As an Ohio attorney that works with cooperatives, I often get asked the question: What is the difference between an ESOP and a Worker Cooperative? Converting an existing business to a Worker Cooperative or creating an ESOP are two options often explored by business owners interested in succession (or retirement) planning — although a start-up business may also organize as a worker cooperative. A number of factors drive which of these options, if either, is right for an existing business and should be explored in consultation with legal and accounting professionals. Let me give you a quick overview of what each one is before sharing some pros and cons.
What is a Worker Cooperative?
A worker cooperative is a business that operates pursuant to a cooperative business model which prioritizes its employees and the communities it serves. Some characteristics of a worker cooperative include employees being owners (called “Members”) –that is they receive profits (or loses) from the business as well as contribute labor and are involved in democratic decision making. Members also participate in the business’ governance, which includes each member having a vote for the board of directors. A cooperative model can be utilized in most any type of industry and with various types of legal entities (i.e., corporations, partnerships, LLC, etc.) Learn more about worker cooperatives here. Conversion to a worker cooperative is an alternative to selling a business to third party investors. A business that converts to a worker cooperative will transfer its ownership to its employees-members. To execute a conversion, the original owners’ shares are purchased by the newly formed cooperative. Typically this is financed via a loan personally guaranteed by the original owners. Then the loan is repaid over time from the cooperative’s profits.
What is an ESOP?
An ESOP (Employee Stock Ownership Plan) on the other hand is a type of employee benefit plan, i.e., a retirement plan. With an ESOP, the existing business establishes an ESOP trust separate from the business wherein some or all of the original owners’ stock is transferred and held for the benefit of its employees. Typically, a loan is secured by the business to buy the owners shares that are transferred to the ESOP. Trustees (not the employees) are appointed by the board of directors to administer the ESOP trust. As the loan and interest are paid, shares of stock are released and allocated to individual employee accounts in the ESOP pursuant to a pre-determined formula that usually relates to employee salaries. Employees receive their retirement benefit from the ESOP once they are both vested in the business and retire. They pay tax on the money received from the ESOP. A business that chooses to establish an ESOP has no legal requirement to utilize cooperative business practices such as involving employees in democratic decision making or governance, however studies have shown that ESOPs which utilize cooperative practices tend to be more successful financially and have greater employee satisfaction and retention.
Pros and Cons of a Worker Cooperative
Conversion of a business to a worker cooperative not only may allow owners to obtain a fair price for their ownership interest in the company, but also has the potential to enable the business to carry on in a way that empowers and benefits its employees and the greater community. Also, the original owners also may qualify for preferential tax benefits including deferring or eliminating capital gains on the money they received for the stock shares transferred to the cooperative when certain criteria are met for a §1042 rollover. For owners who are concerned about what happens to their business and its employees after they leave, conversion to a worker cooperative can be a great option. However, conversion to a worker cooperative can take time and involve substantial legal and accounting fees and other costs. Training employees to become employee-owners and participate in a democratic decision making within the workplace may take more or less time depending on how the company already operates and its current culture. Conversion to a cooperative is particularly worth exploring for a business that is financially sound. However many worker cooperatives have been created when the business could not find buyers and employees wanted the business to continue on, hence taking it upon themselves to buy the company through conversion to a worker cooperative. Conversion to a worker cooperative should be weighed against the time, costs, feasibility, and impact of selling the company to outside investors or creating an ESOP and should be done in cooperation with knowledgeable legal and accounting professionals.
Pros and Cons of an ESOP
As a general matter, an ESOP may provide substantial tax benefits to owners who transfer their shares to the ESOP including deferring or eliminating capital gains if requirements are met to qualify for a §1042 rollover. However, ESOPs are expensive to establish as they are subject to federal ERISA laws and require specialized lawyers and accounting professionals. Plus they require specialized annual audits and have other on-going administrative costs. Also, an ESOP can be negative for employees if it is the only retirement option–like having your eggs all in one basket. It is often preferable to offer an ESOP in addition to other retirement options from an employee standpoint. And again, utilizing business practices consistent with a cooperative business model correlates to the likelihood of success of the company after the original owners depart and thus is desirable when creating an ESOP. However, establishing cooperative governance practices will add to the time and costs of this form of succession planning. The costs of creating and maintaining an ESOP should be weighed against other succession options such as converting to a worker cooperative or selling to a third party buyer. Gathering those potential costs should be part of the process of exploring whether an ESOP is a good option for your business.
A word of caution – not all (in fact very few) ESOP attorneys are versed in best practices of cooperative business principles. An attorney technically need not know anything about cooperatives in order to establish an ESOP. Be sure to ask your attorney and accounting professionals about their expertise with both ESOPs and worker cooperatives. A business owner may need to involve an attorney with ESOP specific knowledge and another attorney with cooperative expertise. Also, various excellent organizations exist throughout the US (and world) that provide different types of assistance to business owners regarding worker cooperatives and ESOPs. Please feel free to contact me, Lisa Nelson, of Positive Law, LLC via email or call (800) 806-1803 if you need referrals to legal and accounting professionals, or organizations in your area that provide such assistance. Please check out Positive Law’s resource page too.
One final note: The type of legal entity (i.e. corporation, LLC, partnership, etc.) that is best for your business is a very different question from whether conversion to a worker cooperative or establishment of an ESOP is desirable. This is a question to be explored and discussed with your accounting and legal professionals.