Modifying the Corporate Structure
Founders of organizations whose mission is to help build a just and sustainable economy face a dilemma if they plan to operate a large capital-intensive business. Generally, a corporation is the most appropriate structure for a large business that needs to bring in many investors, but it is not ideally suited to maintaining a mission that is inconsistent with shareholder profit maximization. This section discusses how to modify the corporate structure in order to mitigate potential shareholder pressure to choose profits over mission.
Super-Majority Voting Stock
State corporation law gives a great deal of flexibility to boards in the design of their capital structure. Founders of a sharing corporation can modify voting and profit rights to further sharing goals. For example, some corporations are structured so that the founders have controlling voting rights even when they own only a small percentage of the company’s stock. They may create a separate class of stock – so-called “Class F Stock” – that carries, say 100 votes per share, rather than the standard one vote per share. Examples of companies with this kind of capital structure include Google, the New York Times, and Interface, a flooring company with an admirable commitment to social and environmental responsibility. The obvious flaw of this model is that it is completely dependent on the commitment of the founders. If the founders leave or start to drift from the original mission, the commitment to goals unrelated to profit maximization will be diminished.
Another innovation with a bit more teeth than the super-majority voting stock structure is to incorporate provisions into the company charter that make “mission drift” more difficult. For example, Portland, Oregon–based Upstream 21 Corporation is a company that was set up for the purpose of buying other companies and helping them improve their financial, social, and environmental performance. Upstream’s articles of incorporation include the following provisions (summarized here):
• Each director is required to sign an agreement stating that he/she shall discharge the duties of a director in a manner the director reasonably believes to be in the best interests of the Company, and the best interests of the Company are defined to include the Company’s and its subsidiaries’ social, legal and economic effects on their employees, customers, and suppliers and on the communities and geographic areas in which the Company and its subsidiaries operate; the long-term as well as short-term interests of the Company and its shareholders; and the Company’s and its subsidiaries’ effects on the environment.
• When evaluating any offer of another party to purchase the Company or merge, the directors are required to consider the following: the social, legal and economic effects on employees, customers and suppliers of the Company and its subsidiaries
and on the communities and geographic areas in which the Company and its subsidiaries operate; the economy of the state and the nation; the environment; the long-term as well as short-term interests of the Company and its shareholders, including the possibility that these interests may be best served by the continued independence of the Company; and other relevant factors.
• There are four classes of voting stock:
• The president and each member of the board of directors gets one share of Series 1 Class A Common Stock.
• When outside investors invest in the Company, they get Series 2 Class A Common Stock.
• Employees of the Company and its subsidiaries are issued Series 3 Class A Common Stock after 12 months of employment.
• Class B Common Stock is sort of a catch-all class for any other types of shareholders. For example if a board member is voted off the board, his or her share of Series 1 Class A automatically converts to Class B, unless that person is an employee, in which case the Series 1 Class A converts to Series 3 Class A. Series 2 Class A converts to Class B if the investor transfers his or her stock to someone else.
• When shareholders vote on any matter such as the election of the board, each share is entitled to one vote, but when the shareholders must vote on one of the following actions (“Extraordinary Actions”), different voting rules apply (described below):
• Amendments to the articles of incorporation
• Amendments to the bylaws
• Share exchange
• The sale, lease, exchange, or other disposition of all or substantially all of the Company’s property
• Removal of a director
• An Extraordinary Action may only be approved if (1) a majority of all shares entitled to vote on the action, without regard to class or series, vote in favor of the action AND two-thirds of all shares of any two series of Class A Common Stock entitled to vote on the action, voting separately by series, shall not vote against the action; OR (2) two-thirds of all shares of any two series of Class A Common Stock entitled to vote on the action, voting separately by series, vote in favor of the action.
Upstream’s complicated voting structure is designed to give greater control to employees and directors and to reduce the authority of outside investors, especially of those investors that acquire shares from other shareholders as opposed to directly from the company.
Note that most constituency statutes allow directors to consider interests other than shareholder profit maximization but do not require them to do so (Connecticut is an exception to this). Upstream 21 actually requires its directors to consider stakeholder interests.
Would such a structure be advisable under the law of a state that does not have a constituency statute, such as Delaware or California? In states without a constituency statute, many attorneys would advise clients against provisions that require consideration of interests of stakeholders like the environment, the economy, and the community. Such provisions arguably conflict with state law requiring, at least in a sale situation, that directors maximize shareholder profit. 1However, the complicated structure of shares and voting rights would likely be permissible in any state.
Some attorneys would argue that as long as the provisions requiring directors to consider stakeholders other than shareholders were in the corporate charter before investors bought shares, shareholders would not have a valid cause of action even in a non-constituency statute state if directors failed to maximize shareholder profit. As one law professor put it, “Because shareholders would have bought their shares with the provision already in place, the price they paid for those shares would reflect any appropriate discount for that provision.” 2
Examples of other ways that corporations can be structured to protect their social or environmental mission include
• Bylaw or charter provisions that require one or more board members to have expertise in certain subject areas such as environmental conservation or corporate social responsibility;
• Bylaw or charter provisions that require the board to report on the company’s performance in areas such as employee satisfaction and resource efficiency;
• Bylaw or charter provisions that require the company to maintain certain certifications or ratings with independent standards organizations such as the Global Impact Investing Rating System;
• Bylaw or charter provisions that require the company to buy only fair trade sourced inputs;
• Bylaw or charter provisions (or a separate buy/sell agreement) that prevent shareholders from transferring shares to third parties, that limit the return the shareholder gets from redeeming the stock with the corporation, and/or that give other shareholders the right of first refusal to buy the shares at a fixed price. This creates disincentives for shareholders to sell their shares at a profit.
Note that bylaws and articles can always be amended. When including such provisions in these documents, it is important to think carefully about additional provisions that reduce the ease with which these socially responsible commitments can be removed.
Modifying a partnership or an LLC
LLCs are known for their flexibility. LLC operating agreements can include creative provisions regarding voting rights and profit sharing. While standard provisions confer voting rights and profit distributions based on percentage ownership, these can be altered if the founders so choose.
Many organizations that are committed to the values of a sharing economy have used the LLC structure as their entity of choice. For example, Women’s Action to Gain Economic Security, a nonprofit organization that helps low-income people organize and operate cooperatively structured businesses, uses the LLC form to set up the businesses it helps to launch. These businesses are identical in many respects to cooperatives. However, in some states, such as California, they may not use the word “cooperative” in their names because they are not formed under that state’s cooperative statute.
Creating an Employee Stock Ownership Plan
By Loren Rodgers, Executive Director of the National Center for Employee Ownership
Over 11,000 companies in the United States have employee stock ownership plans (ESOPs), making them the primary vehicle for employee ownership of company stock. Most ESOPs are in closely held companies, often with 75 to 150 employees.
Since the Employee Retirement Income Security Act (ERISA) established a framework for ESOPs in the 1970s, analysis by diverse researchers has come to several points of consensus: ESOP companies tend to grow faster in terms of sales and employment, tend to have higher productivity, and tend to survive longer than comparable non-ESOP companies. ESOP participants have, on average, 2.5 times the assets in company-sponsored plans than do employees in comparable non-ESOP companies.
ESOPs are retirement plans, subject to the same rules as other defined contribution plans, such as 401(k) plans. Two major differences between ESOPs and 401(k) plans are that ESOPs, by design, invest primarily in a single security, the stock of the employer, and that ESOPs may borrow money in order to purchase stock.
The ESOP trust, a separate legal entity from the company, is the legal owner of the shares, and as employees become participants in the plan, they become beneficiaries of the trust, which has an obligation under ERISA to operate the plan for the exclusive benefit of plan participants.
The most common uses for ESOPs are to allow business owners to sell their shares and to provide a competitive benefit that attracts and retains employees.
Setting Up an ESOP
A minority of ESOPs, roughly 15 percent, do not borrow money and are termed nonleveraged ESOPs. The company makes contributions at its own discretion to the plan. Contributions may be in the form of stock or in the form of cash, which would then be used to purchase stock.
Leveraged ESOPs borrow money and use that money to buy shares. A typical practice is to obtain external financing from a bank or other source. Rather than lending to the ESOP, lenders typically make their loan to the company (the external loan), and the company reloans the funds to the ESOP (the internal loan). Another common structure involves seller financing, where the owner of the shares sells those shares to the ESOP in exchange for a note. As the ESOP repays the loan, whether that means the internal loan from the company or the note from the seller, it releases shares into the accounts of participants.
ERISA establishes requirements for employees to become plan participants, for employees to become vested in their accounts, for the form and timing of distributions to those that leave the plan, and for diversification when employees meet age and years-of-participation requirements. Companies are free to be more generous than the requirements, but cannot be less generous.
ESOP participants have the right to direct the ESOP trustee how to vote their shares on specified shareholder issues, though in practice these voting rights tend to be of trivial importance in company operation.
Companies with ESOPs have a variety of tax benefits. The most important one in the current tax environment is for S corporations. S corporations pass taxes on to their shareholders, so if a non-tax-paying entity such as an ESOP is the sole shareholder, the company does not pay federal income tax. Also, most states will not impose state income tax in that situation. ESOPs first become allowable shareholders of S corporations in 1998, and since that time the number of 100 percent ESOP-owned companies has increased dramatically. The second major tax incentive is a tax deferral. People who sell C corporation shares and meet certain requirements can defer their capital gains tax.