What is limiting widespread adoption of employee ownership
Despite a clear wave of interest in Employee Stock Ownership Plans and increasing numbers of worker-owned cooperatives being established in the US, companies owned by their employees remain relatively few. Depending on where you’re standing, these companies or their ownership structures may be highly visible or not at all. We have dozens of shining examples of employee-owned business here in Vermont, yet many, if not most people, still hold only a vague idea of what ownership by employees looks like.
As employee ownership advocates, it’s useful to have an idea as to what could be standing in the way of widespread adoption. One factor, as we wrote about earlier this month, is the difficulty in competing with well-capitalized private equity funds that can quickly buy out a business owner and send them off with the full value of their business in cash. The ESOP holding company model is one useful strategy, but it’s clear we need more financial tools that can mimic the ease and convenience of private equity deals but with the aim of transferring ownership to the employees. And insofar as we’re focused on getting employee ownership onto the default menu of options to consider when a business owner is ready to sell, such tools are essential.
It’s curious, though, why a sale to employees isn’t already on that default menu of succession paths. After all, the ESOP as we know it has been around since 1974, and worker co-ops have been forming in the US since before it was a nation. It would seem this would be long enough for word to get around. Is there something beyond the external factors commonly cited (lack of awareness, insufficient financing tools, outdated or unfavorable government policies, inaccurate cultural misconceptions, etc.) that is holding the movement for worker ownership back?
This question naturally arises when reading retired Yale Law School professor Henry B. Hansmann’s 1996 book, The Ownership of Enterprise, which was selected by our intern, Matt Cleary, for our second annual VEOC summer book club (see here for our 2023 choice). In the book, Hansmann lays out an analytical framework to study company ownership based on the idea that trends in ownership structures in various industries offer clues as to what ownership type is likely most efficient in a given situation, citing the prevalence of employee ownership in law and other service professions (often not broad-based), producer ownership in agriculture, and consumer-owned utility companies as examples. Extending this logic, the relative absence of such ownership structures throughout much of the economy suggests their efficiencies are limited to a small range of circumstances, which he attempts to explain.
On the one hand, the book’s operating assumption feels obvious — groups of people tend to seek arrangements that minimize costs and maximize rewards for themselves. If you notice a lot of people taking a certain route to a destination, it may mean that’s the quickest way to get there. On the other hand, it can be tricky to establish causation as to precisely which factors are influencing a cost-benefit analysis. People frequently choosing a given route could mean that it’s the quickest, but it could also be that the actual best route has become riddled with potholes or is frequently under construction.
Investor-ownership being the path so often taken, Hansmann’s book suggests it is roughly equally often the most efficient ownership arrangement for a company. And certainly, the model has its advantages. However, employee ownership advocates will be aware that comparatively speaking, the employee ownership route has a number of potholes needing to be filled (external factors mentioned above) if it is to become a commonly chosen path. Despite its real potential, subjecting business owners and entrepreneurs to any amount of nuisance can change the calculus and deter companies from pursuing that potential in favor of a smoother journey. Although largely excluding these external factors in its analysis, the book nonetheless offers a useful framework for thinking about employee ownership from an intentionally constrained economic stance.
The costs of ownership
Costs are central to Hansmann’s framework of ownership. He therefore pays little attention to the types of motivations that are often spoken of by employee-owned companies and employee ownership advocates, motivations such as rewarding dedicated employees with a stake in the company, broadening capital ownership, or preserving the company’s legacy over the long-term. Instead, Hansmann frames the chosen ownership arrangement as the result of a relatively simple math problem that examines the costs of contracting with a group of stakeholders (investors, employees, suppliers, customers, etc.) and compares them with the costs of making one of those groups of stakeholders the owners. If it is costly to interact with one of these classes of “patrons” (as he calls them) through market contracting but would be much less costly to interact with those patrons through ownership, that group may be the optimal candidate for ownership of that business.
Taking investors as an example, a company needing capital to get off the ground or expand may face a degree of financial uncertainty or cash limitations that discourages them from getting locked into debt even when the alternative means giving up a portion of ownership to outsiders. The company has to choose between the costs and potential risks of taking on debt and the costs and potential risks of awarding their capital providers with the rights of ownership, including the exercise of control and the receipt of residual earnings, as Hansmann defines them. In cases where investment is needed and giving up some amount of control and earnings is more palatable than paying down a debt plus interest, investor-ownership emerges as a preferable arrangement from the company’s perspective. At the same time, the investor too is weighing their costs and may demand a higher rate of return if equity is not offered, thus raising the costs of debt for the company and tipping the scale in favor of investor-ownership. Of course, the true costs and risks of assigning ownership to a group of individuals only reveal themselves in time.
Employee ownership
With regards to employees, a company may likewise consider whether there are significant advantages to be gained by making them owners of the company. Hansmann notes several, including improved information flow between employees and management, lower risk of downsides associated with developing company-specific skills in lieu of increasing professional marketability, and overall greater employee satisfaction. Rather than explore these in detail here, we direct you to the book itself if you’re interested in exploring the various factors that he argues can make employee ownership more or less favorable. Most important here is his conclusion that none of the most often stated advantages of employee ownership are able either individually or collectively to adequately explain the overall trend in the distribution of employee-owned firms. For understanding where we find meaningful numbers of employee-owned companies (defined as companies offering employees both financial and control components of ownership) and where we don’t, he points to the costs of shared decision making as the only truly explanatory factor.
The overall idea is that employee ownership works best in companies where workers have similar or identical interests and does not work well in companies where workers have a diverse set of interests. The reason given for this is that owners with diverse roles in the company will be impacted in different ways by decisions made, resulting in conflicts of interest that slow or complicate governance and drag down productivity. Law firms, to take Hansmann’s example, have historically operated as employee-owned firms, with the employees being the firm’s partners. This arrangement was efficient because the lawyers shared similar interests overall and were able to decide on clear methods of distributing compensation. The same is seen in drivers’ cooperatives and other industries where workers perform similar tasks, whereas larger firms with many employees working on different kinds of tasks are rarely owned by their employees.
Of course, “employee ownership” as commonly discussed today includes models that offer participation in earnings but limited or no formal avenue for exercise of control by employees, such as in many ESOPs. Applying the book’s analysis, this provides one possible rationale as to why ESOPs are often the form of employee ownership chosen by larger more diverse companies, despite the ability for larger companies to adopt the worker cooperative model if desired.
Grappling with governance
In the chapter on Governing Employee-Owned Firms, Hansmann summarizes his observations: “Apparently employee ownership is worthwhile, as a means of reducing the costs of labor contracting, even where those costs are, compared with those of other industries or other types of employees, relatively low — as long as collective decision making is not a potential problem. … The natural conclusion from this pattern is that, if costs associated with collective self-governance were not a problem, employee ownership would be far more widespread than it is.”
For those not familiar with employee ownership, it might be tempting to conclude based on this analysis that collective self-governance inherently leads to inefficiencies, and that employee ownership would not actually be a great benefit to most companies if broadly adopted. But this conclusion would be far from satisfying based on what we know (consider, for example, the work that Vermont ESOP company Carris Reels has done to increase participation among its workforce). While there’s no doubt that shared governance can present challenges (a quality of democracy at any level, in the workplace or elsewhere), the ability to navigate those challenges well is a skill that can be sharpened like any other when adequately taught and regularly practiced. And, as VEOC’s generalist and former teacher Annie points out, whether or not workplace democracy is efficient and effective or not also has a lot to do with how well a society prepares its citizens for democracy throughout their school years.
In the absence of these skills being adequately taught in primary and secondary education, it may appear that getting employees with different backgrounds and interests to make good decisions together is too heavy a lift. This conclusion, though, neglects the fact that even in the US, numerous employee-owned companies are discovering and refining ways to govern effectively across differences. It neglects also that the differences that can slow some decisions can also serve to improve decisions overall by increasing the amount of information shared across the company, to say nothing of cultivating trust.
If, then, we can accept Hansmann’s claim that adoption of employee ownership has been significantly limited by the challenges of shared decision making, the question then becomes: What are the real limitations and solutions to improving shared governance in heterogeneous groups?
This brings us to our big takeaway from our discussion on Hansmann’s book. Wanting many more companies to adopt employee ownership in the full sense, including participatory management practices if not formalized democratic governance, there’s room for a renewed focus on participatory governance tools and resources that can help bridge gaps between groups of employees with different backgrounds, interests, and workplace experiences. Shared governance methods have evolved in the nearly three decades since Hansmann’s book was published, but this is still very much an area that stands to benefit from further innovation and exploration.
Applied in the right circumstances, such governance improvements may have the potential to lower the costs of collective decision making and amplify the productivity advantages of assigning ownership to the employees. Returning to Hansmann’s conclusion about what is limiting the adoption of employee ownership throughout the economy, we can restate it as a prediction about the future of the movement: When costs associated with collective self-governance are no longer a problem, employee ownership will be far more widespread than it is.
