The Growth Of Employee Ownership

If you want employees to think and act like owners, make them owners.

By Corey Rosen

It's hard to avoid the topic of employee ownership these days. Michael Lewis, the New York Times business writer, called it the most important trend in the American workplace. It's no wonder. Two decades ago, just a few million employees owned stock in their companies. Today, well over 20 million do. Over two-thirds of the Best 100 Companies in America to Work For have employee ownership plans, and employees at all levels are increasingly demanding equity to come work for a company. Should your company then be joining the wave, or is employee ownership one business trend you should avoid?

To answer this question, you need to know how these plans work, what their pros and cons are, and what impact they are likely to have on your company and its employees.

Why Is Employee Ownership Growing so Fast?
The growth of employee ownership can be attributed primarily to three factors:

1. A tight labor market has given employees more ability to demand more from their employers. At the same time, low inflation, global competition, the Web and other factors have all made it difficult for companies to raise prices to justify higher labor costs. Offering employees a piece of the company is one way to deal with this issue. From the employees' perspective, they realize that wages, for a long time, have gone up only nominally, while returns to capital ownership have soared.
   
   
2. Corporate cultures have evolved from "command and control" to "high performance organizations" in which employees are asked to work in teams, take more responsibility, learn more about how the business makes money and, in general, think and act more like businesspeople. There are many reasons for this, but the principal one is changing technology. Technology has made it possible, indeed imperative, for companies to offer a broader array of products and services, to develop new products and services more frequently, to customize what they do, and to process a great deal more information. Consequently, businesses have to make a lot more decisions about a lot more things a lot more quickly. The old model of passing these decisions slowly along a hierarchy where just a few people could consider them is too slow and unresponsive in today's environment. The result is that authority has to devolve to employees. But if you are going to ask employees to take more responsibility for the business, how do you reward them so that they will care to make the right decisions? Well, if you want them to think and act like owners, why not make them owners?
   
   
3. Tax and accounting advantages for employee ownership plans have been created or affirmed in recent years, making these plans especially appealing for certain business situations. For instance, in closely held companies, an employee stock ownership plan (ESOP) provides a tax-favored way to sell all or part of an owner's shares to an employee benefit trust that can be controlled by management or by employees or some combination.

If your company falls into one of these categories—you need to attract and retain good people and pay is not enough, you need to create a more participative culture, or you need to provide a way for business liquidity—then read on, because a stock option plan or ESOP (or a combination) may be worth considering.

Employee Stock Ownership Plan
ESOPs have been around since 1974. There are now about 11,000 such plans in the United States covering about 10 million employees, mostly in closely held companies. Despite popular conception to the contrary, they are rarely used to bail out companies, nor are they mostly found in large public companies. ESOPs provide that companies can establish non-taxable employee benefit trusts to hold shares for employees. Companies fund these trusts by:

1. Contributing new issues of shares directly to them,
2. Contributing cash to buy shares, or
3. Having the trust borrow money to buy shares, with the company repaying the loan.
Within very broad parameters, company contributions in each case are tax deductible. Employees do not purchase shares, directly or indirectly, under these arrangements.

ESOPs can be used as a simple employee benefit plan, usually with the company just making tax-deductible contributions of shares to the plan. They can also be used to borrow money to buy new shares in the company, with the company using the sale proceeds to acquire new capital, another company, or for any other business purpose. Their most common use, however, is for business continuity. Sellers of shares to ESOPs in closely held C corporations can defer taxation made on the sale of shares to an ESOP owning 30 percent or more of the company's stock if they reinvest the money in individual stocks and bonds of U.S. companies. No tax is due until these replacement investments are sold, but if they are held until death, there is no capital gains tax at all.

To do this, a company typically borrows money to buy out the shares for sale. It reloans the funds to the ESOP, which purchases the shares. The loan is repaid out of tax-deductible contributions from the company to the ESOP. Generally, up to 25 percent of the pay of participants in the plan can be used to repay to ESOP principal, and all the interest can be repaid on top of that. As the loan is repaid, as in all ESOPs that borrow money, shares held by the plan are allocated to individual employee accounts.

In closely held companies, share value must be set by an annual outside appraisal. In return for tax benefits, companies must run the plans in defined ways that do not discriminate in favor of higher-paid employees. Employees do not get their shares until they leave the company, at which time they can shelter taxation of the shares by putting them into a retirement account. ESOPs are found in both listed and non-listed companies.

Participation in the ESOP must include at least all full-time employees who have worked for at least one year. Employee allocations are based on relative pay or a more level formula. Allocations are also subject to vesting, usually over five to seven years. If employees leave before they are fully vested, then unvested shares go back into the plan and are reallocated to everyone else. However the shares are acquired, if the company is not publicly traded, it must offer departing employees the right to sell their shares back to the company at an appraised value.
Employees are guaranteed only limited voting rights in closely held companies, but companies can voluntarily pass through full voting rights. For issues where the employee does not vote the shares, they are voted by the plan trustee. The trustee is often an officer of the company or a committee of management and non-management employees, but may also be an outside specialist in these issues.

ESOPs are more expensive than other benefit plans ($30,000 and up to set up; about half that for annual costs). They rarely work well for companies that do not make consistent profits, and they almost never make sense for companies that are not interested in the idea of sharing ownership broadly, but just want the tax benefits. In these cases, the employees often see the ESOP as a sham, and motivation declines.

Stock Options
The most common other form of broad employee ownership is the stock option, a simpler but less tax-favored approach than ESOPs. Options can also be used just for executives, of course. In 1992, just one million non-executive employees got options; today the number is much higher. Most of the employees getting options actually work for transitional businesses like General Mills, Starbucks and Bristol-Myers Squibb, all of whom give options to everyone. Unlike ESOPs, broad option plans cover mainly employees of public companies and fast-growing private companies that intend to go public or be sold. That's because options do not have a built-in liquidity mechanism the way an ESOP does. Closely held companies can redeem the shares employees come to own through options, but, so far, most have seen that as a cost they do not want to take on.

With a stock option, a company gives employees either a one-time or periodic right to purchase shares at a fixed price, usually, but not always, the market price at the day of the grant. The right may be based on a percentage of pay, a merit formula, a group or team approach in which a number of options is given to a group and the group's leader or a committee divides up the options to individuals, on hire or promotion, or an equal basis. The options are typically subject to vesting, usually over less than five years. The purchase of the shares is called a stock option exercise. Many publicly traded companies offer a "cashless exercise" alternative in which the employee exercises the option, and the company gives the employee an amount of stock or cash equal to the difference between the grant price and the exercise price, minus any taxes that are due. Alternatively, the employee may purchase the shares with cash or, in some cases, with shares already held.

There are two kinds of options. Nonqualified Stock Options (NSOs) provide no special tax treatment. When the option is exercised, even if the shares are not yet sold, the employee must pay ordinary income tax on the spread between the grant price and the exercise price. The employer gets a corresponding deduction. In an Incentive Stock Option (ISO), if the shares are held two years after grant and one year after exercise, the employee pays only capital gains tax, and only when the shares are sold. The company, however, gets no deduction.

Making the Choice
While ESOPs and options are the primary choices, employees can also just be given shares, the company can contribute shares to a 401(k) plan, or employees can buy shares. Generally, these plans do not have as many advantages as ESOPs and options for broad-based ownership. If you are serious about employee ownership, get educated first by visiting the Web. There are a number of detailed articles on our Web site at www.nceo.org. If you do proceed, make sure you get qualified, experienced advice. Be ready to spend the time and commitment necessary to figure out how ownership will fit into your corporate culture. Done well, sharing ownership can provide great rewards. Done poorly, it can be a very large headache.

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The PEI Journal • Third Quarter 2007 • Volume 1, No. 3 • Contents are Copyright © Data Key Communications, Inc.
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