Choosing the Structure for Your Employee Ownership Plan
Deciding on an employee ownership structure involves more than just picking out a plan. Even if a structure with special requirements is selected, you must still make decisions on many other issues, such as:
Will Control Be Shared with Employees or Only EquityOwnership?
One of the first decisions to make is whether employees will have controlling interest in the company. Does the sort of employee ownership you have in mind involve only equity rights, or will it involve employee control as well? It makes sense to think of there being two basic kinds of employee ownership companies: those with equity benefit plans and those that are employee controlled.
In a company with only an equity benefit plan, employees receive an equity stake in the company but do not as a group have voting control over the company. Such plans are often set up as a retirement or savings benefit and as a way to let employees in on the equity growth of the company while creating an incentive to stimulate productivity. In such plans, ultimate control remains with either a top manager or an outside owner (although perhaps subject to some legal rights of the employee owners).
In an employee-controlled company, employees as a group have voting control over the company. Ownership may not even involve significant equity rights, but any outside owners are minority or nonvoting owners. Employee ownership in such a company is a means of sharing control and dividing up corporate income among employees.
It is important to be clear on which approach you intend to take for your employee ownership. Formal voting control brings with it important legal rights. Most decisions are made on a day-to-day basis, not through formal corporate mechanisms. Experience has shown that employees are conservative shareholders, supporting recommendations made by management. But business owners should not give voting rights to employees with the expectation that they can retain all control for themselves. Whoever has voting control of the corporation has the right to choose and remove directors and corporate officers. If conflicts arise, these mechanisms may become important. Also, people often assume that "ownership" includes control. If the desire is to create a mechanism by which employees can share in equity growth but not to control the company, then this should be clear to everyone involved from the beginning.
Finally, the type of employee ownership structure chosen depends on which approach you will take. Not only must voting rights be structured differently, but different financial arrangements may be required depending on who controls the company.
For many companies, it will be obvious which sort of approach is desired. A founding owner who wants to let employees share in the equity growth of the company, but who is unwilling to give up control of the company, is thinking of employee ownership as an equity benefit plan. A group that wants to work together to pool equipment, efforts, and clients and sees no particular reason to have hierarchical control or seek outside investors is thinking of an employee-controlled company.
For others, the choice may be less clear. In many employee buyouts, the impetus for the buyout comes from selling owners who will not stay with the company after the sale. The selling owners' only interest is in making sure that the company can meet obligations to them relating to the sale. The decision about what approach to use may rest on those who assume risk in the deal, the attitudes of current managers and employees, requirements of lenders, financial constraints, or a variety of other factors.
Despite the stress here on differences, equity benefit plans and employee-controlled companies are not absolutely distinct categories, and many companies fall in between. Employee owners may be given a vote on some issues (and usually are), even when a principal owner retains control over board selection. Or an owner might give employees voting control but protect his or her own job through an employment contract. Finally, a founding owner might give employees a controlling vote on some issues but not others.
Structuring Employee-Controlled Companies
Employee-controlled companies are much more common in small businesses than in larger ones, perhaps because it is more natural to start a small business with employee control than to convince established business owners to give up control in their businesses to their employees.
Cooperatives are natural structures for employee control, where control will not only go to employees as a group but be shared among employees equally. Employee stock ownership plans (ESOPs) and direct ownership can also be used for a variety of employee control arrangements. Profit sharing plans are the only structures discussed that are not practical for employee control, because of the fiduciary obligations of the profit sharing plan trustee. Some complications may arise when ESOPs are used for employee control. Rights guaranteed by statute to direct shareholders may not be available to ESOP participants because the formal owner of the company is the ESOP trustee.
For example, direct shareholders have the right to call a shareholders' meeting to remove directors and the right to examine the company's books. In order for these rights to apply to ESOP participants, they must be specifically granted in the ESOP trust documents.
Employee-controlled companies will likely be concerned with issues such as keeping one person from accumulating too much voting power, keeping control in the hands of current employees, as well as designing a wage and benefit package that rewards employees for the work they do.
Whatever arrangements are made for control at the corporate level, employee-controlled companies need to make sure that they have efficient ways of making day-to-day decisions, making it clear who has the authority to make these decisions. Formal control arrangements should not be allowed to get in the way of making these day-to-day decisions.
Structuring Equity Benefit Plans
The idea behind an equity benefit plan is to use equity ownership to reward employees and stimulate company performance. Employees receive a share of the value of the company and thus have a motivation to work for the growth of the company and to stay with the company longer in order to realize the rewards of their ownership. At the same time, their equity stake may serve as a valuable retirement or savings benefit. Cooperatives will not work as equity benefit plans because of their voting requirements, but other structures discussed work well. In ESOPs and profit sharing plans, the company can both shelter employees from short-term taxes and deduct contributed shares as a benefit of employment. However, when the costs of these plans are prohibitive, giving employees shares directly may be the best option.
What makes a good equity benefit plan? Studies have shown that the value of the ownership share going to employees is important. This value is affected both by the amount of shares given to an employee in any period of time and the rate at which the value of shares already owned by employees is growing. The company also needs to guarantee that it will repurchase employee shares when employees leave the company. There is no magic level at which contributions to employees become high enough to be an effective motivation to employees, but contributions do need to be high enough so that employees see their ownership stake as a meaningful financial benefit.
ESOPs require a pass-through of voting rights to participants on some issues, and employees receive some limited voting rights with direct equity ownership. These control rights should be taken into account by a principal owner setting up an equity benefit plan, although unless employees will receive a majority of equity shares, the impact of employee votes on these issues may not be especially important.
Productivity Advantages and Employee Input in Work-Level Decision Making
Whether a company sets up an equity benefit plan or an employee-controlled company, many will do so expecting that employee ownership will improve productivity. However, providing equity ownership or voting control and nothing more may not do much for productivity. To increase productivity, companies also need to involve employees in decision making that affects how their job is done -- that is, participation in day-to-day decision making, a form of decision sharing that is usually called participatory management. One study by the National Center for Employee Ownership showed that firms that give employees an ownership stake and nothing more perform only about as well as nonemployee ownership firms, while those that also use participatory management techniques grow 8% to 11% faster than they would have otherwise.
Likewise, numerous studies have shown that participatory management alone does little for long-term productivity. One might expect that employee ownership motivates employees to work harder. But hard work alone usually will do little to increase company performance -- the key is to get employees involved in generating ideas about how to do business better. This means not just listening to employees but going out of the way to get employees to participate in thinking of ways to improve service and efficiency and to reduce costs. Various programs for doing this have gone under names such as "quality circles," "ad hoc teams," "employee advisory committees," and "employee study groups," all of which have the common goal of using the brain power of employees to make the business work better. While some employee-controlled firms may go beyond these sorts of structures in soliciting employee decision making, it is probably through this sort of input that the company can most increase its competitiveness.
Copyright © 2000 by the National Center for Employee Ownership
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