Several new books explore the attractions of ESOPs. But what are the drawbacks?
Several new books explore the attractions of ESOPs. But what are the drawbacks?
No longer do you need to be corporate visionary to consider establishing an employee stock ownership plan, or ESOP; today, even the most tradition-minded of company owners may find an ESOP's advantages compelling.
* A company that channels a bank loan through an ESOP can get the money at below-market interest rates. Both principal and interest payments on the loan are tax-deductible.
* Company owners planning retirement (or just wanting to cash in a chunk of their equity) get sizable tax breaks by selling their shares to an ESOP. Their heirs may be able to avoid taxes entirely.
* According to a recent study, companies with high degrees of employee ownership outperform similar-size competitors. Companies that install an ESOP grow faster afterward than they were growing before.
Given such attractions, you might expect half the corporations in the United States to have set up ESOPs by now. In fact, fewer than 10,000 have done so. But the biggest tax incentives were passed only three years ago, and for a while no one was sure if they would last. Now, with so many other loopholes swept away by the 1986 tax reform, a chorus of consultants, lawyers, and bankers is signing the praises of ESOPs. Several hundred companies a year have been setting up plans; this year the number may be higher. If your company isn't among them, you should know why. It's a safe bet that someone -- your bankers, your employees, or your children -- will someday be asking you.
Conceptually, ESOPs are simply glorified stock-bonus plans. You set up a trust in the name of your company's employees, then provide the trust with company stock. As with any bonus or profit-sharing plan, workers put up nothing, but vesting may take several years. Some plans allow workers full voting rights on the shares held in their names; others don't. For private companies, the law requires only that workers vote their shares on such matters as sale or dissolution of the business.
What sets ESOPs apart from other benefit plans is the dazzling array of tax goodies. The company contributes new stock to its ESOP? It can deduct the stock's full value from its taxable income. The ESOP buys existing stock, say from the founder? It borrows money from a bank to do so, getting a low interest rate because the bank itself gets a tax break on ESOP loans. When the company pays off this loan -- or when it pays off any other bank loan channeled through the ESOP -- it deducts interest and principal.
Since 1984, moreover, owners wanting liquidity have enjoyed tremendous tax benefits by selling their stock to an ESOP instead of to an individual or a company. Provided the ESOP ends up owning at least 30% of the business, owners can reinvest the cash in the stock of any other company, deferring taxes until that stock is sold. And if the new stock later becomes part of their estates, it's automatically "stepped up" in value; an heir who sells the stock right away won't pay a nickel in taxes.
ESOPs themselves are the brainchild of Louis O. Kelso, an iconoclastic lawyer and economist who figured that what capitalism needs is more capitalists (see box on the facing page). The tax breaks -- which began in 1974 but have been added to regularly over the years -- are the creation of former Senator Russell B. Long (D-La.). Long, son of populist politician Huey Long, saw in Kelso's proposals a relatively painless way of spreading the wealth. Since that's a hard goal for any lawmaker to oppose, the powerful senator was able to have his way with the tax code.
In hitching ESOPs so firmly to tax breaks, of course, Long may merely have sugarcoated a hard-to-swallow pill. An employee stock ownership plan is not like, say, accelerated depreciation, a journal entry whose only impact is on the bottom line of a Form 1120. To get the tax benefits, a company owner must be willing to vest a significant piece of the business's equity in its employees. That's a move with potentially dramatic implications, not only for the once and future owners but for the management and performance of the company itself. Who will run the business? How does employee ownership change the way workers and managers relate to one another? What's the potential for conflict -- over share valuation, say, or over lines of authority? Owners of private companies treasure their independence -- that's one reason they stay private -- and those who remain active may not relish sharing any equity, let alone voting stock, with their employees.
Thanks to a nonprofit organization called The National Center for Employee Ownership (NCEO), we know a little about the answers to such questions. NCEO was founded six years ago by a husband-and-wife team, Corey Rosen and Karen Young. Like Kelso, NCEO's founders believe in employee ownership for philosophical reasons: "It can spur economic growth while spreading economic justice," they write. And though they don't lobby, leaving that task to a Washingto, D.C., trade group called The ESOP Association, they spread the word in a dozen other ways. In the past year they have published three books, along with a host of pamphlets and other material, on the theory and practice of ESOPs.
Taken as a whole, these works soothe at least some of an owner's fears. For one thing, they make it clear that ESOPs can now be found in thriving companies of all sizes, in all sorts of industries. Giant Weirton Steel Corp., with sales of more than $1 billion, is wholly owned by its employees. HISCO Inc., a $40-million distributor of electrical materials in Houston, is 40% owned by its ESOP. Wright-Gardner Insurance Inc., a small agency in Hagerstown, Md., is 25% employee owned.
There's some evidence that employee ownership has a salutary effect on corporate performance. A study by Center associate Michael Quarrey, for example, found that companies with ESOPs grew significantly faster, over a period of years, than similar companies without ESOPs -- and the ESOP companies grew faster after they installed their plans than they had been growing before. Even where workers have full voting rights, moreover, there have as yet been no palace coups. "Employees," says a recent Center report, "are very conservative shareholders who regard their stock more as an investment than as an opportunity to control corporate affairs."
To their credit, none of the Center's materials assume that an ESOP can be undertaken lightly. Setting one up can cost several thousand dollars in legal fees alone. Once a company has done so, it must have its stock appraised annually -- and must set aside corresponding amounts of cash for future redemption of employee shares. Nor does the organization argue that ESOPs are a prescription for every corporate malady. Both its books and its newsletter describe the many companies, notably in the airline and trucking industries, that set up well-publicized ESOPs only to find themselves in trouble or even bankrupt a few months later. Usually the ESOP had nothing to do with the companies' difficulties. But a less conscientious organization might prefer to ignore these inconvenient examples.
I wish, given all these virtues, that I could recommend the Center's books and pamphlest wholeheartedly. But they frequently tell you too much about too little and not enough about what seems most important. Take Employee Ownership in America: The Equity Solution (Lexington Books, 1986), written by Rosen, Young, and Katherine J. Klein. The book provides an overview of ESOPs and claims to assess whether they are "living up to . . . expectations." And we learn, in tedious detail, how some of the plans have affected employee attitudes. But we hear scarcely a peep about whether the owners who instituted the ESOPs love them or hate them. Since it is owners who will ultimately be determining the plans' futures, that's a troubling omission.
From a practitioner's point of view, the Center's materials suffer from two generic flaws. One is the relentlessly academic style of presentation. Employee Ownership in America, for instance, reads like a Ph.D. dissertation between hard covers; try wading into a section titled "A Brief Introduction to Correlation, Analysis of Variance, and Regression," and you'll see what I mean. The other flaw, which is more serious, is the Center's unwillingness to probe deeply and skeptically into its subject. Consider Quarrey's report on the improved performance of companies with ESOPs. It's a provocative start -- but we need to know how ESOPs facilitated growth, if in fact they did. Did an equity stake encourage workers to work harder? Or smarter? Were they willing to accept lower wages? What were the trade-offs?
Too many of the Center's writings seem to content themselves with external data, such as financial information and responses to survey questionnaires. What we really want to know is how the changes played themselves out inside the company. Unfortunately, the inside stores provided by Center researchers are terminally bland. A book by Quarrey, Rosen, and Joseph Blasi called Taking Stock: Employee Ownership at Work (Ballinger Publishing Co., 1986) chronicles the experiences or roughly a dozen companies with substantial employee ownership. And guess what? Nearly every one thinks worker ownership is just great, and nearly all the plans seem to be working smoothly. There's no ambivalence, no conflict -- and no credibility.
This is a shame, because elsewhere in the Center's case materials you find hints -- just hints -- of intriguing situations. At a Michigan company called Eberhard Foods, the ESOP became a weapon in a bitter internecine struggle between the 82-year-old principal owner and his daughter. At Up-Right Inc., a California manufacturer, management coped with a business downturn by closing several facilities -- and employees, who voted about 40% of the stock, apparently accepted the move. At Pamida Inc., a Nebraska department-store chain that was 100% employee owned until 1986, the ESOP sold the company to managers in a leveraged buyout.
I'd like to know more about all these cases, if only because they suggest real or potential points of conflict that any ESOP could run into. Did any worker groups at Up-Right oppose the closings -- and if not, why not? Was there any opposition to the sale at Pamida? When the magazine U.S. News and World Report, also employee owned, was sold by its workers to new publisher Mortimer Zuckerman, former employees brought suit, charging that they had cashed in their share for substantially less than the shares turned out to be worth on the marketplace. Did anything like that happen with Pamida? What's to prevent any successful ESOP from selling out once the stock has appreciated?
In such cases, I suspect, lies the truth of ESOPs -- that they are interesting, often useful, and potentially messy structures that, like most changes in ownership, can dramatically affect a company's future for good or for ill. Maybe there are a few visionary owners who can turn equity over to their workers without a shade of self-doubt, and who can make the new structure work harmoniously. But since the tax laws are making ESOPs more and more attractive to us ordinary mortals, it would be nice to learn about ESOPs involving some blood, sweat, or tears. Changing a company's ownership usually entails a little of all three.