Steward-ownership is capitalism 2.0
In my previous post, I explained why we need to change incentive structures if we want to build companies that are a force for good in society. There are several ways to do this. At Sharetribe, we’ve opted for a structure called steward-ownership. In this post, I’ll dive into the background of the model, how it works in practice, and how we’re applying it at Sharetribe.
First, we need to go back in time more than a hundred years.
History of steward-ownership
Steward-ownership is relatively new as a term, but the underlying concept is almost as old as limited liability corporations, the structure adopted by most modern companies. The original steward-ownership model was invented by Ernst Abbe, co-owner of the successful German optics manufacturing company ZEISS, founded in 1846. Abbe had worked as a professor at the university of the city of Jena, where he invented the technology behind ZEISS’s success. This likely led him to the insight that the value and the profits created by ZEISS did not belong just to him, but to everyone working at the company and society at large.
After the company’s founder Carl Zeiss died in 1888, Abbe created the Carl Zeiss foundation, which has owned ZEISS ever since. The foundation ensures that the company cannot be sold and profits are either reinvested or donated to the common good. Abbe then introduced several important rights for the workers, amongst them a health and pension insurance for the workers and an 8-hour workday. He also instituted a principle that the highest salary of any ZEISS employee cannot be higher than 12 times the lowest salary a worker gets after being at the company for two years.
Today, more than hundred years later, ZEISS is thriving. Its business consists of manufacturing optical systems, industrial measurements, and medical devices. Its annual revenue exceeds 5 billion euros and annual profits 600 million euros. Charitable donations from ZEISS are an important source of funding for the university of Jena, where its technology was originally created.
Since then, several other major companies have adopted similar structures. The most well-known ones include German engineering and electronics company Bosch (revenue 78 billion euros and profit 5.3 billion euros in 2017) and British department store chain John Lewis (revenue 2015 11 billion pounds and profits more than 400 million pounds).
Professor Steen Thomsen, the chairman of the Center for Corporate Governance at Copenhagen Business School (CBS), has studied companies with comparable ownership structures extensively. His research shows that such companies:
- Are more profitable than other companies in the medium term
- Live longer — survival probability is 600% higher after 40 years
- Are trusted more by their customers
- Offer their employees better pay
- Have better employee retention
In addition to all this, these companies typically generate many kinds of societal benefits that extend beyond their owners and customers. Charitable donations by ZEISS are a great example of this. Bosch, meanwhile, has been a pioneer in investing in environmentally friendly technology.
The term “steward-ownership” was coined by Purpose Network, a German organization that is researching this model, developing it further, and helping organizations transform into it. The team behind the organization also operates an impact fund called Purpose Ventures, which invests exclusively in steward-owned companies. Purpose Network works for a paradigm shift in the economy, with the goal of transforming it from profit maximization to purpose maximisation.
Based on the research Purpose Network has conducted, the following two key principles apply to all steward-owned companies.
Principle 1: Profits are a means to an end
Traditionally, a for-profit company exists to maximize returns for its shareholders. In many national legislations, it is stated that unless changed in the bylaws of the company, shareholder profit should be the north star guiding the decisions of its management.
For steward-owned companies, profits are a means to an end, not an end in themselves. In most legislations, it’s possible to make this official by changing the company’s purpose in its official articles of association. After this change, if the company’s management sees a way to increase its profits that is in conflict with the purpose of the company, it is no longer bound to choose profits over purpose.
Sharetribe’s new articles of association (which you can download from the “Documents” section of our equity crowdfunding campaign page) state the following: “The purpose of the company is to democratize the sharing economy. The company aims to foster an economy where resources are utilized efficiently, created value is distributed fairly, and people have control over the conditions of their work.”
What practical implications does this change have? Let’s take a concrete example. Based on a thorough analysis of the market situation of online marketplace technology, Sharetribe’s management might come to the conclusion that if the company focuses its efforts solely on building steeply priced proprietary marketplace technology that helps big organizations create marketplaces where retailers can sell their products to consumers more efficiently, it could increase its profits significantly. This approach would be in conflict with the company’s purpose in several ways. First of all, if our technology is accessible only to wealthy people or big organizations, we’re not moving towards our purpose of democratizing the sharing economy. Second, the company would be contributing to the increased consumption of new goods instead of decreasing it, which would be in conflict with the goal of more efficient utilization of resources. Thus, in such a situation, management would be incentivized to choose a business focus more aligned with the company’s purpose and ethics.
It should be noted that a company’s purpose is something that should be able to evolve. For instance, ten years from now, the term “sharing economy” might no longer be used. Because of this, steward-ownership allows the company to make changes to its official purpose statement. At Sharetribe, such a change can be made if people holding two-thirds of the company’s shares agree with it.
This raises the question whether a steward-owned company could initially be purpose-driven but later change its ways by redefining its purpose to profit maximization. And even if its purpose is not officially changed, these types of definitions are relatively fuzzy — they alone are not enough to guarantee that the company doesn’t end up creating an incentive structure that focuses on profits if free profit distribution to shareholders is allowed. To remedy these issues, steward-owned companies often cap the returns they offer to shareholders. We’ll return to this aspect a bit later. First, let’s examine the second principle of steward-ownership.
Principle 2: Ownership equals entrepreneurship
The second principle of steward-ownership states that the company should be in control of people who hold active roles in it. Sometimes steward-ownership is also referred to as “self-ownership”: steward-owned companies are ultimately governed by the people working in them. This guarantees that the decisions conducted by the management of the company will be in the best interest of its employees and all other stakeholders.
Typically, this principle is achieved by restricting the ownership of shares with voting rights so that these can only be held by people who have an active role in the organization. As an example, at Sharetribe, we have several different share classes. Only A-shares and B-shares have voting rights, while only C-shares and D-shares have profit sharing rights. Our articles of association contain the following statements:
“Any acquisition of the company’s A, B or D Shares shall require a prior consent of the board except in a situation where D Shares are acquired by an existing holder of D Shares. As to A Shares, the consent can be given only to a person who is either in employment or in a service relationship with the company or one of its affiliates.”
In practice, this statement prevents the company from being sold to an outside buyer since such a buyer cannot achieve decision-making power in the company. It also means a steward-owned company cannot be taken public in a traditional way. If a person holding voting shares decides to quit active participation in the company, they need to give up their voting shares for a nominal cost (in our case, it’s one cent per share as Finnish legislation doesn’t allow share redemption without payment).
Steward-ownership doesn’t prescribe how the voting shares should be distributed among the team members. Currently, all of the members of our team hold some voting shares or options for them, but me and my co-founder Antti still hold the majority. The topic of how a steward-owned company should be governed is an interesting one. It’s beyond the scope of this post, but we hope to return to it later.
Reliable returns to investors: Redeemable shares
Like a traditionally structured company, a steward-owned company might also encounter a situation where its business would benefit from an outside investment. This means that it needs to be able to offer attractive return prospects to its investors.
In the world of technology startups, the most common source of funding is venture capital. VC firms typically expect their returns to come via a company sale or an IPO. They make high-risk investments and typically expect that one out of every ten companies they invest in will be able to generate enough returns to justify all the other nine investments (which end up returning nothing). In his excellent article, venture capitalist Homan Yuen explains why a venture firm investing $1M in a startup valued $10 million needs to believe the company has the potential to produce an exit with a valuation of $1B-$2B within the lifetime of the fund (typically 10 years) to justify its investment. This explains why venture capitalists are so obsessed with “unicorns” (startups that exceed $1B in valuation).
While steward-owned companies can’t generate such returns to their investors (as they won’t sell or go public), this doesn’t mean they can’t be attractive investment targets if the investment instruments are structured in a different way. After all, as Yuen notes, venture capital funds’ target returns to their investors (“limited partners”) that are typically between 2x and 4x in ten years, which translates to 6–15% per annum. The only reason VC funds have such high return expectations per company is the high failure rate of VC-funded companies.
As experienced impact investor Aner Ben-Ami of Candide Group points out, venture capital should have never become the default way of funding companies. It definitely has its place in building truly disruptive, capital-intensive businesses — if you’re building rockets or electric cars, for instance — but for many businesses, striving to become a unicorn can be detrimental: the increased burn rate causes the company to rapidly run out of cash before finding a sustainable business model.
What’s more, Ben-Ami notes that the traditional VC model is not even that great for the venture capitalists themselves:
“In general, only the elite ‘top quartile’ venture funds have generated what is often referred to as “venture returns” for their investors. Unicorn hunting is a tough business!”
Perhaps companies, investors, and society at large would be better off if, instead of focusing so much of their energy on the small group of potential unicorns, more investors would fund a large amount of profitable, medium-sized businesses that can become profitable early on. This is the investment thesis of Indie.vc, a US-based venture fund started by experienced venture capitalist Bryce Roberts. On their homepage, they state:
“At Indie.vc, we believe that companies with a focus on making a product customers love and selling it at a profit from the very beginning have a distinct long-term advantage over those who don’t. We’ll trade slower, thoughtful, compounding growth over scaling fast and failing fast every time.”
Such a focus also requires a new kind of funding instrument. Indie.vc, Candide Group, Purpose Ventures, and other pioneering investors have started investing with instruments based on profit-sharing instead of focusing on an exit.
Imagine a fund that still invests in ten companies and expects a return of 3x over a period of ten years. Instead of asking these companies to exit, it could require them to buy back its shares at a 5x price over that same period. This requires a much larger portion of these companies to succeed in generating the desired return (six out of ten), but on the other hand, they can do so without selling the company and their growth doesn’t need to be enormous. Ben-Ami presents a concrete scenario where the company has annual revenue of $1M and is not yet profitable at the time of the investment. After seven years, the company is generating $10M in revenue with an EBITDA of $1.5M. That sounds like a reasonable estimate. Ben-Ami’s calculations show that such growth — which would never attract a traditional venture capitalist — would be enough to provide investors with returns comparable to those of venture capital funds.
For Sharetribe, a profit-sharing model is a natural fit. In our current funding round, we offer investors redeemable shares for the price of 20 euros per piece. In the shareholder agreement, it is stated that our company uses 40% of its annual profits to redeem back these shares for 100 euros apiece until they have been fully redeemed. Our model has been inspired by a debt vehicle called Demand Dividends, which was designed to create reliable returns in impact investing, but our model uses redeemable shares instead of debt royalties.
In our projections, we expect faster growth than in Ben-Ami’s scenario — while the target we agreed upon with our investors is ten years, we hope to be able to redeem all the investors’ shares within six to seven years. If these projections fail, Ben-Ami’s calculations show how even a relatively modest annual growth would be enough to provide a sufficient return in the target timeline.
If we don’t meet the 10-year target, we would need to either redeem back the remaining shares immediately from our free cash flow, figure out a refinancing option, or continue using 100% of our EBITDA in the following years for redemptions until all investor shares are bought back. This condition ensures that it is also in the best interest of the company to redeem all the shares on time.
In our specific model, there’s an aspect that gives the management of the company a personal financial incentive to ensure the investors will get their shares redeemed: there will be a “delayed compensation” waiting for them once the investor shares have been redeemed in full.
Rewarding founders and early employees: Delayed compensation
Starting a technology company is a risky business. It often involves at least some level of personal financial risk from the founders and early employees. Our situation is not an exception. Sharetribe was founded in October 2011, and during the early years of the company, we worked for a relatively low salary (during some periods even without any salary) to get the fledgling business going. Similarly, the first team members to join typically accepted a salary lower than their market rate. To compensate for this, they received stock options that would entitle them to a financial reward in case of a liquidity event in the form of a company sale or an IPO.
Our transition to steward-ownership removes the possibility of such a liquidity event. Thus, we needed to come up with an alternative way to reward the team for their early financial risk. Such incentive structures are important if we want more people to start steward-owned companies and join them. The steward-ownership model didn’t have a standardized way of structuring delayed compensation, so we decided to design our own.
We opted to create one more class of redeemable shares. In our transition, the earlier shares held by founders and early team members were split in two: each old share became one A-share and nine D-shares. A-shares have voting rights but no rights to profit-sharing. D-shares don’t have voting rights, but they have a similar right to a redemption as investor shares. The redemption schedule of D-shares is designed in a way that most of their redemptions will happen only once the C-shares (the shares of the investors) have been redeemed in full.
What, then, is a fair compensation for the early risk? We calculated this by assuming a situation where, instead of founding the company, we would have taken day jobs with the average market rate salary for people with our specific degree. We then calculated how much extra income we would have earned this way compared to our earnings during our time at the company, and used this calculation to give our original investment a monetary value. To this sum, we then applied the same average annual interest rate as what our investors would get in a scenario where all their shares are redeemed. We arrived at roughly 1.9 million euros (before taxes) per founder. A similar calculation was then applied to each team member, but in a way that the compensation each team member would get would be in proportion to the number of shares or options they were holding. We then had conversations with the entire team to calibrate these calculations and figure out a fair level of delayed compensation for everyone.
Beyond the share redemptions, the only other financial compensation team members (including founders) can receive is a salary, which cannot exceed market rates. Sharetribe will never pay dividends as our articles of association prevent that for A and B shares (and holders of C and D shares get their returns via share redemptions). This guarantees that once all the C and D shares have been redeemed, 100% of the company’s profits will be used either to develop the company further or other activities aligned with its purpose, like charitable donations or investments in other steward-owned companies.
After this final piece of the puzzle, all the components of Sharetribe’s steward-ownership structure were in place. There was just one more thing: how can we prevent the management of the company from changing the structure later on?
Safeguarding the structure: Foundation and veto shares
When a company transitions into a steward-ownership structure, it’s important that the transition is permanent. This way, it can give a binding promise to all its stakeholders — employees, customers, investors, and society at large — that it won’t change its ways later on and revert back to profit-maximization, even if there’s a change in the company’s management.
Since ZEISS, steward-owned companies have used foundations to safeguard their structures. The great thing about a foundation is that it can be assigned rules that its board must obey, no matter what their personal preferences.
Creating a new foundation is, of course, expensive and requires quite a lot of work; it wouldn’t make sense for every startup to create their own. Luckily, there’s no need for that: Purpose Network has created a foundation that any steward-owned company can use. The Purpose Foundation is dedicated to helping companies stay independent and mission driven for the long-term through steward-ownership.
In our case, we created one more share class (B-shares) and issued exactly one of these shares, which was then given to the Purpose Foundation. This veto share can only be used to veto any change in the company’s articles of association that would attempt to dismantle the steward-ownership structure. The foundation is bound by its rules to veto any such change, and whoever is on the board of the foundation must respect these unchangeable rules.
In a nutshell: from now on, Sharetribe will always remain a steward-owned company.
Summary: The best of capitalism
Steward-ownership is not only reserved for “impact companies” trying to cure diseases, build technology for renewable energy, or tackling poverty. The model can be applied to any company that is building useful products, like the examples of Bosch, John Lewis and ZEISS show. The purpose of the structure is simply to make sure that our companies are in service of society, not the other way around. If the management of a steward-owned company comes to the conclusion that the company’s net impact is no longer positive due to its negative externalities, the management is incentivized to change the company’s ways.
To me, steward-ownership is a way for our society to get all the benefits of capitalism and free markets while remedying their negative effects. A decentralized market economy is an extremely efficient solution to allocating scarce resources when compared to alternative solutions like central planning. Entrepreneurship is a great way to increase the standard of living of everyone, and capitalism offers good incentives for both entrepreneurs and investors. This system has brought us enormous wealth and prosperity and lifted large amounts of people out of poverty. However, it has also brought enormous inequality and a myriad of environmental problems with it. Steward-ownership is a great example of how, with a few simple changes in how companies are structured and governed, we can get the benefits of capitalism without its downsides. To use Silicon Valley terminology, steward-ownership is capitalism 2.0.
For Sharetribe, there’s another reason why the steward-ownership model is a perfect fit. The goal of our company is to do to the sharing economy what steward-ownership does to capitalism: restructure it in order to get its benefits without the downsides. In future posts, I’m going to discuss how exactly that will happen.