8 Pros and Cons of Employee-owned Companies

Last Updated on March 11, 2021 by Filip Poutintsev

Companies and businesses can take different forms. Employee-owned companies are companies where the employees hold ownership over the majority of the company’s stock shares. While most companies have employee ownership, a company is said to be ‘employee-owned’, only, when the employee owns a significant stake, which must be more than 30% of the share.

Employee-Owned Company — Photo by You X Ventures on Unsplash

Companies can be employee-owned in various ways. According to the National Centre for employee ownership, the most common structure is the employee stock ownership plan (ESOP) which is estimated to be implemented in around 7,000 companies in the U.S, meaning there are 14 million ESOP participants.

Usually, an ESOP is applied when the company owner plans to leave the company. This way, they don’t have to deal with the process of selling their company to their competitors which gives them more control over the internal decisions, making it favorable to both the employee and the business too.

The other available structures for an employee-owned company are the worker co-operative, direct share ownership, and perpetual trust. All of these types own either significant or broad ownership over the stock shares.

The popularity of employee-owned companies is growing these days since it brings substantial benefits to the company by boosting the overall performance of the company, bringing tax benefits, and securing employee’s retirement security- to name a few.

However, like any other issue, an employee-owned company has its disadvantages too. If you’re thinking about starting or working at an employee-owned company it’s important to understand the pros and cons it has to offer, which we will take a deeper look in this article.

A Brief History of Employee-owned Companies

Although this concept might be new to you, the origin of employee stock ownership plan dates back all the way to 1733 A.D. Benjamin Franklin initiated a form of employee ownership back then when he set up print shops in different cities.

It’s said that he covered the capital cost and one-third of the expense and along with that, took one-third of the profit for the next six years. After this, the employees had the choice of using the profit to either purchase equipment and even own the business.

Later on, in 1957 A.D. Louis K. Olson, a lawyer, and an economist created the Employee stock insurance plan when the two owners of Peninsula Newspaper Inc. were about to retire and wanted their employees to inherit ownership after their retirement.

By the 19th century, many leading companies including Sears and Roebuck and Railway Gamble acknowledged the fact that their employees would be left no source of income after their retirement so further initiated these plans. Furthermore, in 1974, Congress passed the Employee Retirement Income Security Act due to a weak employment retirement plan.

As of today, there’s an increased interest in this plan since it has been related to business growth and ensures economic security. In the next few years, its popularity is said to significantly increase given the lack of other viable options for the company owners in the increasingly tough and competitive economy.

Pros of Employee-owned Companies

Here are the advantages of employee-owned companies

1. Tax benefits

One of the primary advantages of employee-owned companies is that they have an ESOP structure in which the principal amount from its loan is tax-deductible. This means that if your company takes a loan financed by an ESOP, then the tax money is exempted when the company has to pay it back.

For companies that are C corporations, when a seller reinvests the proceeds of the sale to other security they receive a tax deferral, meaning that the taxpayer can delay the tax for later future.

Then for companies which are S corporations, if an ESOP owns 40% of the share, then the company won’t have to pay tax on the 40% profit. Also, dividends paid to the employees or reinvested by them are all tax-deductible.

2. More Effective Internal Control

With employee-owned companies, the owners have more power and control over the transition. The ESOP structure allows the owners to review every transition and stop those which should not occur.

Both the owners and employees are benefitted since the decision-making power is distributed equally between them. Along with that, the net worth of employees is increased too which is good if they are planning for retirement.

3. Motivates Employees to Work Harder

The fact that the employees get some share of the company’s success is a big incentive for them to work harder and smarter. Researches show that companies with an ESOP structure are more productive and have fewer turnovers. A recent Rutgers study, even found that employee-owned companies can increase the profit by up to 14%.

Employees are more committed and invested in generating benefits since they are rewarded from it too. It brings effective communication and engagement in the workplace.

4. Easier Ownership Transition

Another advantage gained from an employed owned company is that an ESOP permits a more flexible transaction. This means that the owners have the option of selling any percentage of their stock, depending on their requirements, at any time. Along with the friendly transaction, this structure protects confidential information from other third-parties.

Cons of Employee-owned Companies

Here’s a comprehensive list of the cons of employee-owned companies

1. Eliminates the Benefits of Strategic Purchasing

The major issue with employee-owned companies is that its structure makes it difficult for the company to sell the shares to strategic buyers. So, the owners are left with no other choice than to sell the share at a fair market value which is a loss since strategic buyers are ready to invest more if they see the potential for the company to grow.

2. Financial Difficulties

Another issue is that including a third party is a risky move so the company usually rely on and uses seller financing. All the workers of the company might not be interested in investing a huge amount of money. Thus, the company has to use seller financing to complete all their sales.

3. High Administrative Fees

The administrative fee to run a company is high itself. With an employee-owned company, the expenses are piled up even further since carrying this structure requires additional administrative effort and cost, trustee fees, and various other fees.

Moreover, the expense differs and depends according to the size of the company. So, the administrative fees might add up to hundreds of dollars, wiping out all the profits earned by the company.

4. Distribution Restriction

When the sellers carry out an ESOP transaction, no amount of money can be allocated to their family members, not themselves or even their kids. So, if their children are part of the business then they are not allowed to participate in the ESOP transaction which is a great loss. Also, if shareholders have more than 25% share of the stock they are automatically excluded from the transaction.

Conclusion

Employee-owned companies have significant benefits for both the company and the employees themselves. Following the ESOP structure motivates the employees to work harder to significantly improve sales. However, there are risks to consider.

Running an employee-owned company is relatively expensive and not for everyone. If the company goes out of business, then all the investments are lost which will be a terrible financial loss.

So, you are required to do proper budgeting before implementing this structure. However, if done in the right way then it can bring substantial advantages to the company.

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