The Risky Business of Employee-Ownership
Employee Stock Ownership Plans, like other employee-ownership plans, have gotten much more attention lately due to the impact of the COVID-induced recession. This is because employee-owned firms tend to have more financial stability, fewer layoffs and higher survival rates, particularly in economic recessions, said Douglas Kruse, an economist at Rutgers University.
ESOPs are defined as pension contribution plans and are the most popular form of employee-ownership plan in the US with close to 7,000. Employee-owned companies, in which employees own shares of their company’s stock, have proven to be more resilient throughout the pandemic by “[putting] their employees first,” said Alison Lingane, co-founder of Project Equity. It is a “business model that has [been] proven… and outdid itself during the time of COVID.” Many are calling for ESOPs as a model to build back economic resilience and help bridge equity gaps, particularly in race and gender, that have been exacerbated throughout the pandemic.
Kruse is co-authoring a forthcoming peer-reviewed article on whether employee-owners face “too much risk,” which finds that employee-ownership “tends to come on top of standard wages and benefits, which substantially lessens the financial risk.” Employee-ownership, however, is no guarantee of the firm’s success nor does it protect employees if the company goes “belly up,” Kruse said. Employees must understand the overall risk of owning company shares just like in any other investment.
When most, if not all, of the employee’s retirement futures are invested in the company stock, including the employer’s matching contribution to the employee’s 401K plan, this risk increases, said an employee benefits attorney formerly at the Treasury Department.
However, Lingane countered that “the employees aren’t really taking a risk… they are getting it for free on top of their 401K.” The attorney argued that all employee fringe benefits are part of an employee’s total compensation package, so the “distinction” between employer versus employee money “is really artificial.”
Private company ESOPs are riskier to workers than public companies ESOPs, which have regulatory disclosure and diversification requirements, added Daniel Feinberg, partner at Feinberg Jackson Worthman & Wasow. Public companies encourage their employees to diversify their portfolio as a way to spread the risk, he said. Private ones don’t have to do that and can hire a third-party of their choosing to appraise the value of the stock, but all “the input for the valuation comes from …the same people selling the company.”
ESOPs have at times been subject to rare but conspicuous abuses such as questionable valuation of stock contributed to the ESOP, use of the funds by the company, lack of worker control and lack of financial literacy.
“It really should not come down to a market that is regulated by private lawsuits,” Feinberg urged.
“Typically, ESOPs are beloved by everybody, but you shouldn’t be so enthusiastic about ESOPs. In certain cases, they can be disastrous for people,” the attorney said. “Participants are often seduced by their employer and can’t see the risk to evaluate it,” he added.
Lingane, whose organization provides technical assistance to private ESOPs, said the companies they work with provide financial training to their employees, and some find ways to diversify their portfolios.
ESOPs may seem to be losing their way from their original purpose of addressing income and wealth inequality, according to a report by the Democracy Collective’s Fifty by Fifty initiative. “If ESOPs continue to be prompted primarily as a tax loophole for wealthy business owners seeking liquidity, they’ll face an uncertain future.”
The tax incentives that favor ESOPs have become so “broad” and “aggressive” that a struggling employer can save on cash by “[replacing] the cash contribution to a plan with employer stock” and still getting the tax break as if they had contributed cash, the attorney said. And the law, he warns, is “carefully designed to protect the employer in the case of privately-traded stock that’s invested as ESOPs.”
But this reputation is changing as more ESOPs begin implementing more democratic governance in their operations – giving employees a say, disclosing information to them and the likes.
“Employee-ownership stabilizes the company in the community, creating access to business ownership to people who otherwise wouldn’t be able to start a company or have wealth diversification,” Lingane said.