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Using Employee Ownership as Creative Capitalismby Ben Durwood
The term “creative capitalism,” used regularly by Bill Gates, describes a society in which companies strive for dual goals – profitability and social responsibility. As an example, Microsoft has donated billions of dollars worth of software and computers to people who wouldn’t have access otherwise. Not only does this charitable effort allow Microsoft to address the problem of computer illiteracy, but it may also increase their profits, because consumers will view Microsoft more favorably and use their products more regularly.
Problem: Increasing Gap in Wealth Between the Upper and Lower Classes
“The Roman arena was technically a level playing field. But on one side were the lions with all the weapons, and on the other the Christians with all the blood. That’s not a level playing field. That’s a slaughter. And so is putting people into the economy without equipping them with capital, while equipping a tiny handful of people with hundreds and thousands of times more than they can use.”
Unfortunately, society is facing many problems beyond computer illiteracy. One such problem is that the retirement age for low and middle income Americans will be delayed in the coming years. In addition to a nearly bankrupt Social Security program and the obsolescence of pension plans, the return on equities (which are included in most 401(k) plans) is expected to decline. A study by the Center for Retirement Research at Boston College confirms that a record number of Americans are in danger of living in poverty in their sixties and seventies.
Part of the problem is that the earning gap between the very wealthy and the middle class has widened considerably in the past several decades. The discrepancy between the 10th percentile of American wage earners and the 90th percentile has increased by 30 percent since 1980. According to a study by UC Berkeley Economist Emmanuel Saez, wages for middle class Americans have remained stagnant, while the top one percent of wage earners make 20 percent of the aggregate income. The distribution of capital is even more asymmetric than the distribution of earnings, as the richest 1 percent own 33 percent of total wealth in the United States.
One of the causes of this wealth discrepancy is our outdated tax structure. Generally, higher earning individuals pay higher tax rates than lower earning individuals, but only to a point. The highest tax bracket begins at an income of $370,000, meaning that the doctor or sole proprietor earning $370,000 is in the exact same tax bracket as Lebron James and Warren Buffet. An argument against higher taxes for the wealthy is that it disincentivizes hard work. High tax rates minimize differences in net income, reducing the individual benefits derived from working hard.
Potential Solution: Employee Ownership
“The widest distribution of active ownership results from ESOPs (employee stock ownership plans). The idea is very appealing, for employee ownership both closely aligns workers’ self-interest with that of the corporation and provides the company with probably the ultimate source of patient capital. When managers and workers are owners, accountability pervades the economy with beneficial results.”
Taxation is not the only means of distributing income. For example, the owner of a company could distribute stock to his employees by implementing an employee ownership plan. Allocating ownership to employees helps redistribute wealth, allowing low and middle income workers to save more and retire earlier. Meanwhile, employee ownership plans transform a company’s culture, because if employees adopt the mentality of owners they work harder and become more involved in process improvement and cost management, causing their company’s net income to increase at a faster rate. In this regard, it has the reverse effect of higher taxation, because instead of normalizing income levels, employee ownership motivates workers by linking their savings to their job performance.
In addition to achieving equitable distribution, employee ownership also increases the total amount of wealth. A study by Douglas Kruse and Joseph Blasi at Rutgers University found that revenues at employee owned companies increased two to three percent faster than they would have had they not been employee owned.
Another Benefit of Employee Ownership: Effective Exit Strategy
Employee ownership offers far-reaching benefits aside from distributing wealth to middle and low income employees and motivating employees. One benefit of employee ownership is that it provides business owners with an attractive exit strategy, which is particularly relevant given our nation's demographics. With an estimated 78 million baby boomers between the ages of 47 and 65, a considerable number of Americans will be attempting to liquidate their businesses in the near future.
Typically, an owner’s options for tapping into their company’s value are limited to a merger, an acquisition or a public offering. All of these scenarios involve giving control to unfamiliar individuals, leaving the company and its employees with an uncertain future. However, by implementing an employee ownership plan, profits are comparable to those made through a merger or IPO, while granting ownership of the company to the people whose ideas, work and skills were responsible for the success of the company in the first place.
Employee ownership as a liquidation strategy is even more attractive when you consider the tax incentives. If the owner of a C-Corp sells 30 percent or more of the company to an employee ownership plan, the owner can defer the otherwise taxable capital gains on the transaction, provided the funds are reinvested in other qualifying investments. This allows owners to assist employees in building wealth through capital ownership and also gives them the opportunity to diversify their own risk by building a more balanced portfolio.
Other Benefits of Employee Ownership: Attracting Top Talent
“In those early days, I was primarily focused on winning contracts and getting SAIC staffed up to perform on them. As it turned out, giving employees an ownership stake in the company – based on performance – worked like a charm, and the employee roster grew quickly,” said J. Robert Beyster, founder, Science Applications International Corporation (SAIC).
Another benefit of employee ownership is that it enables a company to differentiate itself from competing employers by offering recruits an opportunity to share in the ownership of the company. For years, Bob Beyster was able to convince the most talented scientists and engineers in the country to leave their current employers and join SAIC, largely because of the promise of ownership and the culture this ownership cultivates.
Source: Great Place to Work Institute, Inc.
To assist with recruiting, one benchmark many companies strive for is recognition as one of Fortune magazine’s “100 Best Companies to Work For.” In the past, distributing ownership has been a shortcut to being placed on the list – just ask Google, Cisco, Starbucks or one of the myriad of companies on Fortune’s list that have offered ownership to employees. Unsurprisingly, not only do many companies appearing on Fortune's list frequently distribute profits to employees, but the companies on the list outperform most of their competitors, supporting the notion that treating employees well and distributing profits leads to improved performance.
Taking Advantage of the Benefits
There are very few situations that can be described as “win-win.” It seems as though nearly every decision involves some kind of trade-off. Research by Nobel Laureate Harry Markowitz indicates that portfolio diversification is one of those rare examples. By purchasing assets with a low correlation to one another, it is possible to decrease your risk without decreasing your expected return. Distributing ownership to employees (funds they would not have received otherwise) is another one of those rare win-win situations. Martin Staubus, leading expert on employee ownership and senior consultant at the Beyster Institute, agrees. “The attractions are so compelling, it’s hard to turn them down. A very high percentage of owners are going to want to do it.”
Ben Durwood (Rady Full-Time MBA ’11) is San Diego native, who received his bachelor’s degree in psychology from UCLA. Ben is also a CPA candidate who currently works as an associate at the Beyster Institute. Beginning in summer 2011, he will work as an auditor at KPMG.