Closing the wealth gap through "ownership trusts"

Social bonds are taking off.

High investor demand for Atlanta's recently launched $369000000 social bond helped cut the city's interest payments.

The city group together recreation, transportation, public safety, and other capital projects under the social label to draw orders for more than 1200000000 from 54 institutional investors.

Real estate developers in Baltimore are testing strategies for inclusive growth.

A developer on the city's east side is rehabilitating vacant and distressed buildings and helping local residents buy them at a discount.

It's one of a number of projects that are turning Baltimore into a case study in real estate impact investing.

Mission Investors Exchange will showcase some of the examples at its national conference in Baltimore next week.

Meanwhile, in Texas, a microlender is partnering with a real estate crowdfunding platform to help women of color get into the real estate market to build generational wealth.

Just a community development financial institution in Austin, partnered with arrived homes and Schmidt futures to stake the women to a share of ownership of a portfolio of rental homes.

The collaboration is an example of how the so-called client asset ownership is aiming to address persistent racial wealth gaps.

And we've got some bonus agents of Impact podcast for you this week.

Seth Bannon of 50 Years is this week's Agent of Impact.

He spoke with David Bank about the crypto meltdown and apparent resilience of climate tech investing, and Toussaint Bailey shared uplifting capital strategy for bringing everyday investors into impact investing.

You can listen to all of our podcasts on the Impact Alpha podcast feed wherever you listen.

Zoe, why did you start common trust?

So I've been in the impact investing world for about the last decade?

Uh, and in 2018 was running an impact BC fund?

One of the key areas of interest for me has always been rising wealth inequality.

And running an impact VC fund.

I started to ask some questions about what happens to wealth inequality when these businesses exit, namely because the people who have access to ownership of these, these businesses and will benefit from a liquidity event, uh, tends to be folks who are already wealthy.

Um, and if you look at rising wealth and equality in the United States, what you'll see is that worker wages have steadily fallen or stagnated over the last 50 years, even as a stock market and economy has grown.

And the reason for that is that the way to build wealth in America is through ownership, not wages.

At the same time, it's incredibly difficult to access ownership, if you are not already an owner of something, if you're not already wealthy.

So, early on, I started to ask the question of, are there ways for us to build mechanisms for more Americans to access ownership of the assets that they're contributing to?

I spent the last 2 years at a family office investing in shared ownership, so that was across a wide range of asset classes that included everything from employee ownership, but also community ownership of real estate.

We looked at building option pools for contractors and gig labor, gig laborers at labor marketplaces.

The key question here is how do key stakeholders who are contributing to an asset's value also benefit from its upside.

So I understand your theory of change here is that ownership is very important for wealth and equality, and that you want to expand the notion of who has access to ownership.

And so where does I come into the small business arena?

So in the small business arena, we're at a really interesting stage.

Over the next decade, it's projected that 3 and 5 small businesses are going to seek a sale.

And that's because the large majority of these businesses are owned by boomers who are preparing to retire.

What that means is that we are at the precipice of a massive transfer of wealth, and how and to whom these business owners exit matters tremendously.

So what are the opportunities or options for the small business owners to exit their businesses right now?

What's that landscape look like currently?

So today, if you own a small business in yours, getting ready to sell, you have a couple options.

One, you can sell to private equity.

Um, two, you can go to a business broker.

They'll help you find a private buyer, uh, increasingly from NBA programs or seeing a number of search funds, uh, for, you might find a strategic buyer who's going to acquire your business into a larger business.

Um, and then, and then 5 they're also, there are also other employee ownership options, specifically Aesop sales, and worker co-ops.

All right, so those are those are the traditional models right now, but it sounds like that with common trust, you've come up with a new option altogether.

Yeah, what we found in talking to business owners is that none of the 1st couple options that I mentioned, private equity, private buyers, search funds or strategic acquirers are very attractive to small business owners, primarily because when you're a business owner and you're seeking to sell your business, you're thinking about 2 things.

One is liquidity, but two, you're also thinking about the legacy you've built in your business.

And the 1st options there, put that at risk.

We've seen too many horror stories of private equity firms acquiring small businesses, hollowing them out, selling them for parts.

Uh, and so, These small business owners are really wary of those solutions.

At the same time, we already have a couple methodologies for small businesses to exit to their employees, Aesops and co-ops.

We haven't seen that space scale to the level that I believe it can and should.

Um, and that's because they come with some constraints that business owners end up walking away from.

So we're using a new structure for employee ownership exits called purpose trust.

This is adapted from a long-standing model used in the UK and Europe. That combines steward ownership and employee ownership.

What a purpose trust does is it will purchase the business from a selling owner, and then what's important about a purpose trust is it establishes a purpose that the business will be governed by.

Purpose trust we're in the news recently with Patagonia's founder choosing to sell his stake in Patagonia, not to private equity, not to go public, but to a purpose trust as well.

So there has been some attention paid to this model recently, right?

Yeah, that was actually a really exciting development for the field and speaks to the flexibility of this model, which is one of the things that selling business owners are really attracted to.

The Patagonia deal was interesting because, uh, it wasn't actually an employee ownership exit.

What the purpose trust does that they establish is it protects a specific purpose for them around climate change and climate advocacy.

Uh, so if you kind of peel that back to the optionality that this provides to business owners, if I'm a business owner looking to exit my business, I get a level of flexibility and design and customization in the creation of this purpose trust that I'm exiting my business too, that no other vehicle can provide at this point.

And so for these business owners, the decision to sell can be very emotional, as you've noted.

And there's a lot of complexity to this, to the feelings that they have about creating a business, running a business and now trying to hand it over.

And so how does a purpose trust kind of help assuage the kind of range of emotions that they have in thinking about their exit opportunities.

I think that's one of the advantages that purpose trusts have over other sale processes.

Because if you're selling to a traditional buyer right now, you're essentially taking 2 decades of, you know, this business that you've poured your blood, sweat, and tears into and turning it into hard negotiations about pricing and things that you certainly care about, but you also care about other things.

You care about your people, the employees who've worked alongside you and, you know, sent their kid to college as a result of this business and their employment there.

And with a purpose trust, because you have a level of creativity and customization in the design of it.

These business owners get to harness all of the creativity and entrepreneurialism that they've used for the last 2 decades building their business and point it towards the design of their exit.

So can you give us a few examples?

What do these businesses look like that typically sell into a purpose trust?

So we've worked with a wide range of businesses.

Everything from profitable startups to going concern businesses that have been around for 3 decades.

One of the recent deals that we worked on was a set of auto shops in Utah, Cleigado.

This was 4 different businesses that wanted to transfer into employee ownership.

And, you know, they'd looked at alternative employee ownership models and decided that the co-op and the Aesop wasn't for them.

And so we worked with them to design a customized employee ownership trust, that there are 4 businesses, then exited into.

So can you walk me through the mechanics.

So who provides the financing to actually purchase the business from the business owner on behalf of the trust?

It really depends on the deal.

So typically, it will involve some amount of external capital and then some amount of seller financing.

The way that works in practice is the external capital, which might be senior debt from a bank, at common trust, we provide a trunch of mezzanine debt funding.

Uh, and then the seller financing can be structured across various instruments, but that capital comes into the newly formed and designed trust to then purchase the assets from the selling owner.

That's how you get your liquidity.

And then the investors are all paid out over a long-term time horizon through company cash flow.

This is done alongside profit sharing for employees, so investors are being paid out at the same time that employees are benefiting from profit sharing, which is one of the mechanisms that investors are most attracted to because it's a really strong incentive alignment across all parties.

You said the seller might provide financing themselves.

So they're providing financing to pay themselves.

Yes.

This is one of the strange parts of these transactions, which is very common in actually a lot of small business sales.

Let's say external capital comes into to take up 70% of the capital stack, and the other 30% is going to be done through seller financing.

That means as the owner, you're going to get 70% of your liquidity on day one from the external capital coming in, and the 30% of seller financing will be converted into.

For instance, a debt note and you'll be paid out that remaining 30% over the term of the loan.

Got it.

So, and that's the, is that a typical uh, kind of ratio of 70% external financing, 30% seller capital or?

That's, um, in the Aesop world that's pretty common, but we found with a lot of businesses that we work with is they actually want to do more seller financing than external capital, and that's primarily because they can be more creative with the seller financing instruments to allow for a successful and well-balanced exit.

Um, but that's a that's a pretty typical uh, capital structure for an Aesop sale.

So, is what I would expect this industry will evolve into.

And besides local banks, what other kind of external financing is typically available?

So the senior debt is typically coming from banks, the mezzanine debt, uh, you know, there, there aren't a huge number of dedicated capital providers for purpose trusts.

In fact, to my knowledge, we're the 1st dedicated capital provider for purpose stress.

Um, we work with family offices, RAs, uh, a wide range of a wide range of groups, uh, but increasingly, we're seeing more and more financial platforms, banks, and uh, capital providers, showing a lot of interest in this model.

And uh, how do you get your own financing for common trust?

So common trust is structured as a platform.

We have kind of 2 sides to what we do.

One is legal design, uh, and feasibility for these transactions, the other is a financing arm.

Uh, so we have, we raise some equity into the parent company, common trust, and then have subsidiary funds that provide the direct investment into the deals.

And this purpose trust model that you have kind of rediscovered and are trying to bring to as a new option for exits for owners, of companies, 2 employees.

What's been the uptick like?

What are the common rejections you get from people who are curious and want to learn about more about it and they decide not to go with it?

And then what are the reasons why you've had people go forward with it as well?

That's a good question.

We haven't yet had someone reject this and then go pursue another sale, rather, the quote unquote rejections that we get.

I would say our folks who are just not ready for the exit.

So they're early on in their exploration process.

Like we, we have a handful of folks we've talked to over the last 6 months or so who, you know, demonstrated some interest, but I would expect that they'll actually pursue their exit in 3 to 5 years instead of the next 12 months.

Um, what are the common objections?

You know, one of one of the challenges to this space is that it's nascent, what that means is that there aren't as many dedicated capital providers as you'll find in the Aesop world or just traditional M&A. Uh, that is a real barrier.

We think the market is large enough that we're going to start seeing more capital providers moving into the space.

And in fact, you know, we're already seeing several large institutional capital providers reaching out to us about these opportunities.

But that is a real consideration for these businesses.

The flip side of that that is kind of like the benefit to that is that the capital providers who are here are very, very strongly aligned with this model, so you know that the capital you're taking in is going to be really aligned with what you're building.

And the upside for the business owners, like they're not losing on any of the financial upside that they might buy selling to private equity or through a private sale or some other model, right that?

Is that fair to say?

Or is there some sacrifice of financial returns?

To pursue a purpose trust?

It depends on the business.

There's definitely a subset of businesses that will get multiples from private equity that an employee ownership transaction just can't and won't support.

And that's because the private equity fund.

Uh, can pay that higher price, uh, due to the the future price they believe they'll be able to sell the business at.

So there is a subset of businesses where there's a real financial trade-off.

That said, we've actually worked with a handful of business owners who compare this, uh, apples to oranges, but compare this directly to a private equity offer that they've gotten.

And when they look at the legacy benefits of a purpose trust exit, they're actually willing to take a haircut on the price in order to ensure that their people in the business are protected for the long term.

Uh, there is nothing more existentially terrifying to a selling business owner than being afraid you're going to sell to someone who is going to dismantle your business for parts 3 months later.

Right.

So it's not just a purpose trust, but a legacy trust in a way of kind of embedding your legacy and your...

And so just to that point, these trusts are kind of perpetual.

I mean, what's the, what's the lifecycle of these, of these trusts?

Yeah, that's a really good question.

So this is a fundamentally different form of business ownership than what we typically think of when you exit a business with a private equity exit.

You're going to sell to a private equity owner.

They're going to become the owner of the business, but their purpose and intent is to sell the business to someone else.

Um, typically that's on a, Shorter time horizon, so it puts a lot of pressure on the business to basically rapidly appreciate shared value in a short period of time.

And the downside of that is there negative effects on the business in years, 7, 8, and 9 that the private equity firm may not care about because they've already gotten their liquidity.

With a purpose trust, you're moving a business into the trust and the aim is for it to stay there.

For the long term, into perpetuity.

What that means is the business can start operating in a fundamentally different way.

It can make investments in the business where the return on that investment is going to be.

A decade down the road, it can do profit sharing, it can think about things on a much longer term time horizon than a private equity firm who owns a business and is thinking, how am I going to get my IRR up to be able to raise my next fund in 2 years.

So it's a fundamentally different way of operating businesses, but I should flag the, this is a, uh, ownership structure and an ownership approach that has existed in Europe for over a 100 years.

Some of the biggest private companies in Europe exists under a similar structure.

Novo Nordisk, Bosch, Zeiss, there's several of these businesses who have operated under a similar structure for decades and have done so successfully.

In fact, the research from Europe shows that businesses under this structure have a 6X higher survival rate over a 40 year period than their peers.

This is in contrast to private equity owned businesses that have a 10 X higher bankruptcy rate.

Then they're non-private equity own peers.

Well, uh, the the private equity portfolio companies might have the higher bankruptcy rate, but the private equity firms, uh, certainly do not.

Correct.

So in the in the move to reimagine ownership and thinking about ownership as a tool in combating wealth and equality, and rewarding those who helped create that wealth, namely employees and perhaps other stakeholders as well, this purpose trust is an old tool newly discovered, and that you're trying to put into motion.

What are you most excited about for the future?

I think there are 2 things that we're most excited about.

One is the market demand, when I look at the wave of business owners that are going to seek a sale over the next decade, 3 and 5, it is the largest single ownership transition our country has seen and represents, in my opinion, our biggest Archimedes lever to be able to actually impact wealth inequality.

Um, The 2nd side of things is creativity.

Because purpose trusts allow for a large degree of creativity in terms of establishing a purpose and including multiple stakeholders.

I think we're going to see more and more businesses that take a more holistic lens of their value chain, then think critically about which are the stakeholders that should actually benefit with upside, if they're contributing to the value of this asset in this business that we own.

As businesses have become more and more globalized, necessarily their value chains have increased, and there are more and more stakeholders that are involved in these businesses, with purpose trust because they allow for the inclusion of multiple stakeholders.

I think we are in a position where we can see businesses better prepared to weather shocks that are experienced across their value chains because they're integrating those stakeholders, both into the governance and into the economic benefit of these businesses.

All right, well, Zoe, thank you so much for joining us and sharing your thoughts on purpose trusts and excited to see what common trust does in the future.

Thanks for having us.

You can read all about ownership trust and Zoe's story over at impactalpha.com.

That's going to do it for this week's impact briefing.

Thanks so much to my guest, OH log, and to our producer extraordinaire Isaac Silk.

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