Exploring Employee-Owned Business Structures

By William Rudnick, Executive Managing Director, Co-Founder

Aligning the interests of business leaders, employees, and shareholders can enhance the long-term health and success of any business. By setting up a structure where employees have a stake in the company’s ownership, businesses not only foster a sense of shared purpose and commitment, but also unlock a myriad of benefits. From enhanced employee engagement and productivity to greater innovation and resilience, the advantages of an employee-owned business extend far beyond financial incentives.

The following employe ownership business structures have the potential to empower employees and create alignment of interests across the key stakeholders in your company.

What is an Employee-Owned Company?

An employee-owned company is a business model in which employees hold a stake in the company. This ownership can vary in form and extent, but the key feature is that employees possess a substantial portion of the company’s equity and frequently participate in its management and decision-making processes.

How do Employee-Owned Companies Work?

Employee-owned companies operate by giving employees a significant ownership stake in the business, which can be achieved through various mechanisms. This model can lead to numerous benefits, including enhanced engagement, better financial performance, and smoother succession, but it also comes with challenges such as complexity and the need for a shift in management practices.

Employee Ownership Equity Compensation

Restricted Stock

Restricted stock gives employees shares of the company that are subject to certain restrictions, such as vesting periods or performance goals. Restricted stock can be an effective way of rewarding and retaining key employees.

In addition, capital gains from selling a business benefit from a preferential tax rate. For example, if the profit from the sale of your business qualifies as a long-term capital gain (assets held longer than one year), it would be taxed at a maximum of 20%. If the same profit was treated as ordinary income, it might be taxed at a rate as high as 37%.

However, restricted stock can have drawbacks, including:

Creates tax liabilities for employees when they receive the shares, and as the restrictions come off.
Reduces liquidity and flexibility, as employes must hold the shares for a certain period of time or until certain conditions are met.

Phantom Equity

Phantom equity provides a share of the profits or value of the company to employees, without actually giving them any shares or equity, hence the name “phantom” equity. For example, phantom equity can be structured as a deferred compensation plan or a profit sharing plan. It also has some advantages over restricted stock.

Avoids tax implications and the dilution effects of granting actual shares or equity to employees.
Allows employees to participate in the upside potential of the company, without exposing them to the downside risk.

Disadvantages of phantom equity:

Lack of legal protection and enforceability of actual shares or equity, as the employees do not have any ownership rights or claims on the company’s assets.
Dependence on the discretion and goodwill of the company, as the company can change or terminate the phantom equity plan at any time.
Although the upfront tax treatment is better than restricted stock, the earnings on phantom equity are generally taxed as ordinary income.

Profits Interests

Profits interests give employees access to future profits or appreciation of the company, without giving them any ownership in the current value of the company. Profits interests can only be used with entities that are taxed as partnerships (typically partnerships or limited liability companies). Profits interests can have significant benefits:

Tax-free for the employees when they receive their grants, if they meet certain requirements.
Flexible and adaptable to the specific needs and goals of the company and the employees, as the profits interests can be based on different metrics and criteria.
Compatible and complementary with other forms of employee ownership, as profits interest can be granted alongside or in lieu of other equity or compensation.

Profits interests can also have drawbacks:

Valuation challenges – determining the value of profits interests can be challenging, particularly in rapidly growing or fluctuating businesses.
Missteps in structuring or valuing profits interests can result in unexpected tax liabilities for both the company and the recipients.

Options

Options provide employees the opportunity to buy a certain number of shares at a predetermined price, within a specified period. Options can be an attractive way of incentivizing and rewarding employees, as they can benefit from the appreciation of the company’s value. Like other equity choices, options also have limitations:

Expiration after a specified period, which may not align with the long-term goals and interests of the employees.
Investment risk if the company’s value does not exceed the exercise price of the options.
Tax liabilities for employees when they purchase the options, which can reduce their net gain.

Employee Stock Ownership Plan (ESOP)

An ESOP involves a trust that holds company shares on behalf of employees. The company can contribute shares to the trust, which then allocates those shares to employees based on specified criteria, including compensation, seniority, and other factors. Benefits of an ESOP include:

Providing a tax-optimized way of transferring ownership and control of the company to employees, as the company can deduct contributions to the trust and the trust can defer the taxes on the shares.
Creating a market for the shares of the company, as the trust can buy and sell shares from existing or departing owners or employees.

Noted challenges of an ESOP.

Significant upfront investment and ongoing administration costs, as the company must set up and maintain the trust and the valuation of the shares.
Limiting the diversification and liquidity of employees, as they must hold shares in the trust until they retire or leave the company.
Introduction of a corporate trustee into the company’s governance.

Other Employee Ownership Structures

Employee ownership can take various forms, including worker cooperatives and employee ownership trusts. These structures offer different methods for providing employees with a stake in the company, aligning their interests with those of the business, and motivating and retaining talent. Each structure has unique benefits and considerations, tailored to the company’s goals and employee needs.

Worker Cooperatives

A worker cooperative is a business entity that is owned and self-managed by its workers. Each worker-owner has an equal say in decision-making processes, typically following the principle of one worker, one vote. Profits are usually distributed among members based on agreed-upon criteria, such as hours worked or roles performed. Worker cooperatives emphasize democratic control, equitable profit distribution, and collective ownership. Benefits include:

Democratic decision-making, as every worker has an equal vote, fostering a sense of ownership and empowerment.
Profits are shared among worker-owners based on predetermined criteria, often leading to a more equitable distribution of wealth compared to traditional business models.

Worker cooperatives can also be burdensome in certain areas.

Equal voting rights can lead to disagreements and conflicts among worker-owners, which can be difficult to manage and resolve.
The cooperative model can be harder to scale compared to traditional businesses, particularly in industries requiring significant investment and rapid decision-making.

Employee Ownership Trusts

Employee-owned trusts, also known as Employee Ownership Trusts (EOTs), are a form of business ownership where a trust holds the shares of a company on behalf of its employees. EOTs can provide a stable ownership structure, particularly in situations where the founder or owner is looking to retire or exit the business. It offers a succession plan that allows the company to remain independent and continue operations without disruption.

Challenges can include the below:

EOTs require robust governance structures to ensure transparency, accountability, and effective decision-making. Managing the balance between employee participation and professional management can be challenging.
Determining the value of the company and providing liquidity for employees who wish to sell their shares can be complex. Illiquidity can be a concern for employees who want to access the value of their shares but have limited options for selling them.

Pros & Cons of Employee-Ownership

Benefits of Employee Ownership

Increased engagement and productivity: Employees who have a stake in the company are often more motivated to work harder and contribute to the company’s success.
Better financial performance: Research has shown that employee-owned companies often perform better financially than non-employee-owned companies.
Retention and recruitment: Offering ownership stakes can be a powerful tool for attracting and retaining top talent.
Succession planning: For business owners, selling the company to employees can be a way to ensure the business continues to thrive and maintain its culture.

Challenges of Employee Ownership

Complexity and cost: Setting up an employee ownership structure can be complex and costly.
Management challenges: Transitioning to an employee-owned model requires a shift in management style and often involves training employees in financial literacy and business management.

Employee-owned businesses can help ensure alignment across all stakeholders, but most of these structures also have the potential downside of diluting company equity. Before setting up an employee-owned business structure, you should be confident that the benefits will outweigh the impact of dilution.

FAQs:

What is employee equity? Employee equity refers to the ownership interest that employees have in the company they work for. Employee equity is designed to align the interests of employees with those of the company and its shareholders, fostering a sense of ownership and investment in the company’s success.
How do employee stock options work? Employee stock options (ESOs) are a form of equity compensation granted by companies to their employees. They give employees the right to purchase a certain number of shares of the company’s stock at a predetermined price, known as the exercise or strike price, after a specified period or upon achieving certain performance milestones.
What is an employee stock purchase plan? An Employee Stock Purchase Plan (ESPP) is a company-sponsored program that allows employees to purchase shares of the company’s stock at a discounted price, typically through payroll deductions. ESPPs are designed to offer employees an ownership stake in the company and to encourage a sense of partnership and investment in the company’s success.
How are employee stock purchase plans taxed? An Employee Stock Purchase Plan (ESPP) allows employees to buy company stock at a discounted price through payroll deductions over a specified period. The tax treatment of these shares depends on how long they are held before being sold. For a qualifying disposition, where shares are held for at least one year after purchase and two years after the offering period begins, the discount is taxed as ordinary income, and any additional gain is taxed as long-term capital gain. For a disqualifying disposition, where these holding periods are not met, the discount is taxed as ordinary income, and any additional gain is taxed as short-term or long-term capital gain based on the holding period after purchase.

Contact Peakline to explore how an employee-owned business structure might benefit your company.

Peakline Partners, LLC is a registered investment advisor. This material is presented solely for informational purposes, and nothing herein constitutes investment, legal, accounting, or tax advice, or a recommendation or solicitation to buy, sell, or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Investing entails risk, including the possible loss of principal. This document should not be construed as a recommendation to purchase or sell any particular securities. Market conditions can vary widely over time and can result in a loss of portfolio value. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.