“B” a Better ESOP: Why the Marriage of B Corps and ESOPs Makes Sense
“B” a Better ESOP: Why the Marriage of B Corps and ESOPs Makes Sense
Because many existing ESOP companies share the same corporate values as B Corps and value their independence, existing ESOP companies may make good B Corp candidates.
Those familiar with Employee Stock Ownership Plans (“ESOPs”) have undoubtedly heard of C Corporation ESOPs and S Corporation ESOPs. Now there’s a new letter to throw into the alphabet soup – the “B Corp” ESOP. Unlike C Corporations and S Corporations, the B Corp label doesn’t relate to a company’s status under federal income tax law. Rather, the B Corp designation is an independent certification held by companies that have met rigorous social and environmental performance standards. Because many B Corps have adopted an employee-centric corporate culture, ownership transition to an ESOP may represent a compelling exit strategy for shareholders of privately held B Corps. And because many existing ESOP companies share the same corporate values as B Corps and value their independence, existing ESOP companies may make good B Corp candidates.
What Is a Certified B Corporation?
A Certified B Corporation is to an ordinary business what a LEED-certified building is to an ordinary building, or what a Certified Organic banana is to, well, an ordinary banana. There are currently more than 550 Certified B Corporations located primarily throughout the United States and Canada. Many are national brands like Patagonia and Seventh Generation, and ESOP-owned King Arthur Flour and Dansko; others are industrial companies like family-owned Cascade Engineering or Solberg Manufacturing; others are law firms, venture funds, office supply companies, and a range of others across more than 60 industries.
Certified B Corporations are companies that have earned the independent B Corporation certification administered by B Lab, a not-for-profit organization based in Berwyn, Pennsylvania. To qualify as a Certified B Corporation, a company must meet comprehensive and transparent social and environmental performance standards. Candidates for the certification begin by taking a 60 to 90 minute B Impact Assessment, which measures the overall impact of the company on all stakeholders, including employees, the community at large, customers, and the environment. Companies must achieve a minimum verified score of 80 out of 200 possible points to become a Certified B Corporation.
Once it passes the Assessment, depending upon its corporate structure and state of incorporation, a company may be required to amend its corporate governance documents (i.e., Articles of Incorporation for corporations or Operating Agreement for LLCs) to explicitly include consideration of the interests of employees, consumers, the community, and the environment, and to allow legal permission and protection to officers and directors to consider all stakeholder interests in making business decisions, even in change of control scenarios. This last part may be particularly useful for ESOP-owned companies that want to maintain their independence even in the context of an unwanted acquisition offer.
Certified B Corporations receive a variety of services and support from B Lab that help them attract and retain talent, generate press and sales, and save and raise money. Certified B Corporations pay annual fees to maintain the certification ranging from $500 per year (for companies with less than $2 million in revenues) to $25,000 per year (for those with greater than $100 million. To maintain the integrity of the certification, 20% of all Certified B Corporations undergo an on-site review during each two-year certification period.
Are Benefit Corporations Different from Certified B Corporations?
Somewhat confusingly, the abbreviation “B Corp” is sometimes mistakenly used to refer to Certified B Corporations as well as to a new corporate entity called a benefit corporation. And while Certified B Corporations and benefit corporations are related, they are nonetheless distinct. Whereas the B Corporation certification is a designation given to qualifying companies by B Lab, a benefit corporation is a new corporate form and legal status that has been recognized so far in eleven states. Any company in the United States or around the world can voluntarily pursue the B Corporation certification, whereas only companies incorporated in U.S. states that have enacted benefit corporation legislation can elect benefit corporation status. It’s important to note that becoming a benefit corporation does not affect a company’s tax status; rather, companies that become benefit corporations still continue to be taxed as they were previously (i.e., as either a C Corporation or S Corporation).
Benefit corporations share the same general corporate objectives as Certified B Corporations, but provide a formal, state-recognized legal construct to provide a higher level of clarity and legal protection to a company’s directors and officers in considering the interests of a company’s community, workforce, and the environment when making corporate decisions, even in liquidity and sale scenarios. According to Bill Clark, a partner at Drinker, Biddle & Reath LLP, who drafted model benefit corporation legislation, the benefit corporation legal structure “tells directors that it’s their duty to consider other interests, rather than say they ‘may’ consider them.”1
Maryland was the first state to pass benefit corporation legislation in 2010; since then, ten other states have enacted such legislation, including California, Hawaii, Illinois, Louisiana, Massachusetts, New Jersey, New York, South Carolina, Vermont, and Virginia. Several other states have legislation pending. In January 2012, Patagonia – the popular maker of outdoor clothing and gear – joined 11 other businesses in becoming the first companies to take advantage of California’s benefit corporation law. “Patagonia is trying to build a company that could last 100 years,” Yvon Chouinard, Patagonia’s founder, said. “Benefit corporation legislation creates the legal framework to enable mission-driven companies like Patagonia to stay mission-driven through succession, capital raises, and even changes in ownership by institutionalizing the values, culture, processes, and high standards put in place by founding entrepreneurs.”2
What Are ESOPs?
Given the central role that employee welfare plays in the corporate objectives of many B Corps, it is not surprising that founders and shareholders of privately held B Corps are turning to ESOPs as a potential exit strategy. (In fact, “Worker Ownership” is a specific category assessed in the B Impact Assessment.) Nor is it surprising that existing ESOP companies are increasingly considering becoming B Corps, since ESOP companies and B Corps share many of the same overarching core values.
ESOPs are tax-qualified retirement plans created as part of the Employee Retirement Income Security Act (“ERISA”) in 1974 that enable broad-based employee ownership. According to the ESOP Association, there are approximately 10,000 ESOP companies in the United States covering over 10 million employees. ESOPs are similar to other retirement plans, including 401(k) and profit-sharing plans, but have several distinguishing characteristics. Unlike other retirement plans, which are required by law to diversify their assets, ESOPs are required to primarily invest in the stock of the employer company for the benefit of all qualified employees on a non-discriminatory basis. Also, unlike other retirement plans that generally invest employer contributions when received, ESOPs can borrow money to fund the purchase of company stock from the current shareholders and repay this debt through future contributions. Therefore, an ESOP can be used by a business owner to create an internal buyer of his or her company stock as long as the ESOP does not pay more than Fair Market Value for the business owner’s shares.
In order to increase employee ownership in companies, the federal government has created compelling tax incentives for the formation of ESOPs for both the business seller and the company. The seller of the business can defer capital gains taxes on the sale of stock to an ESOP through what is known as a “1042 rollover.” Under section 1042 of the Internal Revenue Code, an owner of a C Corporation can defer capital gains taxes on the stock he or she sells to an ESOP if (i) the ESOP owns more than 30 percent of outstanding company stock after the transaction and (ii) the seller reinvests (“rolls over”) the sale proceeds into “qualified replacement property,” which consists of stocks or bonds of U.S. operating companies. Selling shareholders using the 1042 rollover often avoid taxation completely by retaining the qualified replacement property until death, at which time the property transfers to their heirs at a stepped-up cost basis.
The company can fund the purchase of stock using pre-tax dollars since principal payments on the loan the ESOP uses to purchase the stock is tax deductible. This enhances cash flow and creates a comparative advantage to traditional leveraged buyout structures in which post-tax dollars are used to repay debt. And, if 100% of an S Corporation is owned by an ESOP, the company is exempt from paying income taxes altogether, since S Corporations pay no corporate income tax and the ESOP, as a tax-exempt shareholder, pays no individual income tax on the company’s pass-through income.
B Corps and ESOPs: A Logical Match
B Corps may be different from other companies in many respects, but shareholders of all privately held companies, B Corps or not, eventually need an exit strategy. And, while all of the traditional exit vehicles – going public, sale to a strategic buyer, or sale to a private equity buyer – are available to shareholders of B Corps, a sale to an ESOP may hold particular allure.
Unlike other exit strategies, a sale to an ESOP enhances the ability of the selling shareholders to protect the company’s legacy, maintain operational independence, preserve local jobs, and align the interests of the employees with shareholders (since the employees beneficially become the shareholders). In contrast, becoming a public company may put pressure on the company’s directors and officers to focus on meeting quarterly earnings targets at the expense of the company’s long-term core values. Selling to a strategic buyer may put the company’s brand and legacy at risk, and could result in operational consolidation, leading to a loss of local jobs. Selling to a private equity buyer may also result in operational restructuring and layoffs, but also creates long-term uncertainty since most private equity firms have a five- to seven-year expected holding period. And none of these traditional exit strategies come with the unique tax benefits for both the selling shareholders and the company as a sale to an ESOP.
Dansko, the Pennsylvania-based designer and seller of innovative comfort footwear, is one example of a Certified B Corporation that became a 100% ESOP-owned company. “Becoming an ESOP, like becoming a B Corp, helped us align our values with our business practices,” says Mandy Cabot, co-founder and CEO of Dansko. “Dansko is our baby; our employees are our family. Becoming an employee-owned B Corp protects our legacy, ensuring that we can not only remain independent, but also maintain our focus on being a great place to work, a valued member of our community, and a good steward of the environment.”
For existing ESOP companies, becoming a B Corp may not just make sense from a corporate values perspective, it may make good business sense as well. “Becoming a B Corp can be accretive to value,” says Alex Moss, principal at Pennsylvania-based Praxis Consulting Group, which provides consulting services for employee-owned companies (and is itself a Certified B Corporation). “B Corp certification reinforces a culture of long-term shared ownership that will attract and retain the best talent – your most valuable asset whether you’re a consumer-facing or b2b business – and that has consistently been shown to drive performance improvements across a range of business metrics.” Top institutions, including the Yale School of Management and the New York University Stern School of Business, have started to offer loan forgiveness programs to alumni who take jobs at B Corps, giving B Corps a competitive advantage attracting talent that increasingly seek to work for companies that take social and environmental issues seriously. Becoming a B Corp can also enhance corporate value by generating additional positive media exposure, cultivating the trust and loyalty of consumers, and providing access to significant discounts on a variety of services from other businesses like Salesforce.com and Netsuite (a provider of customer relationship management and enterprise resource planning solutions). And, B Corps may even be able to command a pricing premium for their goods and services from a more discerning and loyal customer base.
The Vermont-based King Arthur Flour, founded in 1790, was already a 100% ESOP-owned company before becoming a Certified B Corporation and a Vermont Benefit Corporation. According to CEO Steven Voigt, “the company became a B Corp to help ensure that King Arthur Flour would still be around for another 200 years with its mission, culture, values, and independence intact.” Says Voigt, “the social and environmental components of the B Corp certification give us useful management tools to improve our practices on these measures. We feel long term, our employee-owners and our customers will have a stronger connection to a great company managed this way.”
Because ESOPs are qualified plans under ERISA, there are some special considerations that should be addressed by ESOP companies interested in earning the B Corporation Certification or electing Benefit Corporation status under state law. Because of ERISA, the trustee of a company’s ESOP has a fiduciary duty to the ESOP separate from corporate directors and officers. According to Jim Steiker of Steiker, Fischer, Edwards & Greenapple, P.C., a law firm specializing in ESOP companies, “In making the Benefit Corporation election or amending corporate governing documents to qualify as a Certified B Corporation, the ESOP trustee should document that one purpose of the election is to continue to maximize shareholder value by ensuring the company’s ongoing commitment to its core values, sustainability, and public benefit.”
Many ESOP-owned companies and Certified B Corps are kindred spirits motivated as much by higher purpose as by higher profits. For shareholders of closely held B Corps, it is not surprising that an ESOP buyout is becoming a more common and compelling exit strategy, enabling the founding entrepreneurs and selling shareholders to protect the company’s legacy and maintain operational independence in the process. And we expect that for an increasing number of existing ESOP companies, the B Corporation Certification will prove to be a helpful tool to maintain independence and enhance corporate culture and shareholder value.
Also contributing to this article:
Jay Coen Gilbert
1 Loten, Angus, “With New Law, Profits Take a Back Seat,” Wall Street Journal, 19 January 2012.
2 Lifsher, Marc, “Businesses Seek State’s New ‘Benefit Corporation’ Status,” Los Angeles Times, 4 January 2012.