ImpactAlpha, Feb. 21 – Who better to buy an established, profitable small business than the employees who work there? They know the operations, the products, the customers and the suppliers.
Worker-owned businesses tend to outperform, to be more resilient to downturns, and to preserve or create more jobs than other companies. Worker-ownership is a proven strategy, second only to home ownership, for building generational wealth among families that historically have not had access to such assets.
But when it comes time for the aging generation of business owners to retire or otherwise exit, many still accept offers from private-equity buyers, or perhaps from direct competitors. Both routes are more likely to result in laid-off workers, shuttered facilities and empty storefronts.
Making employee ownership competitive with private equity is the aim of a raft of state and federal initiatives. The policy thrust has taken on new urgency as the ‘silver tsunami’ of exiting baby boomer business owners begins to crest.
“A big part of why employee ownership is bipartisan is because you’re working through market channels to broadly enable property ownership,” says Jack Moriarty of the nonprofit Ownership America, which has been working to free low-cost loan capital to finance employee-ownership transitions. Moriarty will join this week’s Agents of Impact Call No. 49, The Year of the ‘S’ (rsvp).
Moriarty says the strategy is “predistributive,” rather than redistributive, increasing its political appeal. “You’re doing it in a way that is more effective, because you are preventing the consolidation in the first place.”
Transition financing
There’s a simple reason many business sellers gravitate to private-equity buyers: price. For example, employee stock ownership plans, or ESOPs, are barred by law from paying more than market value for a company’s shares, so can easily be outbid by private buyers.
Transitions to employee ownership do provide federal tax advantages that can help even the score. The ability to defer capital gains taxes, sometimes forever, can help make some marginal deals attractive.
But there remain sizable capital gaps in the financing needed to pay off exiting business owners. Banks, wary of an unproven class of loans without a single responsible borrower, have typically been willing to finance only a fraction of purchases. Sellers have typically provided notes for the difference, tying up their capital.
A handful of private funds have emerged to bridge the gap. In December, Apis & Heritage Capital Partners closed its $58 million Legacy Fund to specifically help low-income and workers of color become owner-operators of small businesses. Project Equity’s evergreen Employee Ownership Catalyst Fund has raised $5 million to similarly help finance employee-ownership transitions.
“There are some real barriers to walking into your local lender and getting a loan for transitioning to employee ownership,” Project Equity’s Alison Lingane said recently on ImpactAlpha’s Impact Briefing podcast. “During the pandemic, we saw a need for very flexible capital to support companies.”
Support in the states
Advocates for employee ownership in the U.S. won a small victory when the Small Business Administration included such ownership transitions in the State Small Business Credit Initiative, or SSBCI, which was expanded under the pandemic-era American Recovery Act. A separate bill, the Worker Ownership Readiness and Knowledge, or WORK Act, sponsored by Sens. Bernie Sanders (I-VT) and Jerry Moran (R-KS), authorizes $50 million in grants for state-level employee ownership centers.
California and other states have applied federal SSBCI funds to expand existing small business loan-guarantee programs to include financing for employee-ownership transitions. California Gov. Gavin Newsom last year signed the California Employee Ownership Act to create a coordination hub in the governor’s economic development agency.
Colorado Gov. Jared Polis is perhaps the most visible state-level champion. Polis in 2020 established an employee ownership office to provide tax credits, grants and technical assistance to business owners. The office has assisted in the transition of 18 businesses. Ohio, Vermont, Massachusetts and other states have similar legislation; bills are pending in Texas and Washington, which is also considering a state-level revolving loan fund.
Rudimentary as they are, the state-level initiatives at least insert employee ownership into local economic development strategies. “That’s relatively novel: the idea that we should be applying credit-enhancement investment tools to help make it easier for businesses to sell to their employees,” Moriarty says. “That is not a mainstream economic development idea yet, but I think that’s starting to change.”
Catalytic capital
More far-reaching would be incentives not just for individual deals, but for the creation of a robust capital market for hundreds or thousands of employee ownership transitions.
Moriarty advocates for a regulatory change to allow the Small Business Administration to guarantee loans to employee-ownership buyout funds in the same way it guarantees loans to designated Small Business Investment Companies, or SBICs. Such guarantees, which allow private-equity managers to top up their limited-partner investments with low-interest loans, are credited with jumpstarting the U.S. venture capital industry.
“That effectively subsidizes the returns of their private investors and in return for all that they have to go invest in small businesses,” Moriarty says. Similarly, Ownership America’s design for Employee Equity Investment Companies would stand up a credit facility specifically purposed for employee ownership focused funds. Significantly, because defaults are low and fees cover administrative costs, the program costs taxpayers nothing.
The availability of low-cost debt can enhance the return of private investors, turning perhaps marginal investments into solid market-rate opportunities with internal rates of returns in the high teens or even above 20% per year.
“At the end of the day, we want investors to come in and do this,” Moriarty said. “Certainly if they have an appetite for social impact, but even just to make this a mainstream asset class.”
