Inštitut za ekonomsko demokracijo

Prospects and problems in the US ESOP and UK EOT

Author: David Ellerman

27 Day Cash Buffer

The American ESOP provides the best model in the US for the partial or whole conversion of a company to employee ownership. In the forty-plus years since its inception, there are roughly 7,000 ESOPs covering about 10% of the private US workforce. The basic idea that separates ESOP from Employee Share Purchase Plans (ESPPs) is that the company makes contributions to the ESOP as a separate legal entity that then buys off the shares of old owners or pays off the loan that was previously funded the purchase of those shares. By a “share”, we are referring either to a certain percentage (e.g., one percent or one-hundredth of one percent) of ownership in a limited liability corporation (LLC) or to an actual share in a joint-stock corporation. In an ESPP, by contrast, the employees are paying for the shares out of pocket (e.g., as a payroll deduction) often at a discounted price. That turns the employee ownership into an individual decision depending on one’s spare income to invest in the company.

Another feature of the ESOP is that all employees are included so this allows a better development of an ownership culture—rather than dividing the workforce into owner-employees and non-owner-employees.

A most important feature of ESOPs is that there are individual capital or share accounts so the ownership is not collective or social ownership. This is in contrast to the recently legalized Employee Ownership Trusts (EOTs) in the United Kingdom which implement collective ownership with no individual capital accounts. John Lewis Partnership (JPL) is the well-known model for the EOTs, but the JLP was a gift to the workforce, and the EOTs are typically buyouts from existing shareholders. That difference cannot just be ignored.

Since there are no capital accounts in the EOTs, the financial rewards of the “employee ownership” are supposed to be in current cash bonuses. But in a buyout as opposed to a gifted enterprise, the first generation or cohort of employee-owners will need to forego such bonuses to pay off the acquisition debt. As one promoter of EOTs admitted:

“While these [bonus] payments are still subject to NICs [National Insurance Contributions], they provide a real, material benefit to the employees of an EOT company. The company must still generate sufficient cash flow to pay the bonuses and they may not be paid up to the full level, if at all, for the first several years of EOT ownership, as the company may need to dedicate its excess cash flow to repaying the debt used to finance the transaction.” [Karch, Gary R. 2018. The UK Employee Ownership Trust: Shared Ownership for the Twenty-First Century. Second. New Malden UK: RM2 Corporate Finance, p. 10]

The next cohort of employee-owners will be entering the EOT without the acquisition debt and can reap the cash bonuses, and the earlier cohort of employees who, in effect, paid off the debt will “go out naked” when they retire. The only way the first cohort can begin to reap the results of their past efforts and sacrifices is to force the sale of the whole company. Thus, the EOT may well turn out to be another type of what Jaroslav Vanek called “mule firms” that cannot reproduce themselves as employee-owned firms.

In spite of the success of the US ESOP model, there are some problems arising from the way they are implemented and from artifacts of the legal implementation in the US that are not necessary to the basic idea.

• While the ESOP delivers the financial side of ownership to the employee-owners, the governance rights are held by a trust that only has a fiduciary duty to promote the welfare of the beneficiary-employees—as if the employees were children that needed a trustee to manage their affairs. In the ESOP model promoted and starting to be implemented by our Institute for Economic Democracy (IED) in Slovenia, the trust is replaced by a new type of employee-ownership cooperative that embodies democratic control of the workers’ portion of the ownership.

• The US ESOP was implemented as a carve-out from the law on retirement pension funds—a special type of retirement fund that can invest 100% of its assets in the stock of the sponsoring company. The problem is that retirement funds are designed to pay out the ownership in cash at or near retirement. To a twenty-something employee trying to build a family, buying cars, and perhaps an apartment or house, the prospect of seeing some cash from their ownership when they retire is not much motivation. However, since they will get a payout from the individual share account when they exit the firm, they may even be incentivized to exit long before retirement. This feature of the US ESOP is not necessary for the basic idea, and it can be remedied by a “rollover plan” that pays out the oldest shares in an employee’s share account after a certain number of years and redistributes those shares to the current employees (including the older still-employed workers whose shares were partly repurchased).

• Another less desirable feature in the US ESOP (without a rollover plan) is that shares are only distributed into the employee share accounts when a loan (or seller note) is being paid off. When there is no loan or note to be paid off, the new employees do not automatically become employee-owners so again the company has owner-employees and non-owner employees. This problem is automatically solved by the rollover plan since when there is no loan or note to be paid off, then the continuing contributions from the company to the ESOP will fund the rollovers and the redistribution of those repurchased shares includes the new employees.

• While the number of US ESOPs initially showed rapid growth, that growth has now essentially ‘plateaued’ or leveled off due to the rising number of ESOP sellouts. What is driving the ESOP sellouts? The root cause seems to be that many ESOP managers are eyeing the big equity packages their counterparts have in non-ESOP companies, so they set up outside the ESOP their own stock option plans, virtual or phantom equity plans, or share appreciation rights schemes—all with the consent of the trustee who is typically chosen by the managers. This is even happening in the UK EOTs where all employees, managers or not, have no equity accounts inside the EOTs, so managers are doubly incentivized to set up their own equity plans outside the EOTs.

Then it is hardly surprising that the only way the ESOP managers can get their “big payday” is to arrange the sale of the whole company—preferably to a strategic buyer so the shares can be valued higher with a strategic multiplier. When researchers ask managers “Why the sellout?”, the answer is not “It was the only to get our ‘big payday’” but “It was the repurchase liability”—the liability to repurchase the shares of exiting or retiring employees. Yet that repurchase liability is only a manner of financial planning with the interests of the non-managerial employees in mind. Of course, once the manager’s outside equity plan is in place, then there is motivation to ‘neglect’ financial planning for the repurchase liability—which will lead to a ‘crisis’ that requires a sellout.

It should be noted that there is no randomness in the repurchases in the rollover plan since management knows years ahead of time when the shares ‘mature’ and need to be repurchased. It is the same repurchase timing if an employee exits or retires; that just closes their share accounts to any new entries such as the redistribution of the repurchased shares.

These are some of the considerations in using a US ESOP or in designing an ESOP for other countries.

 

 

 

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