Employee Ownership Through ESOPS:A Bad Bargain-BECKER

Recently Sam Zell, a leading Chicago businessman, arranged to buy the Tribune company, owner of the Chicago Tribune, Los Angeles Times, other newspapers, and many TV and radio stations. Aside from the low price that he paid, which reflected the rapidly declining fortunes of the print media and conventional TV stations, the most noteworthy aspect of the deal is that he plans to take the company private through the creation of an ESOP, or employee stock ownership plan. The number of American ESOPs has grown substantially during the past 30 years, and they are currently estimated to hold more than ¬Ω trillion dollars in assets and cover over 10 million workers. Probably the main reason for their growth is that ESOPs had during this period sizeable tax advantages that include deductibility from federal taxes not only of the interest payments but also of much of the principal used to finance creation of an ESOP. The argument made for these special privileges is that employee ownership is a good thing for workers that should be encouraged, but is that true? In reality, the creation of an ESOP is often a management tool to fend off unfriendly takeover bids. This was certainly the case behind the pilot-led ESOP created by United Airlines, and may have played a role in the ESOP to be created at Tribune company. ESOPs that help keep poorly performing management in power would contradict the claim that this organizational form improves rather than contributes to poor performance. Employee ownership is said to induce employees to work harder because they then have a financial stake in the company where they work. If that were true, owners would not need a tax advantage to create a sizable employee ownership since they would subsidize stock ownership by employees in order to improve productivity. Employees in a small closely held company with few workers may feel part of a family and work harder when they own an interest in the company. But in large companies with thousands of employees, such as Tribune company and other ESOPs like Science Applications International, ownership is not likely to be a strong motivating factor because hard working employees would then mainly benefit the many other employees and stockholders. Between 1995 and 2000 United Airlines was an ESOP with employee representatives on its board. Soon after 2000 the company entered bankruptcy with employees and management not known either for their great effort. Careful studies that compare the productivity of employee-owned companies with those owned by general stockholders are limited in number and scope, and advocates of ESOPs often get quite emotional in reacting to criticisms of the concept. Still, there is little hard evidence indicating that ESOPs are better run than normal companies. Reputable studies of employee ownership in the United States and other countries generally indicate that both profits and productivity remained about the same after companies introduced employee ownership. This is not surprising since most ESOP-owned companies are not run by employees, and for the reasons I gave employee ownership does not usually better motivate workers of larger companies. However, the most powerful argument against the view that employee ownership improves efficiency is that new firms would tend to take this form if it improved efficiency, and many older firms would convert to employee ownership on their own, even without tax advantages from doing so. Yet despite the competitive nature of American industry, with substantial rates of entry and exit of companies, less than 10 percent of employees in the United States work in firms that have ESOPs despite the considerable tax advantages to this organizational form. This more than all the highly imperfect comparisons between the performance of ESOPs and other companies is persuasive evidence that ESOPs would not usually be more efficient. Indeed, given the tax advantages, there would be many more ESOPs if they were equally efficient. Various types of employee-ownership of enterprises are found in many other countries. Usually they are the result of legislation that either forces or encourages this form of ownership through regulations and tax advantages, sometimes when public enterprises are privatized. The evidence on their efficiency as determined by their spread and performance in these countries is similar to that for the United States: even with special privileges, employee ownership has not become the dominant organizational form of enterprises. This suggests again that employee-owned companies would tend to under perform more conventional ownership structures that have stockholders who either manage the enterprise, or are largely independent of both employees and managers. The biggest and most obvious drawback of employee ownership from the perspective of the financial wellbeing of employees is that they hold their assets in one basket, the company where they work. Even without ownership of equity the wealth of experienced employees is still poorly diversified since it is largely in the form of human capital whose value depends on the success of the company that employs them. When the company does well, earnings from their human capital tend to rise more quickly, while the opposite occurs when the company does poorly. Ownership of shares in the company exacerbates the economic dependence on the company's performance since now the value of the financial assets of employees also rises and falls with the company's fortunes. The same problem arises with the many corporate pension plans that mainly hold bonds and stock that they have issued. When the company does poorly, the value of pension assets, and thus of the retirement incomes of employees, go down along with earnings, employment and profits of the company. Forcing top management to hold much of their financial assets in the stock of the companies they run through stock option and stock ownership plans reduces their financial diversification too, but that may be beneficial to the company's performance since the decisions of CEOs and others at the top do greatly impact company performance. As I indicated earlier, that is not the case for typical employees of large corporations. The disadvantages of being poorly diversified is not simply hypothetical, but was sadly brought home to employees of companies like Enron and United that had substantial stock ownership by employees. After these companies went into bankruptcy, mainly due in Enron's case to mismanagement and corruption, many employees not only lost their jobs but employees lost much of their other wealth as well.

Comments

[Corey]

I worked as an engineer for seven years before attending law school, in four companies of various sizes which all had extensive ESOPs. I find your contentions run counter to my anecdotal experiences. I'll try not to be too "emotional" though.

You noted that comparatice studies on productivity under ESOPs are "limited in number and scope." Then right after that you make your most powerful argument about lack of market adoption. Well, even the invisible hand needs comparative information about business practices in order to chose between them. If the effect of ESOPs is just a little bit contingent on other variables, perhaps enough so that it is hard to produce many broad studies about it, then companies might not know what ESOPs cuold do for them.

Maybe, just maybe, other considerations pull against adoption of ESOPs in industries which do not have strong need to retain highly fungible employees. (i.e. computer engineering) How about the profit motive? Maybe self-regarding CEOs don't want to share their option pool with Sharon in Accounting. They will if Sharon was hard to hire though.

Your understanding of the motivations of the average ESOP employee doesn't match mine. When I worked, the choice was between $80K at one company or $75K plus 20,000 shares at another. I actually decided to make less for the shot at more. However, no one was offering a diversified stock portfolio as a bonus, and that extra $5K would have gone to consumer goods anyway.

However, owning stock did make me more loyal to the company, thanks to 4 year vesting plans (that sadly outlasted the bubble). People don't sit around and think about what percentage of their extra work is recoverable by others. People appreciate having a stake in the collective success, and are happier. The people at Enron were loving their ESOP, and then when they got fired, they thought "easy come, easy go." They would have HAD no other wealth if not for the ESOP. Again, no one is offering unrestricted stock grants to Sharon in Accounting.

Both the startups and the Fortune 500 company that I worked for pulled 60-80 hour weeks out of their ESOP-loving engineering staff. When the last one fell, I went into the same 6 months of unemployment and the same bankruptcy as I would have had if only the CEO got stock options. My underwater, unvested stock options turned out to be the biggest con I ever fell for, since I only ever received token sums from my ESOP. But here I am still defending them.

Employee stakeholding in the enterprise is great. It builds loyalty, encourages organization-centered thinking over self-regarding, and can attract top talent to risky new ventures.

[Anonymous]

"When I worked, the choice was between $80K at one company or $75K plus 20,000 shares at another. I actually decided to make less for the shot at more."

So, you're saying each share was worth less than 25 cents? Or did I miss something?

[Jack]

Corey...... good job for not judging a policy by a "bubble" and good luck with starting over....... been there after the mid-80's R/E and oil crash.

Anonymous: The "worth" of any stock is always in question. Today........ the worth of the "diversified" Dow or SP are also in question.

Jack

[n.e.hat]

Anon., That's startups for you. Little value, big dreams and lack of startup capital. The reality is, approx. 90% or more crash and burn in the first five years. Corey found that reality out the hard way. There is the ongoing issue in economic circles about booms and busts occuring in the economic order due to unregulated or unrestrained free market principles at work. Free Trade? Just another coat of paint on a tired old horse called the "Free Market". Corn anyone?

[Larry]

My anecdodal experience also makes me look favorably on fairly wide employee stock ownership. You cannot base your judgment on the results at United Airlines or some former Soviet steel mill, because in both cases you are talking about ESOPs as rescue operations for economically failing enterprises with bad future prospects. In the case of U.S. airlines, of course, the suffocating debt loads and union work rules and union pay scales made what might be a business with profit potential look more like a race horse carrying too much weight... What I have seen working well is a company where most of the equity was owned by the founders, including top officers, but an important share, around 15%, had been "earned" by various managers making various quotas, and stock bonuses were distriubted annually. (Not to all employees, however, but to someone every employee could reasonably aspire to replace). In the situations where everyone is winning--the founders, the arms-length stockholders and the supervisory employee stockholders--because the business is thriving and growing, there is no better management tool than a judicious scheme of making key people rich by paying them extra for good performance-- with stock which is coveted because it has been appreciating dynamically. But nobody wants stock in a business which has been seized by a bankruptcy judge. And there is a tendency not to part with ANY equity by owners of most businesses which are flourishing. But the wise CEO knows successful businesses will do even better when middle and even lower-rung managers are generously incentivized at capital gains tax rates.

[MS S]

I reside in one of East Asia country and I am not a U.S. citizen, but I studied in U.S. for the improvement of my country. And most of the system and problem in U.S. is same in my country. So I may be qualified to say something.

I agree with Mr. Becker in some points. ESOP is not a panacea to every problem. Like MBO's failure to the management alignment in 8o's, it doesn't fully align interest of employee to the corporate interests. From its origin, ESOP was a kind of political and historical intrument to protect corporate management to block market pressures. Much of its support comes from incumbent managing group and not from market. Also it has support from Wall Street for its role of conduiting new inputs to the market force. It also deepen the firm specific human capital problem to block the diversification. And it is also very vulnerable to the unfaithful corporate managers, as we already saw in Enron Case.

However, it could be a only hope to the employees's voice to the corporate future. 80's Contituency statute fails in most of cases. Voice of employee is ignored and disregarded. Communication system is very important for the longterm growth for the corporation as we see easily from the Toyoda. It could be obtained some heroic or talented manager. But it also could be instituted by ESOP or similar system. I concede most of current ESOP is not working in this way. Much of time, it is just a incentive system or silent complier to the management's will. But Vigilint ESOP role could works as a way of constant communication.

[Andrew]

I agree with Becker because I simply do not see what is so special about ESOPs that merits favorable tax treatment.

Also, too much of it can be a bad thing. I remember reading an article awhile ago that detailed how Enron's policy of having its employees' compensation tied directly to its stock price helped create a short sighted "meet the numbers no matter what" attitude--which clearly lead to a few problems.

[Jack]

Andrew: "Also, too much of it can be a bad thing. I remember reading an article awhile ago that detailed how (any of 100 corp's) policy of having its (CEO and vested upper management bonuses) tied directly to its stock price helped create a short sighted "meet the numbers no matter what" attitude--which clearly lead to a few problems.

............. Indeed. And the tax break is obviously some misguided effort to sweeten the pot a bit and spread stock ownership down below the normal owner class. Those favoring an ever steeper wage/wealth pyramid should avoid it like the plague. What's that Musketeers slogan? All for one and all for one and all fore one?

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[Corey]

"I remember reading an article awhile ago that detailed how Enron's policy of having its employees' compensation tied directly to its stock price helped create a short sighted "meet the numbers no matter what" attitude--which clearly lead to a few problems."

That attitude and the incentives that produce it exist for management decisionmakers regardless of whether they have an ESOP. There is a strong tendency displayed here to try and create a policy result by associating ESOPs with failures at large companies (United, Enron) that may not have actually had anything to do with low level employees.

At me last engineering job, I consistently supported long term thinking, suggesting acquisitions (which happened) and proposing nw products to give the talent something to do. My CEO promised a revenue number to Wall Street that the sales and marketing numbers couldn't support. Rather than miss his revenue "promise" by seven million and further endanger his stock price, he chose to lay off 50 engineers, book their compensation as a cost savings, and meet his number that he had originally pulled from the air.

The 50 employees who were fired were all hard-working and forward-looking engineers (including myself). Earlier layoffs had already trimmed the fat so to speak. It didn't matter one bit whether I had ESOP shares or options, my long term thinking got overruled by the short term numbers play of those who could most benefit from it. (Incidentally, the CEO told us that this was the reason we were let go.)

So lets not talk about "the profit motive" as if it was worse at Enron or United because they had ESOPs. In fact, ESOPs and option grants to workers empowers a class with potential voting power. If the workers vote/act how the CEO would, then nothing is changed. But it is possible that suitably empowered workers could check some of the excesses of plundering that occurs when times go bad at corporations. (Or, maybe not, as my story suggests)

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