Employee ownership is good business, and employee-owned companies make for successful acquirers. In a crowded market for lower-middle market acquisitions, ESOPs stand apart. Few market participants can match an ESOP’s attractiveness as a well-capitalized buyer that preserves the sellers’ legacy, provides their employees future wealth-building opportunities, and potentially allows the sellers to defer a portion or all capital gains tax liability from the sale.
Forward-thinking ESOP leaders have developed acquisition strategies that succeed at both creating value and reducing risk. Acquisitions simultaneously solve multiple challenges facing employee-owned businesses as they mature, most notably issues concerning talent, diversification, scale, and sustainability. This bears out in the empirical data, as acquisitions by ESOPs are more likely to be successful than the broader sample of corporate acquisitions.
Employee Ownership at the intersection of Megatrends
Employee ownership is enjoying a moment. Few ideas like employee ownership sit so squarely at the intersection of Megatrends like the Silver Tsunami, populism, entrepreneurship, wealth inequality, and the resurgent American small business sector. In fact, employee ownership is so universally popular it is on the short list of topics about which Democrats and Republicans agree.
Despite its widespread appeal, employee ownership remains relatively rare in practice. Fewer than 2 million workers, or just over 1% of private sector employment, participate in employee stock ownership plans (ESOPs) of privately held companies. Meanwhile, small businesses employ nearly 50% of all workers.
There are multiple initiatives underway to unlock growth in employee ownership. There is a renewed effort to increase the pace of new employee ownership conversions through bipartisan policy initiatives at the state and federal levels. Additionally, debt and equity investors, including leading private equity firms, are increasingly looking to deploy capital into employee-owned businesses.
However, the most direct way to expand employee ownership is for an employee-owned company to acquire a non-employee-owned company. A recent study by the National Center for Employee Ownership suggests that acquisitions by existing ESOPs created an average of 20k new employee owners over the past five years, accounting for roughly 1/3 of the growth in employee ownership since 2021.
Acquisition opportunities for ESOPs are plentiful. There is a generational wealth transfer underway, commonly referred to as the Silver Tsunami, in which Baby Boomers, who own 40% of American small businesses worth an estimated $10T, are planning to retire and exit their companies. Selling their companies to their employees – or an existing employee-owned company – is an appealing option that owners are increasingly exploring.
Employee ownership works because it creates an alignment of incentives across the business and promotes a culture of mutual accountability and shared success. Employee-owned businesses perform better and lead to better outcomes for workers and communities. Employee-owned businesses demonstrate higher growth and less volatility across the cycle, which leads to higher enterprise value. Additionally, employee-owned companies are 6.2x less likely to lay off workers, while employee owners have 33% higher median wages and 92% greater median household wealth. This increase in wealth and retirement security positively impacts these employees’ families and communities.
There is no single solution to the divisions facing our country, but a good place to start is by sharing the American Dream with the workers who build it, and the generational wealth transition that is underway will offer ample opportunities to do so.
ESOPs are unique and highly competitive acquirers
The increase of supply of small businesses for sale on account of the Silver Tsunami has led to an influx of business buyers, from individual operators to private equity firms to strategics. These buyers seek to differentiate themselves based on their access to capital, operating expertise, and cultural fit with sellers. Existing ESOPs are among the most appealing buyers across all three metrics.
ESOPs are well-capitalized buyers. Within a few years of the initial conversion, ESOP companies have typically reduced their leverage ratios to sustainable levels and are often generating healthy and growing cash flow. This affords ESOP CEOs the opportunity to think creatively and offensively with respect to their capital allocation, allowing them to make investments that both grow enterprise value and reduce risk.
ESOPs have multiple options in constructing an acquisition strategy. They can acquire competitors to consolidate their own industry; they can acquire suppliers or customers to create vertical integration; or they can acquire unrelated businesses with complementary cash flows and risk profiles to create multiple sources of noncorrelated cash flow. Regardless of the approach, ESOPs and their established management teams have a track record and industry expertise, making them credible and experienced operators for a seller’s business.
An ESOP’s greatest advantage may be its ability to align seamlessly with a seller’s goals, providing a competitive exit strategy that preserves their legacy while offering financial and tax benefits. First, ESOPs offer employees the potential to build long-term wealth, which gives sellers the opportunity to reward the people who helped them achieve their own success. Also, ESOPs are a form of permanent capital, making them excellent long-term investors and owners of legacy businesses. ESOPs do not operate on short-term 3- to 5-year fund cycles like private equity firms, so sellers do not need to worry about ESOP acquirers “flipping” their business. Finally, in certain circumstances, owners who sell their company to an ESOP may be able to defer or eliminate capital gains tax on a portion or all the proceeds from the sale, a potentially highly valuable differentiator that other buyers cannot match.
Acquisitions solve key challenges for maturing ESOPs
As ESOPs mature, they may face several key challenges. ESOP performance is often tied to the fundamentals of the core business, which can erode over time. The obligation to repurchase shares from retiring employees can consume a significant portion of cash flow and limit reinvestment opportunities. Uncertainty regarding leadership succession and excessive risk aversion can hinder decision making. Share price gains tend to be greatest in the early years, which can create imbalances in account values for early employees relative to more recent hires.
In short, a maturing business with leadership uncertainty, cash flow constraints, and an underperforming stock price can make the companies susceptible to takeover bids that result in unwinding the ESOP structure.
Whether one attributes the saying to George Washington, To Kill a Mockingbird, or Bill Belichick, the best defense is, in fact, a good offense, and acquisitions offer ESOP leaders a way to create value and manage risk over time. Acquisitions help ESOPs grow, create shareholder value, and expand the reach of employee ownership. Moreover, diversified cash flow streams allow ESOPs to mitigate risk, increase scale, and build resilience across the cycle. These larger and lower risk cash flows offer better ballast against future liabilities, including repurchase obligations. At the same time, acquisitions inject new frontline and C-suite talent to the organization, expanding the management bench and fostering the next-generation of leaders.
A well architected ESOP acquisition strategy creates a long-term vision of shareholder value creation, financial sustainability, and opportunity for advancement that promote longevity of an ESOP.
Examples of ESOP value creation through acquisitions
Given the unique advantages that ESOPs enjoy as acquirers and the potential for value creation and risk mitigation, it is no surprise that research suggests that ESOP acquisitions are more successful. In a 2018 study by Case Western, 95% of 467 ESOP acquisitions studied were considered “successful”. These outcomes were also beneficial to all people involved; in all but five of the acquisitions, 90-100% of the employees were retained. Like ESOPs overall, the exceptional performance of ESOP acquisitions is attributable to the employees, not despite them.
Forward-thinking ESOP leaders have successfully leveraged the power of acquisitions to create millions of dollars in shareholder value for their employee owners. Many of these companies began as ESOPs with a single operating asset and over time built high-value and diversified holding companies.
OwnersEdge, Inc. is a diversified ESOP with approximately $80 million in plan value for its nearly 400 employees. Formed in 1992 as the ESOP of CC&N, a Wisconsin-based telecom infrastructure services company, OwnersEdge has built a diversified holding company of five unique businesses, including a manufacturer of mission-critical two-way radios, an automation systems integrator, an audio technology firm, and a music production company.
Folience offers an example of an ESOP where diversifying acquisitions preserved tens of millions of dollars in shareholder value for its employee owners. The predecessor to Folience was the ESOP of The Gazette, the daily newspaper of Cedar Rapids, IA, which was formed in 1987 and became wholly employee owned in 2012. As independent newspapers were being acquired and shuttered across the country, Folience’s leadership made the decision to divest its radio and TV assets and reposition the portfolio into a diverse set of companies, including capital equipment manufacturers of medical vehicles and recreational and livestock trailers. Today, the company is thriving and has over 700 employee owners.
Empowered Ventures (EV) is another example of a single-asset ESOP that successfully transitioned to a holding company. EV was originally the ESOP of TVF Plastics, an Indiana-based international supplier for a variety of fabric applications and industries. Through a series of acquisitions EV built a diversified portfolio of companies in precision machining, plastics manufacturing, commercial HVAC and plumbing, and K-12 educational markets.
As more small businesses hit the M&A market every day, ESOP leaders are uniquely positioned to acquire these companies and drive shareholder value, reduce risk, and create potentially life-changing wealth for a new generation of employee owners. Extending well beyond shareholders and ESOP plan participants, these benefits may well accrue to all of us in the form of stronger communities and more secure futures for workers across the country.
Michael Morosi is co-founder and Managing Director of 40 Million Owners, a corporate advisory firm exclusively focused on providing buy-side M&A services to ESOPs. Michael is also co-founder and Managing Partner at Southeast Acquisition Capital, a private equity firm focused on employee ownership buyouts.
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