blog and on our website, and here we will discuss them in comparison to ESOPs.
The International Cooperative Alliance defines a cooperative as “an autonomous association of persons united voluntarily to meet their common economic, social and cultural needs and aspirations through a jointly-owned and democratically-controlled enterprise.” Unlike ESOPs, which are organized as legal trusts for holding shares separate from the business entity, a cooperative is the organization itself through which the business is legally organized and conducted. Under state laws, groups can create their own legal cooperative entity (such as a limited cooperative association or cooperative corporation), but if that model is not an option under a particular state’s laws, a business can still legally organize as a standard entity (such as a corporation or limited liability company) and operate like a cooperative under its governance documents.
Cooperatives are owned and operated by their members, who may be individuals or legal entities, and who benefit from the products or services of the cooperative. Members are vital in the decision-making process because cooperatives are democratically controlled, meaning that each member generally gets one vote, which vote is equal in power to the votes of other members. However, cooperatives often appoint a board of directors responsible or management team for day-to-day decision-making, and may also create officer positions (such as president, secretary, treasurer, etc.). Cooperatives may also have multiple classes of members, depending on the purpose of the cooperative.
Cooperatives can take various shapes and sizes and can range from being based in local communities to more far-reaching organizations. The different types can include worker cooperatives (organizations where people who are employed by the company contribute to the cooperative through their labor and the work they do for the organization and become owners), consumer cooperatives (made up of consumers who purchase goods and services from the cooperative, like grocery cooperatives), purchasing cooperatives (made up of several businesses joining together to improve their purchasing power on products and services), and producer cooperatives (organizations where producers of products join together to market their products better or improve their production processes). These are just a few; other types and combinations of types of cooperatives also exist.
As members are the owners of the cooperative business, they also share in the success of the business through patronage allocations. In other types of business entities, the owners share profits based on their percentage of ownership in the company. In cooperatives, however, profits are not shared based on equity ownership but are allocated to members based on their patronage. The amount members “use” the cooperative is tracked by the cooperative, which is used to determine the members’ patronage and patronage allocations. “Patronage” is the term used to describe how a member uses the cooperative. For example, in a producer cooperative, this could be the value of what a member sells through the cooperative. In a worker cooperative, patronage could be how many hours worked or the value of projects completed. Each cooperative’s definition of patronage forms the basis for calculating what share of the cooperative’s profits are allocated to each member – the “patronage allocations” (also called patronage dividends or refunds). Patronage allocations are payments to the members of their shares of the profits, and can be in the form of cash or an entry on the cooperative’s books in the name of the member. Each member’s patronage allocation is based on their patronage of the cooperative, not based on any equity capital contributions. A member who patronizes the cooperative more than another member can receive a relatively higher share of the profits and patronage allocations.
The cooperative business model provides various benefits, many of which depend on the type of cooperative. Benefits include:
- Members generally have equal say in the business.
- Because cooperatives are formed by members coming together for a shared purpose, they also often share the same values and principles.
- Employees are more invested in the worker cooperative’s business because they are directly impacted by the cooperative’s performance and share in its successes and losses.
- Cooperatives have a reduced tax burden compared to other entity types, like corporations. Under sub-chapter T of the Internal Revenue Code (a tax election available to cooperatives) cooperatives are not taxed on the patronage allocations they distribute to members. Further, members are only taxed once, on their personal cooperative income, and not at the cooperative level.
- Owner-employees are more motivated to keep costs down because lower costs ultimately increase the company’s profitability.
- Worker cooperatives have been shown statistically to better weather general economic downturns due to flexible structures and the ability of worker-owners to operate the business so owners do not have to be laid off.
- Local, community-based cooperatives can help stabilize communities because they can be business anchors that distribute, recycle, and multiply local expertise and capital within a community.
- By allowing members to pool together their resources for a common goal, cooperatives provide affordable solutions for those members to succeed together.
- Cooperatives are accountable to their members, not investors, so decisions can be made for the benefit of members rather than purely to maximize profit.
- Cooperatives have open membership, meaning to become a member, one must just have a common interest and the resources to join the organization (such as by paying a membership fee and meeting member participation requirements).
- Cooperatives are more likely to work with other cooperatives, and may be able to access organizational support through a network of other cooperatives.
On the other hand, some challenges for cooperatives include:
- Since cooperatives are usually formed for a specific purpose shared among the members other than maximizing profit (such as creating jobs, marketing products, combining purchasing power, etc.), the organization may not be as profitable for the business owners as another form of entity whose primary goal is to maximize monetary profit.
- Management may sometimes be challenging if the cooperative is relying on members who share the values of the business but lack the experience or willingness to lead effectively.
- Depending on the structure, group decision-making by members may be slow, especially if all members are extensively involved in most decision-making processes.
- Some states are less amenable to cooperatives being formed or operated under their laws because they lack the state laws for encouraging cooperative growth.
- Most cooperatives generate capital from their members and members in small cooperatives may not have the financial resources to adequately capitalize the company.
- Growth capital may sometimes be difficult to obtain, as cooperatives are perceived as less friendly to outside investment than stock corporations or limited liability companies, although cooperatives are authorized to allow investors.
- Some groups may determine that democratic governance (one member, one vote) is not a good fit for their particular goals.
Cooperatives can be an effective way to organize a business, and certain factors make a business a better candidate for cooperative organization. First, where an organization is made of owners who are willing to share in decision-making and are comfortable with not having total control of the business, a cooperative may be a good fit. Since cooperatives are democratically controlled, it helps to have owners who will actively participate in setting policies and making decisions. Second, where shared needs and mutual goals exist for the potential owners (and not just an interest in monetary profit), a cooperative may be an excellent fit. Cooperatives tend to start with a group who have a shared need – such as access to food products, a collective through which they can provide services as workers, sharing housing – that is not otherwise easily available in their area or community. Thus, a cooperative may offer an appropriate platform for the members to achieve that need at scale. Similarly, an organization whose purpose is driven by a concern for its community, such as by providing a missing resource to the community and its members, is also a feature making a cooperative an appropriate fit.
Sometimes, however, cooperatives may not be the best fit for an organization. This may be the case where the business is primarily concerned with profit, and is not otherwise led by a common goal shared among its employees or members. Further, where the initial owners of a business want to retain total control of the operation, a cooperative will not be a good fit because it would otherwise offer greater involvement in the decision-making process to the workers or members of the company. Additionally, if the business knows it will be seeking outside investment (such as private equity), another form of entity may be a better fit, such as a stock corporation.
Brief Comparison of ESOPs and Cooperatives
While both cooperatives and ESOPs aim to empower stakeholders and promote shared ownership, they differ in several key aspects:
- Ownership Structure: cooperatives are owned and controlled by their members, who have an equal say in decision-making. In contrast, ESOPs provide employees with ownership stakes in the company through retirement accounts.
- Profit Distribution: cooperatives distribute profits among members based on their level of patronage (their participation in the business), promoting economic equality. ESOPs, on the other hand, allocate profits indirectly through the appreciation of company stock held in employee retirement accounts.
- Governance: cooperatives operate on the principle of democratic control, with each member having a vote in decision-making processes. ESOPs do not necessarily grant employees direct control over company decisions as the ESOP trustee is the person authorized to vote the shares held by the trust, but may influence management through their ownership stake.
- Purpose: Cooperatives are typically formed to serve the needs of their members and the community, while ESOPs are often implemented as a succession planning tool and employee retirement plan or to align the interests of employees with those of management and shareholders.
Conclusion
In conclusion, both cooperatives and ESOPs offer unique advantages for fostering shared ownership and participation in business. While cooperatives emphasize democratic control and equitable profit distribution, ESOPs provide employees with a direct financial stake in the company’s success. The decision between various employee ownership models (and not just between ESOPs and cooperatives) depends on an organization’s specific goals, culture, and employee dynamics. The ESOP and cooperative models both offer unique benefits and challenges, and thus, the choice of an employee ownership model should be made after careful consideration. Understanding the key differences and implications of each model is a crucial first step in this decision-making process.
Please note, this is not an exhaustive discussion of these two (or any other) employee ownership models; organizations considering a change in their ownership structure should reach out to an attorney before making any definitive decisions.
References:
https://www.esopinfo.org/how-esops-work/
https://www.nceo.org/articles/esop-employee-stock-ownership-plan
https://www.nceo.org/articles/esop-employee-stock-ownership-plan
https://www.esop.org/articles/esop-pros-and-cons.php
https://fitsmallbusiness.com/esop-employee-stock-ownership-plan/
https://ica.coop/en/cooperatives/cooperative-identity#definition-of-a-cooperative
http://www.legalfoodhub.org/wp-content/uploads/2021/10/Co-op-guide.pdf
