As we have reported, on January 11, 2021, the 1,200 employees of Taylor Guitars learned through a video conference that the company had just been sold—to them, at no cost, through an ESOP.
That in itself was not so unusual. But its financing structure could be a sign of things to come. Many sellers sell to an ESOP over time in a series of transactions, but founders Bob Taylor
and Kurt Listug wanted to sell the entire company, if possible. Selling 100% of a successful 1,200-employee, $122 million company isn’t as simple as going to the bank and looking for a loan. No bank is going to finance a deal like that because there is not enough collateral (assets the banks could sell) to get its money back if Taylor defaults.
The founders could have used some combination of a bank loan, mezzanine financing (usually loans from private investment sources at three to four times the interest rate of senior debt), and seller notes (agreements by the sellers to be paid with interest over time) to do the deal, but Taylor and Listug worried about loading too much debt on the company. Instead, they were able to turn to Social Capital Partners in Canada (SOCAP), a nonprofit impact investing advisor that had a strong interest in employee ownership. SOCAP’s Jon Shell reached out to the Healthcare of Ontario Pension Plan (HOOPP) to talk about getting involved. The values of the ESOP and HOOPP were a great match. HOOPP offered a 10-year financing horizon, with no principal payments during the life of the loan (loans are typically five to seven years and principal is paid all along).
If cash is needed for growth, interest payment can be deferred. That is not something normal investors would do. When the deal was completed, Taylor announced that not only would the U.S. employees be in the new ESOP, but employees in Mexico as well, making it one of the first U.S. companies to extend the ESOP abroad.
The Taylor deal is the largest instance of impact investors supporting employee ownership, but there has been growing interest in the idea. By 2021, at least 14 impact investment funds were involved in some way. Some of these funds have focused on developing worker cooperatives in low-income communities and/or supporting non-profit and local government efforts to help interested workers learn more about how to do this. Others, like the Ontario fund, are looking more toward ESOPs.
The largest investment so far has been by the Kendeda Funds, which announced in 2020 that it would invest $24 million to promote conversions of companies to employee ownership. The funds were provided to four organizations that focus primarily on worker cooperatives, especially for low-income workers in industries such as home health care, laundries, retail, or child care. The most notable example of this strategy has been in Cleveland at the Evergreen Cooperatives. The organization has launched three businesses employing over 250 people and has recently used funds from Kendeda and others to acquire and convert two others.
Worker cooperatives are more likely to be good fits for very small business and for some sectors, such as child care, that are made up mostly of small independent providers who can gain operational efficiencies by forming a cooperative that shares marketing, administrative, financial, and other tasks.
ESOPs, however, are generally more scalable, but larger 100% deals can be hard to finance. Usually, a combination of seller and bank financing is needed, and sometimes high price mezzanine debt. While lots of business owners have not found this to be a deal-breaker issue, it does put ESOPs at a disadvantage relative to a sale to a PE firm or another company, or just make the cost of the financing more than the company can sustain. An impact investor can accept a lower rate of return on “junior” debt (a loan paid off after the bank loan) and make a 100% deal more practical. But these investors are not necessarily making a bad deal. NCEO data show that the default rate on ESOP acquisition debt is vanishingly small (two per thousand per year), so that seemingly unsecured debt is actually quite secure.
A handful of impact investment funds have moved into this space. While this is encouraging, it is not a match for the trillions of dollars available to private investors using a more traditional model.
Impact investors have a lot of choices about using their money, of course. They can put it in socially responsible funds or strategically invest in public companies. While this can make their investors more comfortable with where their money is invested, no fund is going to be a big enough investor to change corporate policy. On the other hand, if companies can show they are meeting environmental, social, and governance goals in their reporting, they may attract a wide enough array of impact investors to move their stock price, and that might be motivating.
Impact investing for ESOPs is still very much in its infancy. The amount of capital in traditional investing firms is orders of magnitude larger. It is very unlikely that even if many more impact investors get involved, it will account for more than a small percentage of transaction, but if these transactions succeed, it may help persuade existing capital providers looking to burnish their social image to invest in EP deals.
Most critically, more pension funds might decide that ESOP debt is a good investment, one that meets both their required fiduciary and their optional social goals.