Turns out ESOPs can make your company less competitive, according to a recent survey published in the spring 2020 NCEO bulletin. Despite the obvious benefits of an ESOP--not the least of which is sharing wealth with those who are instrumental in creating that wealth--it's not that surprising. While assuming more debt is not an ESOP requirement, most ESOPs do it. The pandemic revealed whatever fragility existed in every business, and when debt repayment became problematic, many with a leveraged ESOP floundered. Herein lies the first functional fault of ESOPs:
1. Owners use debt to cash themselves out, adding excessive financial risk to the company.
The celebrated ESOP successes of Publix, SRC, Trinity Manufacturing, Comfort Supply, and Dorian Drake International share a sharp focus on employee participation and limited use of debt. They all also enjoyed a more natural evolution from some form of profit sharing to an ESOP, which is subsequently funded by the growing profits of the company. And when it works, everyone benefits--owners, employees, customers, and even communities.
But how does it work? Take Trinity Manufacturing. Owner Robert Griggs developed an employee engagement program using economic engagement principles, and eventually integrated it with an ongoing cost improvement program. This served the company in two important ways: increasing the profitable growth and preparing employees to take over more and more of the owner's managerial responsibilities. Employees at every level began to think and act like owners, and soon they were part owners. Their success was not driven by stock, but by worker participation.
Corey Rosen, founder of the National Center for Employee Ownership, did the research and concluded, "Regardless of company size, or the size of employee contributions, or even the percentage of the company owned by the ESOP, the most salient correlation was between corporate performance and workers' perceptions of their managers' attitudes toward worker participation. ESOP companies that instituted participation plans grew at a rate three to four times faster than ESOP companies that did not."
We'd argue that worker participation drives business results regardless of whether an ESOP is in place. Yet the following remains true for the vast majority of ESOPs:
2. Workers don't meaningfully participate in the economics of the business.
Spectacular ESOP failures, like the 1995 United Airlines ESOP or the 1987 Bain & Company ESOP, point to these flaws and a couple more. Worker approval is required for union representation, but employees have no voice in their financial representation for the ESOP--they don't determine the trustee or approve the use of debt. And existing fees generated by trustees, valuations, accountants, and lawyers provide a vested interest in the status quo. Startup costs and ongoing costs can be so prohibitive that some companies we know have even decided to end their tax advantaged ESOPs for this reason.
3. Companies are stuck with high start-up costs ($100K-$300K) and annual costs ($20K-$70K).
In short, owners hitch their employees to their exit strategy without their consent. To access the substantial tax advantages, owners sell to a tax-advantaged ESOP and have to follow the tax laws' rigid arrangements. Given this, a growing number of companies are developing their own employee ownership programs, foregoing taxpayers subsidies and the associated high costs. A good example is Southwest Airlines' unprecedented 10-year pilot agreement, exchanging stock options for pay rate increases. KKR also rejects the tax-advantaged ESOP, promoting employee ownership with their own stock program.
4. ESOP designs lack flexibility because of tax legislation requirements.
At a smaller company, Choice One Engineering, president Matt Hoying considered many different ownership structures (including a formal tax advantaged ESOP), none of which fully addressed what he was trying to achieve: empowering employees to feel and act like owners who support the company's purpose. A tax advantaged ESOP may have been easier to roll out, given its well-regulated structure, but the cost constraints and loss of organizational control made it unappealing. Instead, Hoying developed his own program, without the tax advantages, costs, or complexity. Today, the ESOP is open to all employees and provides a transparent path to ownership.
Most important, he involved employees in the process of developing the program, creating the kind of engagement that tax advantaged ESOPs could only dream of. Customizing the program allowed employees to create their own valuation, eliminating the annual valuation costs and enabling them to see how their daily work drove the value of the company. Building the ownership structure from scratch was a challenge, but it afforded Hoying and his team simplicity, and it guaranteed they could reach their organizational goals.
These pitfalls aside, companies who trust their employees as partners in a participating management structure can and should eventually consider stock ownership. When employees master how to drive short-term results, they tend to show interest in what they can do to drive the company's long-term results. The best part? As documented in our research with Harvard Business School professor Dennis Campbell and research associate Iuliana Mogosanu, companies with this approach can substantially improve their competitive edge and eventually enjoy the benefits of an ESOP.