The ESOP-erative

A new design: worker cooperative governance with ESOP tax benefits

By Martin Staubus

Businesses interested in transitioning into employee ownership are often presented with a structural dilemma: convert into an ESOP or a cooperative? Go for the democratic worker control and participation of a cooperative, or the tax benefits of an ESOP? I recently helped a company, Sun Light & Power, combine the two in an innovative design that others might find of interest.

A cooperative is attractive in principal because its legal structure inherently assures democratic ownership and governance. Cooperative employee-owners decide their own pay scales, schedules and management structure. Each member of the cooperative typically purchases one share, so all worker-owners have the same ownership interest and an equal voice in decision-making, a rarity in today’s economy of temporary, stratified, and low-paying jobs..

Another form of employee ownership is the employee stock ownership plan, or ESOP. With this arrangement, the stock of a corporation is put into a company retirement plan, and the shares are allocated among individual accounts for each participating employee. Thus, the employees are the shareholders of the company. While cooperatives pay taxes on their profits, ESOPs can have a significant business advantage because they are free from income taxes.

“...Ordinary workers are retiring from ESOP-owned companies with personal ownership accounts holding as much as $1 million in company stock.”

Free of taxes on its profits, the ESOP-owned business has more cash available to invest in the growth and success of the business. This generates financial gains for the employees through capital appreciation that has traditionally been the exclusive reserve of our society’s top 1 percent of earners. With the benefit of this advantage, ordinary workers are retiring from ESOP-owned companies with personal ownership accounts holding as much as $1 million in company stock.

The rules for ESOPs, however, do not require that employees receive equal ownership interests, or that the governance structure will assure democratic control of the business by workers. At the same time, the rules do not prevent ESOPs from organizing with full democratic governance by employees.

Here’s how these two models were combined at Sun Light & Power, a solar power company based in Berkeley, California. It has implemented an ESOP — coop hybrid arrangement that yields the best of both forms of employee ownership. The company, formed by a UC Berkeley engineering grad back in the 1970s, was considering transitioning to employee ownership as the founder retired. They established a committee of employees who researched the available options. Predictably, they found themselves on the horns of that dilemma: ESOP or coop?

The solution grew out of a collaborative effort of the Beyster Institute at UC San Diego and the ICA Group, consultants based in western Massachusetts. The great majority of existing ESOPs (there are about 7,000 in the U.S.) allocate the company’s shares among the employees in proportion to each employee’s pay, which means those with big salaries get considerably more shares than employees with modest salaries. But that practice, while common, is not required.

Likewise, most ESOP companies give employees only limited voting rights; and they tend to provide that those limited rights will be exercised on a one share, one vote basis (as typical corporations traditionally do it with shareholders). That means larger shareholders (with higher salaries) have greater voting power.

Yet the ESOP rules do permit a structure in which: a) employee-owners will participate in all votes; and b) the voting will be conducted on a fully democratic one person, one vote basis.

“The formula calls for 50 percent of the stock to be divided among all employees equally”

At Sun Light & Power, the employee committee developed their own formula for allocating the shares of stock that the ESOP would acquire from the founding owner. The formula calls for 50 percent of the stock to be divided among all employees equally; 25 percent to be allocated based on the number of years the employee has been with the company; and the final 25 percent on the basis of the employee’s salary level.

Next, they developed rules for their ESOP to assure that the employees will participate in all shareholder votes, and that the voting will be conducted on a one employee, one vote basis, without regard to the number of shares in an individual’s personal ESOP account. Most importantly, this approach now determines how the company’s board of directors is elected, where crucial decisions related to financial performance and management are made.

But there is one more essential issue that the Sun Light & Power model addresses. Yes, for the election of the board of directors, ballots go to all employees, who each get to vote their shares. But what is usually overlooked is this question: who selects the candidates whose names will appear on the ballot? This is a critical issue that often goes unaddressed. After all, if employees are asked to elect seven people for the seats on the board, and the ballot only shows seven names, the selection of the board has in truth already been made.

At Sun Light & Power, the solution was to form a body of employees known as the Cooperative. All employees of the company are eligible to become member of the Cooperative, once they have satisfied certain eligibility requirements, such as learning the basics of business finance through a financial literacy program. It is the Cooperative that selects the candidates whose names will appear on the ballot for the election of the board of directors.

“A company that is democratically owned and governed by its workers, and can operate free of income taxes on its profits, turning the company into a wealth-generating machine for its workers.”

The result? A company that is democratically owned and governed by its workers, and can operate free of income taxes on its profits, turning the company into a wealth-generating machine for its workers. It’s the best of both worlds.

Sun Light & Power has also registered as a “B Corp,” formally committed to triple bottom line success: that is, it’s aim is not just positive financial results, but also positive social and environments results.

Their own name for their arrangement? The “B/ESOP/erative.” When over 7 million baby boom small business owners will retire over the coming years, without succession plans, the ESOP-coop and B Corp model is a promising path for them to continue their positive legacies in their communities. Granting ownership to employees creates more stable, positive work environments. When we have more control over the work we do, we are more invested in its outcome, and more responsive to our co-workers. It’s just good business.

Martin Staubus is the Executive Director of the Beyster Institute, a consulting organization and center of expertise on employee ownership based at the University of California San Diego.