When Democratic ESOPs Fail

Causes of failure in majority employee-owned firms

 

While employee-owned companies have generally outperformed their conventional competitors, there have been a number of highly publicized failures of majority employee-owned firms. Hyatt Clark, Rath Packing, Seymour Specialty Wire, and the plywood cooperatives in the Pacific Northwest quickly come to mind.

Employee ownership failed to survive in some Ohio ESOPs as well. Commercial Lovelace, a Columbus-based 51% employee-owned trucking firm went out of business in the aftermath of deregulation. Republic Hose, an industrial hose producer in Youngstown that was 100% owned by management and employees through conventional stock ownership, was sold but shut down by the buyer (the American subsidiary of Sweden's Trelleborg Rubber). North Coast Brass, a 100% ESOP brass and copper rolling mill in Cleveland, shut its doors in 1990 after two years of employee ownership, but was reopened under conventional ownership by a Korean firm. Mansfield Ferrous Castings, a 100% ESOP foundry, was sold during troubled times by the employees but continued to operate as a conventionally organized firm after the purchase. A similar transaction permitted the financially troubled Ironton Iron to continue operating, and the employees even retained some ownership rights.

Thus in three of these five Ohio cases, employee ownership saved jobs that otherwise would have been lost. In addition, in Ironton, hundreds of new jobs were created. In these situations, employee ownership proved to be a transitional phase between conventional owners. But the fact remains that employee ownership as an alternative was ultimately unsuccessful in all of these companies.

Why did these firms fail to sustain an employee-owned structure? Did democratic employee ownership and participatory structures themselves play a role in the failure?

And what can we learn from their stories about how to structure more robust and successful employee-owned firms in the future?

 

The Study

In 1995-96 the Ohio Employee Ownership Center (OEOC) took part in a collaborative research project on causes of failure in democratic ESOPs and cooperatives. The project, funded by the Cooperative Charitable Trust, included an OEOC survey of all majority employee-owned firms which failed over the past 25 years. The "democratic" threshold was defined as simply majority worker ownership with pass through or direct voting rights.

We identified 38 majority employee-owned firms on which we collected information. From these we selected 20 firms for interviews; ultimately interviews were conducted with representatives of 17 firms about why the company failed under employee ownership. In all cases we attempted to interview three representatives (labor, management and consultant) from each firm on topics which included legal structures of ownership, governance structures, participation systems, internal communications, characteristics of management, composition of the workforce and its institutions, labor/management relations, wages and benefits, production processes and equipment, market, finances, the deal, and the outcomes.

 

Findings

The major finding of the study was that democracy did not kill these firms -- it probably kept them going longer than they would have survived otherwise -- but it gave them conflicting goals. Because of employee sacrifices in buyout efforts, a majority of the firms had dual goals of profits and job retention which led to irregular and sometimes fatal actions.

The study tested five commonly offered "hypotheses" about why democratic employee ownership might fail. Here are the results:

 

1. Adversarial labor relations. Generally speaking, labor and management relations improved significantly after the employee buyout. While 12 of the 17 firms (71%) had adversarial relations prior to employee buyout, only two (14%) reported poor labor and management relations during employee ownership. A significant minority -- four firms or 24% -- continued to experience severe labor/management problems within selected areas of the operations, including slowdowns and work stoppages, although these problems were not system-wide and were not cited as causal in failure.

 

2. "Management by the boot." Harsh, non-participatory management did not cause failure within the group as a whole. Management in eight of the seventeen firms was considered open to participation, and lack of a participatory management style was not cited as central to failure in any of the firms. However, management was cited as causal in failure of twelve firms for other reasons: alleged illegal dealings, "general incompetency," management turnover, and/or failure to fill key positions. Moreover, board oversight of management seems to have been weak, and outside assistance from previous consultants, community and public sector groups, or the union, was generally too little and too late.

 

3. Was it just "lemon socialism"? Practically all the democratic firms in the study were lemons when the employees acquired them. All cited lack of capital, three quarters cited market problems, and over half cited production problems as causal in failure. All ESOPs in the study were established to avoid plant closure. There often were no other bidders except liquidators. After employee ownership, almost a quarter of the companies were purchased by conventional owners, saving 600 jobs, but the other three quarters simply shut down.

But while the "lemon socialism" hypothesis explains their failure, it falls short of explaining why many firms acquired by employees under similar circumstances have not failed. So the question becomes: why did these lemons die while others flourished?

 

 

There is little evidence that more democratic internal structures were a source of difficulties.

 

4. Like other firms on Rustbelt Alley, the primary causes of firm failure included poor financial management, poor marketing decisions, and dubious business activities. Many of these difficulties may be traced to four basic factors common to the firms interviewed:

 

 

5. Are the inmates running the asylum?

Perhaps the most commonly held fear is that democratic employee-owned firms will pay too much to employees today in wages and benefits and fail tomorrow because of lack of investment. Yet only three firms cited inappropriate resource allocation to compensation and other worker demands as causal in failure. Further, anger among members of the work force, about concessions taken during the buyout ("wage rage"), was not cited as causal by respondents.

In short, there is no simple explanation for failure of democratically controlled and operated ESOP or co-op firms. By and large they fail for the same reason as conventionally run firms: poor management compounded with inability to master the market. Democratic structures generally appear to have been positive rather than negative. The fact that they operated as long as they did, in spite of management and marketing problems and usually in the face of declining worker compensation, illustrates the positive force of a participatory work place.

Rules of Prudence

Our study of factors contributing to failure in democratic employee-owned companies suggest some "Rules of Prudence" for those venturing to establish democratic work places.

 

(1) Be skeptical of optimistic feasibility studies. Careful scrutiny of feasibility work is vital. Both management and the union leadership must be comfortable with its accuracy and realism. Unduly optimistic feasibility studies stick out like a sore thumb in many of the failures.

 

(2) Doublecheck the market. Market factors were the most important predictors of firm failure. Feasibility studies should include a thorough check of major customers and concentration of customer base with a realistic view of market expansion. Offering new products or entering new markets sometimes proved fatal. The best one could hope for is success in the current market. Therefore, assessing the firmís sales and marketing management and staff -- their ability to land contracts, be accountable, and to price correctly -- is paramount to assessing the firmís ability to survive.

 

(3) Keep an active employee commitment after the buyout. A unionized workforce which takes the bit in its teeth and carries out a buyout is not necessarily an activist workforce after employee ownership. Sixty-nine (69%) percent of the firms had work forces largely considered passive. Specialized training is needed in appropriate roles and associated behaviors within a democratic environment. Such training might also assist in building functional shopfloor committees.

 

(4) Democracy works. There is little evidence that more democratic internal structures were a source of difficulties. Quite the contrary: such structures seem to have provided a channel to mobilize employee knowledge and skill to sustain the firms economically. However, in many troubled firms, managerial commitment to such structures was limited. They are expensive and the rewards seem, at least to conventional managers, to be uncertain. Moreover, many employee participation efforts produce few results, in part because they are not particularly result oriented. Democratic firms should move into a functional participation scheme with strategic planning based on internal capacity.

 

(5) Not all training is equal. We found significantly more employee training, especially for non-managerial employees in group processes, team-building, and problem solving, than we expected. But training and employee participation did not seem to have been particularly effective. Our suspicion is that closer analysis would lead to the conclusion that too much of the employee team building was without concrete results. The need for teaching basic business skills was repeatedly cited as a leading need in the area of training.

 

(6) The board seems frequently to have been ill-prepared for its role. Culture clash on the board and pigeon-holing of members presented problems in some firms; board training, including team building, might have helped. Inadequate board oversight was a major issue. Here the solution probably requires both training for inside directors and appointment of strong, experienced outside directors who will have far more of an oversight function than is the norm on American corporate boards.

 

(7) Good conventional management is not enough. Next to the market, management was the most significant problem in the firms examined. Managing the democratic employee-owned company requires all the skills of the conventional manager. A number of the managers in this study lacked adequate conventional management skills; most notably the lack of tight financial controls and careful oversight of marketing proved fatal.

But conventional management skills, while necessary, are not sufficient. The CEO of the employee-owned firm needs genuine leadership skills. Managers hired from outside often lack an understanding of what has driven the buyout process. For employees, democratic structures and a commitment to egalitarianism are the quid pro quo for their sacrifice. The average employee comes back to work at the same machine doing the same job for the same supervisor in the same plant -- but at lower pay. His only benefit is input and a belief that sacrifice is shared. This means that democratic structures are not a luxury expected by spoiled employees but, in effect, a part of the unwritten contract about how the company will be run.

In a recent paper on determinants of success and failure of cooperatives, Frank Lindenfelt and Pamela Wynn make a plea for the "integrated network of mutual supporting organizations" in the Mondragon cooperative system in Spain.1

 

 

An examination of the survival of jobs among the 17 firms interviewed revealed that of the four ESOPs that were sold and changed ownership structure but kept the doors open, three were in Ohio -- where economic history has led to a State and local economic development system knowledgeable of employee ownership and supportive of job retention efforts.

 

Specifically, this system provides access to capital and expertise on favorable terms and additional technically competent oversight of troubled firms by friendly critics. Such a network could provide support to firms in troubled positions.

An examination of the survival of jobs among the 17 firms interviewed revealed that of the four ESOPs that were sold and changed ownership structure but kept the doors open, three were in Ohio -- where economic history has led to a State and local economic development system knowledgeable of employee ownership and supportive of job retention efforts.

Had such institutional support been in existence nationally, many more of the firms included in our study could still be in business.

 

Endnotes

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1. Frank Lindenfelt and Pamela Wynn, "Why do some worker co-ops succeed while others fail? The role of internal and external social factors," paper presented at the conference of the International Institute for Self Management, Hondarribia, Spain, September 1995.