What Private Equity Gets Right, And Wrong, About Employee Ownership

Lately, there has been a flood of new information concerning private equity firms’ interest in employee ownership, specifically by Pete Stavros and KKR, one of the largest PE firms. 

Pete has been in communication with me, and has expressed an interest in finding ways to work with the existing ESOP community.  He and others have recently launched a coalition called Expanding ESOPs, which is seeking federal legislative and regulatory changes that would provide incentives for PE firms to offer equity stakes in more of their acquisitions, especially larger companies.

Stavros’ idea, on its face, does make a few compelling arguments. He and his coalition argue it can be too complicated to form an ESOP, that the threat of post-transaction government meddling and second-guessing in ESOP transactions is too large, and that for most large businesses the existing ESOP structure is impractical and a likely magnet for nuisance lawsuits. 

Sadly, the evidence is that Stavros is likely correct. For decades the Employee Ownership community has allowed seemingly small, but collectively consequential, issues to accumulate while nearly singularly focusing on protecting the S-Corp benefit, which has in reality only faced minimal, if any, genuine threat in nearly three decades of existence.  In their totality these multitudes of issues have created barriers both real and perceived to more ESOPs and employee ownership.  Without revisiting current laws and regulations, and addressing emerging issues like nuisance lawsuits, it requires true faith to see how employee ownership can reach the kind of growth rate necessary to be impactful at scale and help reverse a decades-long trend of income disparity and wealth inequality.

However, there is genuine and legitimate cause for concern with some of the proposed ideas being advanced by the Expanding ESOPs coalition. First, their new version of “ESOPs” is not employee ownership, no matter how much they may want to ride on our coattails. It’s more like profit sharing, and it’s conditional on the business being sold for a large enough profit and on employees working for the company at the time of sale.  By its very nature it is temporary, in contrast to real ESOPs and employee-owned businesses, which are designed to be more permanent, even multigenerational.  Real employee-owned businesses are meant to span decades, not just a few years, in order to benefit the employees rather than seek a very specific near-term profit-taking.  The goal of the Stavros model is to take profit within a short time window and share a portion of that profit with the employees.  That is a laudable goal, but what is shared with the employees to get more out of them should come from the investors, not taxpayers.

Second and more importantly, the policy changes required would be an extremely tough sell to Congress.

His coalition initially proposed that in exchange for providing a 10 percent equity stake to employees, PE firms would be allowed to double their payroll expense deduction for income taxes for five years, plus carryover beyond that. Those specifics have since gone from their website, with current language saying the tax incentives must be “commensurate with the cost of providing ownership,” and “at an up-front cost that is manageable to a company.”

I get it – if the goal is to provide a targeted return to investors within a specified period of time, then shortening that window is pure gravy.  Giving an equity stake to employees is highly motivational and will almost certainly align and expedite the time frame for investors to take their profits.  But regardless of specifics, the coalition’s expectation is that American taxpayers pay for the equity grant with a tax deduction to offset the cost to PE firms. Boldly, any new tax break would be in addition to the generous tax treatment PE already receives via carried interest, which allows profits to be taxed as capital gains, a much lower rate than ordinary income. 

Asking the taxpayer to foot the bill for short-term profit taking runs counter to Congress’ intent in encouraging the formation of true ESOPs: There are long-term societal, economic, and job stability benefits for truly employee-owned companies that are absent in the 4-7 year investment horizon for PE firms. At its core, that’s what the PE argument is missing. ESOPs are about more than merely allowing employees to share in the profits from the sale of a company. True ESOPs are about permanence, and creating a business that will endure and continue creating wealth through multiple generations of employees.

Apart from being very short-sighted, the cost to taxpayers is problematic. A 200 percent deduction on payroll expense as originally proposed would be enormously expensive, perhaps into the hundreds of billions of dollars per year. And because labor costs are usually a company’s greatest expense, what business wouldn’t want to transition to this kind of model? It’s very difficult to see how the government could pay for such a plan at a scale that would bankroll PE firms’ equity grants to employees.

Mr. Stavros and his coalition are also seeking some kind of safe harbor protection whereby PE can avoid government scrutiny and potential litigation, exempting PE firms from using the DOL’s guidelines for establishing the fair market value of an ESOP. While The ESOP Association has our issues with the DOL and adequate consideration, this would effectively create an entity outside of ERISA, in which employees would lose the safeguards and protections that ESOPs offer.

There are many more aspects of the coalition’s proposals, and The ESOP Association is keeping an open mind while taking a very close look at all of them. But we do agree that statutory and regulatory complexity is a key reason there are not more ESOPs in America. This is especially true when one considers that it’s been 50 years since ERISA passed and while the business landscape has changed dramatically, our laws have not kept pace.

We should indeed look at legislative and regulatory fixes, and now is a good time for Congress to undertake a comprehensive review of America’s policies toward employee ownership. However, any changes in current law or regulations must make it easier for a business owner to sell their company to an ESOP, and to shift perception of ESOPs from one of many options to the most preferred avenue for an owner to sell all or part of their business. This approach hews much more closely to Congress’ original intent when it codified ESOPs under ERISA, and reflects the attitude of ESOP supporters in Congress and the White House, who are excited about the long-term potential to build wealth and reduce income inequality in America. 

While I believe Pete Stavros personally has good intentions with his model to provide equity to employees at KKR’s portfolio companies, calling these types of businesses “ESOPs” is a stretch, as is asking taxpayers to fund what PE firms should have been doing all along – sharing a portion of THEIR very sizeable profits with the employees who created the value of the business. Why should taxpayers be asked to pay for expediting PE profit taking?

We in the ESOP community have known for decades that offering employees a real stake in the business leads to better morale, less turnover, greater productivity, and higher profitability. Given the scale of the profits and tax breaks that already exist for PE firms, and the short-term nature of their investments, it’s not unreasonable to ask that the incentives for employees come out of PE’s side of the transaction, not out of taxpayers’ pockets.