Control Without An Owner
Foundations and ESOPs look like ideal long-term owners — But no one with authority owns the upside — Outside investors bear the cost of deferred decisions and missed deals.
CONTROL WITHOUT AN OWNER
In Families, Foundations & Founders, we looked at controlling owners who settle for credit-like returns on their equity shares. Foundation and employee stock ownership plan (“ESOP”) control presents a different problem for outside investors.
Foundations and ESOPs are theoretically long-term, risk-averse, prudent owners, but in practice they tend to fall short, because no one truly owns the upside.
Who Controls the Business
These ownership structures result in a diffusion of responsibility. Who, ultimately, benefits from the company’s success and has the authority to make difficult decisions? Unfortunately for foundation- and ESOP-controlled businesses, there is no overlap in this Venn diagram.
Employee owners obviously care about the business. But they primarily care about its survival, as opposed to its potential upside. Employees have jobs because the business exists. If the business doubles in size, additional opportunities may present themselves and the ESOP shares will be worth more, but for most employees, keeping their jobs matters more. The result is an incentive to manage the business too conservatively.
The dynamic is the same with foundations. Higher share prices or dividends to the foundation may mean more dollars are donated, but the foundation employees making decisions may not share in this upside. The incentive for the foundation is again to keep the business surviving as opposed to thriving.
Tough Decisions
This incentive misalignment matters even more in times of crisis. The environment in which a business operates is constantly changing. Successful businesses adapt rapidly to shifts in technology, geopolitics, and social trends. But what if the owners of the business are more interested in preserving jobs than in the business’s success?
Foundations and ESOPs often postpone needed restructuring. The decision to let employees go is always difficult, and it is easier to kick the can down the road. Too many of these businesses take this approach.
Often, there is no one paid to make these difficult decisions, as foundation or ESOP ownership may result in diffuse, committee-based decision-making. Like a garden left unpruned, the business slowly deteriorates if these decisions aren’t made.
Buying and Selling
Pursuing the correct business strategy is not a “set it and forget it” decision. Often, a change in strategy must be accelerated through M&A, as either a buyer or a seller.
For foundation-controlled businesses, selling is rarely an option. The structure of foundation ownership frequently requires the foundation to retain its controlling stake, and the foundation typically depends on the ongoing dividends. These restrictions, generally put in place to ensure the original owners’ wishes are honored, present an immediate competitive disadvantage. ESOP-controlled businesses, which may need the buy-in of numerous constituents beyond equity shareholders, face similar challenges when selling.
Buying is also an issue. Given the conservatism described above, the willingness to take on debt to finance acquisitions is often lacking at these businesses. The failure to use debt capacity to execute the right strategy is another handicap.
Winning in the Equity Markets
As business continues to become more competitive globally, having owners willing to make the tough decisions required to win is increasingly important. To be clear, being overly aggressive is not the right answer, as survival in the public equity markets is the first step to creating value. But languishing without strategic direction is no better.
At widely held companies, shareholders often push for more aggressive action while management and boards try to manage risk. This push and pull, while not perfect, is generally superior to an overly conservative approach that prioritizes employment and the status quo over long-term returns.
