By Priya Parrish
The widening economic gap between the rich and poor in the U.S. is a complex issue that requires a multi-faceted solution. While policymakers have a significant role to play, investors also have an opportunity to make a measurable and lasting impact. Investments that Impact Engine is making to create and support employee-owned firms, which have the potential to directly close the wealth gap, is a paradigm-based impact strategy that we are excited to share with our community.
The private middle market is vast and growing. It currently accounts for roughly one-third of U.S. private sector employment, and the wave of baby boomer retirements has been fueling the opportunity set for private equity funds for years now. This silver tsunami of more than two million business owner exits should be on the minds of impact investors wondering if the type of ownership structure can create a positive impact. While it is most common to see businesses exit to corporates or investors, alternative ownership structures can facilitate employees, customers, or other stakeholders to partially or fully own a company.
Research suggests that companies owned by their employees, as opposed to its founders, executives or external investors, demonstrate fewer layoffs, improved wages and benefits, and significantly increased wealth-building opportunities for workers at ALL income levels. For example, the average ESOP (employee stock ownership plan; more on this structure below) account in 2018 was valued at $134,000—a significant nest egg considering that 70% of Americans have less than $1,000 in savings.
Importantly, there is also a strong business case for employee ownership. A study conducted by the National Center for Employee Ownership found that after becoming ESOPs, firms saw sales, employment, and productivity grow more than 2 percent faster per year than otherwise would have been expected. A Rutgers University study showed similar results, in addition to evidence that employee-owned firms were more likely than peer firms to survive downturns or other routine causes of business failure.
Our experience as primarily product-based impact investors is that when the impact-intentional design of a product becomes its differentiation and value proposition, the likelihood of impact continuing to be a priority improves. Impact essentially becomes the competitive advantage. As we investigated further, we saw numerous examples of viable, profitable employee-owned companies, including easily recognized consumer facing companies such as Eileen Fisher and Publix, with an analogous moat. Seeing this pattern with employee-owned firms caused us to dig deeper and look for opportunities to invest.
There are several legal structures to support employee ownership, but most common are ESOPs, EOT’s, co-ops, and perpetual purpose trusts. We will not get into the specifics of each here (but this guide to Steward Ownership is a useful starting place), except to say that governance, tax treatment, availability of capital, visibility to the customer, cash flow characteristics of the company, and organizational culture alignment are notable factors to consider for both the business owner/seller and the investor seeking to facilitate the conversion to employee ownership. The investor also needs to consider the appropriate financial instrument, which can range from traditional debt or structured equity to more creative options such as revenue-based financing or demand dividends.
If not already clear, investing in these structures and instruments requires significant financial and legal expertise. Investors with backgrounds in venture stage or public markets companies are typically less equipped than private credit or equity investors, as the latter is already underwriting and structuring deals with similar elements. While employee ownership structures are not new (ESOP structures date back to 1974 and co-ops even further back), investment funds utilizing these as a primary investment strategy is new. It’s gaining momentum as the financial and impact case grows, but unfortunately lacks depth in terms of the number of qualified teams to execute these strategies and investment strategies that can generate competitive risk-adjusted returns.
Mosaic Capital Partners is one rare example. They are an investment firm specializing in employee ownership buyouts. Mosaic’s strategy converts company ownership 100% into the hands of all employees at no cost to employees while generating an attractive private equity-like return for its fund. We first learned of their strategy in 2017 and were impressed with the team’s experience and technical expertise in ESOP transactions. While they did not start with an impact motivation, the outcomes for employees were known and valued by the team. Over time, we began engaging with Mosaic to develop a more intentional process around evaluating and managing employee outcomes that furthered the understanding of these strategies for both our firms. For example, their and our participation in developing the Guidelines for Equitable Employee Ownership Transitions helped solidify best practices to incorporate into Mosaic’s strategy. We made a commitment to Mosaic’s most recent fund with the belief that it will generate paradigm-based impact by setting an example for other private equity and credit investors to invest this way.
We also recently co-invested alongside Mosaic into the Zero Waste Recycling (ZWR) ESOP transaction. The company is a full-service, one-stop solution provider helping manufacturers recycle or divert up to 100% of their operational waste. The product-based impact that is core to our direct investment strategy was attractive, and became our first direct investment in an employee-ownership conversion. We are excited by the potential for our investment to create measurable impact for ZWR’s employees of whom over 90% are BIPOC and/or LMI. It is also an opportunity for us to learn the nuances to this investment strategy, as we know that there is no silver bullet to solve wealth inequality in the U.S. We look forward to sharing our insights in the coming years, and welcome learning from others as well.