Face to Face

More than 15% of the private-sector workforce is now covered by one ownership plan or another, and that figure is growing. It may get an additional boost from a new study on the effects of stock options

Employee ownership is a hot issue these days. Headlines tout the pros and cons of stock options in a volatile market. On Capitol Hill a congressional subcommittee considers legislation creating "super stock options" that would reduce the taxes employees pay on the options they exercise. The measure would no doubt promote the already explosive growth of stock options as a tool for attracting and keeping employees in a tight labor market. Meanwhile, a newly released study addresses the concerns that a growing number of shareholder groups have raised about the cost of the stock-option boom -- and the price that shareholders may be paying for it.

Few people know more about these issues than Corey Rosen does. Employee ownership is a subject he's been interested in since 1978, when as a legislative aide on Capitol Hill he got involved in drafting some of the legislation on employee stock ownership plans, or ESOPs.

Two years later he decided there was a need for some kind of resource center on employee ownership. Not many people knew about ESOPs, and the companies that had the plans had no way of finding out what it took to make them work. Rosen tried to persuade various people to set up such a resource center, but there were no takers. So, in 1981, he cofounded the National Center for Employee Ownership (NCEO), which remains the single best source of information on employee ownership anywhere in the world.

Rosen spoke with editor-at-large Bo Burlingham from the NCEO offices, in Oakland, Calif.

Inc.: Employee ownership has always been sort of a nice idea but a marginal business phenomenon. How important is it in the economy as a whole?

Rosen: It's becoming very important. As near as we can tell, between 16.5 million and 18.5 million people are currently involved in either an ESOP or what we call a broad-based stock-option plan. By that I mean a plan in which more than 50% of a company's full-time employees receive options.

Inc.: Is 18 million a significant number of people?

Rosen: It's more than 15% of the private-sector workforce, and the numbers are rising fast. Over the past decade, we've seen an explosion in the use of broad-based stock options as a form of compensation for employees, from about 1 million people in 1990 to between 8 million and 10 million today, and there's no sign that the trend is abating. The number of employees covered by ESOPs is growing, too, but more slowly. It's up to about 8.5 million people now.

People have figured out that you need to be an owner to accumulate wealth, so increasingly they're asking for equity.

Inc.: So what's going on? Do you think it's a response to the tight labor market?

Rosen: That's a factor, for sure, and probably the most important one, but I think there are at least three other things going on at the same time. To begin with, employees have decided that they want stock. Since 1973, median household income has remained virtually unchanged, while the Dow has gone from three digits to five. People have figured out that you need to be an owner to accumulate wealth, and so increasingly they're asking for equity.

Then there's the continuing evolution of management philosophies. Business literacy, open-book management, work teams -- they all used to be radical ideas; now they're commonplace. People are constantly being urged to think and act like owners. Well, if you don't make them owners, they're going to feel manipulated. Then again, if you do, you gain legitimacy as a manager. You have a stronger case in talking to people about all of these things you want them to care about.

Finally, there's the change in the nature of ownership itself. It used to be that a company's assets were primarily physical and financial. Now they're increasingly intellectual -- brands, patents, reputation, and so on. In fact, according to some brokers, intellectual capital accounts for more than half the value in the stock market today.

Inc.: How would that influence a company's decision to share equity?

Rosen: Who owns the company's future intellectual capital? Who's going to come up with the ideas that will allow you to create the next innovation, the next product, the next service? Employees have the enterprise-specific knowledge a company needs to keep changing and growing and creating value. That's as true for NCEO as it is for Microsoft. If the staff left here tomorrow, I couldn't replace them. We'd be out of business. So it makes sense to compensate people for the intellectual capital they're contributing, just as you'd compensate people for contributing financial capital.

Inc.: OK, but what about the stories we've heard regarding the negative effects of stock options, particularly in places like Silicon Valley? People say that employees become more interested in the value of their options than in building the company. So you get a type of behavior that's the opposite of what you're looking for.

Rosen: To a limited degree, that's undoubtedly true. You're dealing with human nature, after all. At Dell Computer, they talk about employees who "call in rich," meaning that their options are worth so much, they don't have to work anymore. And sure, there are some employees who jump around from start-up to start-up, looking for the best deal on stock options. I don't think it's a very widespread problem, however. In fact, most companies will tell you that stock options dramatically reduce turnover. And remember, if you added up all the employees in all the technology start-ups, you wouldn't get the total number of people in one large company.

Inc.: But isn't this trend being driven mainly by Internet and technology start-ups?

Rosen: They're certainly part of it, but they're not the largest part. We're also seeing a wide variety of large, publicly traded companies that have begun using stock options broadly as a form of compensation for employees. Those companies include most of the mega-banking chains, a few airlines, a lot of the pharmaceutical companies, some big retailers and food businesses, as well as the companies you'd expect, like Microsoft and Intel.

Inc.: What about small, privately owned companies?

Rosen: They fall into two categories. On the one hand, there are the rapidly growing "pre-IPO" companies that give stock options to everyone. They're typically but not always tech companies. Companies that aren't going public would be more likely to use an ESOP, which provides privately owned companies with various tax benefits you don't get with stock options.

Inc.: So how far can this trend go?

Rosen: If you'd asked me that question five years ago, I'd have said, "Maybe 15%, 20% of the private-sector workforce might someday be covered by one of these plans." If you'd asked me 20 years ago, I'd have put the limit at 5% or 10%. Now it's conceivable that we could eventually have half of the private-sector workforce in some such plan. Employee ownership has become mainstream, which feels very odd to me after all these years.

Inc.: But why now? Could the four factors we've already talked about produce such a big change?

Rosen: They could when you take into account the pressures of globalization. With labor markets as tight as they are, you have companies competing vigorously to attract and retain people, and because of globalization they're looking for ways to do that without spending their cash or increasing their costs. Equity sharing fits the bill very nicely. You can use it to give people a benefit -- potentially a very valuable one -- and there's no cost until the options are exercised. At that point the existing shareholders pay for the benefit, in the form of dilution, although it turns out that the dilution may be more apparent than real.

In the long run, your stock price will be determined by your company's performance, not by what Alan Greenspan is having for breakfast.

Inc.: Wait a minute. How could that be true? When you give more people a piece of the pie, each slice has to be smaller, doesn't it?

Rosen: Unless the pie grows. That's what seems to be happening. A group of researchers at Rutgers University in New Jersey has just completed the first major study on the effect of broad-based stock-option programs. (See "Who Pays for Stock Options?" below.) The study found that the companies experienced a 16% to 18% increase in productivity after the issuance of the options and had a 2% to 2.5% increase in return on assets. What's more, the shareholders came out the same or slightly ahead, depending on how you measure the effect.

Inc.: That's an extremely important discovery, isn't it? You're saying, in effect, that the improvement in performance offsets the dilution, which means that the stock options pay for themselves. So employees get this potentially valuable benefit, and there's no cost to anyone. Is that possible?

Rosen: Well, the tax and accounting features are complicated, and I won't try to explain them, but yes, that's what the study indicates: there's no net cost to anyone. And it is indeed a significant finding. Assuming it's borne out by future research, it answers the major argument against broad-based stock-option programs -- namely, that shareholders pay an excessive price for them. In fact, the effect on shareholders is at least neutral, and they may be benefiting.

Inc.: But there's also a potential downside, isn't there? I mean, the options could turn out to be worthless. What happens if the markets plunge and the price of the stock falls below the exercise price of the options?

Rosen: Well, it's true. That can happen. The value of your options can sometimes be affected by factors over which you have no control. But companies can go a long way toward solving that problem by designing a plan that takes those externalities into account. For example, instead of giving people all their options at one time, you can parcel them out over a period of years -- sort of like the dollar-cost-averaging approach to investment. As any economist will tell you, the ups and downs of the market will wash out over time. In the long run, your stock price will be determined by your company's performance, rather than by the economy or the overall market or what Alan Greenspan is having for breakfast.

Inc.: OK, but we also know that some companies deal with the problem of a falling stock price by reducing the exercise price, which sends a bad message, doesn't it? They're telling people, in effect: "Look, don't worry about performance. If the stock price falls, we'll just reprice the options."

Rosen: I think we'll see a lot less repricing in the future, because the Financial Accounting Standards Board has changed the accounting rules. Companies that reprice options now have to show the cost of the repricing on their income statement. Publicly owned companies hate the idea of doing that. As for privately owned companies, well, I agree that repricing sends a mixed message, but sometimes you may not have much choice. What if your stock price has dropped dramatically for external reasons, and you're faced with a mass exodus of employees? Is it in the best interests of shareholders to let them leave or to reprice?

Inc.: I guess the real question here is, does ownership -- in the form of stock, stock options, or participation in an ESOP -- motivate people to work harder and be more attentive to the company's needs?

Rosen: You really have to ask employees that question, and we've only done the research on ESOPs so far. It does show a motivational effect. The more ownership people have through an ESOP, the more likely they are to say that they work harder because they're owners, and the less likely they are to look for other jobs. Given the results of this new study, I imagine we'll find the same thing with stock options.

But I think the link between ownership and performance is a little more complicated than pure financial reward. Equity sharing allows management to go to employees and say: "We need you to think about the company. We need you to understand our financials. We need you to get more involved in making decisions based on business considerations. And if you do that, your stock value will go up." You have a certain legitimacy in talking about those issues that you lack if employees are just getting market-level raises and maybe a little profit sharing. With ownership, you really can ask employees to think and act like businesspeople -- because they're also going to be getting the rewards.

Who Pays for Stock Options?

Are stock options an employee benefit that pays for itself, or are shareholders footing the bill? A new study provides an answer.

As more and more companies have begun using stock options to compensate employees, a fierce debate has raged over the cost to shareholders. The debate has centered on the question of dilution -- that is, the reduction in earnings per share that shareholders would see when the stock options are exercised and thousands of new shares are issued.

Some people have argued that the dilution is excessive, forcing shareholders to pay too high a price for whatever benefits may come from giving employees an ownership stake in the company. Others have countered that a broad-based stock-option plan (BBSOP) pays for itself by improving a company's performance so much that shareholders' returns are unaffected by the dilution and may, in fact, rise.

Until recently, it's been impossible to resolve the debate one way or the other, mainly because the whole phenomenon is so new. It takes time to measure performance under a BBSOP, and you need enough companies with such programs to get a sample large enough to provide statistically significant results. Since the vast majority of these plans have come into existence during the past 10 years, the raw data simply weren't available.

Now researchers at Rutgers University -- led by Douglas Kruse and Joseph Blasi, the preeminent academic analysts of employee ownership -- have completed the first study of the effect of BBSOPs on corporate performance, and the results strongly bolster the arguments of those who say the plans pay for themselves. The study focuses on the performance of 490 companies with BBSOPs -- 105 companies that responded to an in-depth survey conducted by the National Center for Employee Ownership in 1998 and 385 other companies that have been identified in the press as having such a program. The team was able to do a before-and-after analysis by comparing the companies' performance before they set up option plans (from 1985 through 1987) with their performance after the plans were instituted (from 1995 through 1997). The researchers found that productivity improved dramatically following the institution of an option plan -- by 16% when the companies were compared with all non-BBSOP public companies and by 18.3% when they were compared with non-BBSOP companies in their industries. The companies' return on assets also improved significantly -- by 2.5% compared with the larger group and by 2.05% compared with companies in the same industry. The researchers caution that the results do not necessarily mean that BBSOPs directly caused the improved performance. The productivity gains could reflect a decision by more productive companies to give employees performance-based rewards.

As for the effect on shareholders, the researchers found that the BBSOP companies consistently delivered returns to shareholders that were at least as high as -- and sometimes higher than -- those produced by the non-BBSOP companies. The conclusion: "The performance of the firms using broad-based stock options appears to equal or exceed the dilution that these plans initially would have caused," the report says.

Considering that the study is an academic work, it's remarkably readable -- all 119 pages of it. Although it won't be published until fall, it's available at www.nceo.org/library/optionreport.html. --Bo Burlingham

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