Capital Accounts and Profit Sharing: The Two Ways Employee-Owners Build Wealth

Thomas Dudley

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 MIN READ

Employee-owned companies can build life-changing wealth for working people. Take WinCo Foods. After roughly 40 years as an ESOP, the 130 workers at a single store in Corvallis, Oregon had a combined $100M in ownership wealth and across the company, over 400 front-line employees were “millionaire grocery clerks.” Or consider Springfield Remanufacturing Company (SRC). From 1983 through 2017, the company paid nearly $100M in distributions to its employee-owners. CEO Jack Stack highlights one person who, “started here in 1983 making $7.50 an hour [and] has now got $1.2 million.”

While not every employee-owner will become a millionaire, research shows that these remarkable examples highlight broader trends. A 2018 study of S Corporation ESOPs found that employee-owners have nearly double the average retirement wealth of non-employee-owners ($170,326 versus $80,339). In 2021 we used data from the Federal Reserve to show that if every American business became employee-owned, wealth inequality would be reduced to historic lows and the wealth of the median household would increase by over $100,000.

How are employee-owned companies helping people build this much wealth? While there are many ways to create and run an employee-owned company, there are only two ways that these businesses put money in the pockets of their workers: capital accounts and profit sharing

Capital Accounts

Capital accounts are distinct accounts hold company stock directly or derivatives such as stock options on behalf of individual employees. Employee Stock Ownership Plans (ESOPs), Employee Stock Purchase Plans (ESPPs), and stock options are all forms of capital accounts. Capital accounts are typically funded through an initial grant or annual contributions. Funding might come from the company, as with an ESOP, or from the employee-owner, as with an ESPP. Today there are over 5,800 employee-owned companies using capital accounts. 

Capital accounts benefit from compound growth.The value of the stock or derivative in a capital account is tied to the performance of the company through the share price. Assuming the business is performing well, the company’s share price will increase and the value of the capital account will go up. Importantly, the increase in value from share price growth applies both to contributions as well as prior share price growth, which creates compound growth.

Compound growth is how employee-owners can build life-changing wealth. Specifics vary, but many reasonable scenarios that reflect real-world practice lead to six-figure wealth building, and, as we saw with WinCo and SRC, companies that are employee-owned for 25+ years usually have front-line millionaires. While compound growth has tremendous potential, the key ingredient is time. Drawing the account down will erase the compounding. Building substantial wealth typically requires the capital account is untouched for 20 years or more. 

Eventually employee-owners must turn their capital account back into cash. Because employee-owned companies are private, there are generally two options: the company buys the share back or the accounts are cashed out when the company is sold. 

Due to the nature of business valuation, companies almost never have enough cash on hand to buy back all outstanding shares. This leads to a situation at mature capital account companies called “share recycling” where shares are bought from selling owners and recycled back to new owners. This is a time-tested practice that can continue for a long time if both the employee ownership plan and the company are managed well. 

Profit Sharing

Profit sharing is when a company regularly distributes some portion of profits back to employees as cash. The key feature of profit sharing is liquidity. Profit sharing is typically done on a quarterly or annual basis, and once the profits are in and the benefit is calculated a check is cut to qualifying employee-owners within a few weeks.

Profit sharing can be implemented in a variety of ways, but not all forms of profit sharing are ownership. For example, a plan that exists solely at the discretion of management can provide a nice benefit, but it is not ownership because it can be taken away by management without any sort of monetary compensation to the employees. 

To be considered ownership a profit sharing plan must have a legal claim on part or all of the business and it must have codified distribution rules that are broad-based. Profit-sharing benefit plans that own shares of company stock can meet these criteria, but in our experience these plans rarely own enough of the company for it to meet the definition of employee-owned

Currently we see just two types of employee-owned companies where the primary wealth building mechanism is profit sharing: Worker Cooperatives and Employee Ownership Trusts (EOTs). We know of roughly 400 companies operating through these two vehicles today.

Tradeoffs Between Capital Accounts and Profit Sharing

The structure of capital accounts and profit sharing leads to a fundamental tradeoff between wealth building and liquidity. 

Wealth Building

Through compounding, capital accounts help employee-owners build more wealth than profit sharing. Specifics vary, but typically after 30 years compound growth is responsible for at least 80% of the value of a capital account (explore scenarios here). If the account owner had instead received their annual allocations of stock as cash payments, for example through profit sharing, they would have received just one fifth of the value of the capital account over time. I doubt that any employee-owner has ever built a million dollars in wealth through profit sharing alone.

Liquidity (Timing of Payments)

While capital accounts have greater wealth-building potential, profit sharing provides money sooner, and money today is more useful than money later. Most capital account structures at employee-owned companies own illiquid private-company stock, so employee-owners have limited withdrawal options. On top of that, regularly withdrawing a portion of your capital account will diminish or even completely offset the benefits of compounding. 

Delayed gratification is inherent in the concept of capital accounts just as liquidity is inherent in the concept of profit sharing. The ultimate point of employee ownership is to create better lives for working people and if people have immediate needs, waiting might not be an option. While profit sharing builds less total wealth, it provides greater liquidity and that tradeoff might be worth it for some people, especially those making a lower income. 

Investing in Growth

The differences between profit sharing and capital accounts have implications for how a company invests in growth. Capital accounts are fundamentally long-term and therefore can be much better for alignment. Theoretically, profit sharing can disincentivize investing in the business, since investments reduce profit now in exchange for profit later. For example, buying an expensive piece of equipment that would increase profitability multiple years in the future. If employee-owners have a strong need for money now, will they still make that investment?

Why Not Both?

Considering the advantages of both capital accounts and profit sharing it’s tempting to ask: why not do both? In theory you could split the ownership of a company in any way between capital accounts and profit sharing. In practice, we find that companies tend to do one or the other. We haven’t counted exactly, but I would estimate that over 95% of employee-owned companies either have capital accounts or they are owned 100% by an EOT or Worker Cooperative.

There is a major exception: discretionary profit sharing. While not actually ownership, profit sharing that exists at the discretion of management shares the positive characteristics described above, specifically the immediacy of payment and the attendant culture-building benefits. For this reason, we see many companies with capital accounts implement a discretionary profit sharing plan as well. Typically it has a quarterly or annual cadence and the primary focus is to strengthen the connection between the success of the company and the success of the employee-owner. 

Wealth building for working people is the common thread running through all corners of the employee ownership community. Different companies in different industries employing different people will all find their own balance in the tradeoff between capital accounts and profit sharing. What’s important is to consider what’s right for your company and your people.

‍This article was originally posted 4/27/22 and was updated on 5/9/2023. Special thanks to Jon Shell of Social Capital Partners who read an early version of this post and suggested the point about “Investing in Growth”. That section is adapted from his email. 

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After publication, Christopher Mackin of Ownership Associates sent a thoughtful reply detailing a notable example of a non-US company that uses both profit sharing and capital accounts, as well as a template for implementing a dual structure. With permission, I am including the content of the message here for interested readers.

"Your statement that worker cooperatives and EOT's are where profit sharing employee ownership models reside is a bit problematic. You are factually correct about EOT's and most American worker cooperatives. But it is also the case that perhaps the most prominent single example of what you are calling Capital Accounts is in the Mondragon worker cooperative system of - yes - internal capital accounts. David Ellerman and the rest of us at the Industrial Cooperative Association worked hard in the 1970's and 1980's to develop model by laws for worker cooperatives (pps.16-20) that specify how to establish that internal capital account model which David thought through independently of Mondragon.

When we traveled there in the late 1970's we were amazed to find a real world example of scale that made use of the very same ideas - a membership share of stock the price of which was set and adjusted only for inflation separated from individual internal capital accounts into which annual profits were contributed and losses deducted. These same accounts obviously also compound wealth.

It is my guess that only a small percentage (say 10%?) of American worker cooperatives make use of the internal capital account system used in Mondragon. That is or will become a problem for them when the pressure to pay out cash is perceived to be a zero-sum decision on the part of members (cash for persons or undifferentiated investment in the cooperative). The internal capital account system breaks through that problem and does so in a way that is actually superior in my mind to the ESOP structure which has the benefit of capital accounts but the pressure to value those accounts using net present value methodologies."

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