Taking Ownership

By Joanne Sammer Aug 1, 2007
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HR Magazine, August 2007Maximizing the benefits and incentives of employee stock ownership plans takes planning and communication.

Employee stock ownership plans (ESOPs) have been back in the news in recent months thanks to the Tribune Co.’s decision to use an ESOP to finance a bid to become a private company. “The Tribune transaction will be one of the largest done with an ESOP, but it is not your typical ESOP transaction,” says Vern Saper, a partner with law firm Warner Norcross & Judd LLP in Grand Rapids, Mich.

If there is a typical ESOP, it would be a plan run by a closely held small-to-mid-size company with a few hundred employees, usually as a way for the owners to cash out or retire without having to sell the company to outsiders. According to the Oakland, Calif.-based National Center for Employee Ownership (NCEO), there were 9,225 ESOPs in 2006 with 10.1 million participants and holding more than $600 billion in assets.

The number of ESOPs among small and mid-size companies is likely to grow as aging baby boomer business owners look for an exit strategy that will fund their retirement. “A lot of people are reaching the point where they are interested in retiring or getting liquidity out of the business,” says Corey Rosen, NCEO’s executive director. “An ESOP [offers] a good way to provide those individuals with a gradual withdrawal from the business.”

Even so, ESOPs come in several shapes and sizes. Many ESOPs are established by companies of any size as a way to give employees a stake in the company and to create a sense of ownership among them. Many large corporations with tens of thousands of employees, including Procter & Gamble, SAIC Inc. and PepsiCo, have established ESOPs to create employee ownership, to supplement existing retirement programs, or for a combination of reasons.

What It Is


An ESOP is a defined contribution retirement plan that invests primarily in the stock of the sponsoring company and contributes shares of company stock to each participant’s account based on a predetermined formula. The sponsoring company can contribute actual shares that it owns or money with which the ESOP can purchase shares, or the company can require the plan to take out a loan to buy stock that the company will repay over time.

ESOPs are covered by rules regarding plan participation, account vesting and other design elements that are similar to those governing other types of defined contribution plans, like 401(k) and profit-sharing plans, as well as regulations that are specific to ESOPs. For example, an ESOP in a closely held or private company must hire an independent firm to value its stock at least annually. Employees must be able to vote the shares in their accounts. And employees who are age 55 or older with at least 10 years of service must be able to diversify a portion of their ESOP holdings. The Pension Protection Act of 2006 changed these diversification requirements further for certain types of ESOPs established by non-closely held companies.

Because an ESOP provides tax advantages in certain situations and can be used as a tool for corporate finance, the discussion about establishing an ESOP often begins in the finance area of a company. If a closely held company chooses to establish a leveraged ESOP, the process can take up to a year or more as the company obtains the necessary financing, conducts feasibility studies and liability projections for repurchasing shares from employees who retire or leave the company, prepares plan documents, and develops a communications strategy to educate employees about the plan.

HR’s Role


HR’s effectiveness at rolling out an ESOP will play an important role in ensuring its success.

“HR needs to figure out how an ESOP will fit into all of the company’s other benefit programs, how to position the ESOP with employees, whether the company is really looking to change behavior following the introduction of the ESOP, and what kind of budget there will be to communicate the plan,” says Dave Cantor, a principal with Mercer HR Consulting in Charlotte, N.C.

The laundry list of activities for HR begins with finding the right administrator for the plan. Because ESOPs have their own unique regulatory and administrative requirements, it is unlikely that a company could handle administration in-house. But HR executives cannot simply turn over ESOP administration to just any third-party administrator (TPA) or an existing vendor handling a 401(k) or profit-sharing plan.

“ESOPs have many special rules that not all defined contribution plan TPAs may know about, especially if the company has a leveraged ESOP,” says Brian Snarr, a partner and leader of the compensation and benefits group for law firm Morrison Cohen LLP in New York. “Companies often wait to undertake the task of finding a TPA until late in the process, but HR executives need to start early to find vendors with ESOP-specific experience and knowledge because the rules governing an ESOP tend to be more complex than the rules for 401(k) plans.”

The People Side


Once a TPA for the ESOP has been chosen, HR executives and their staffs can turn their attention to more people- oriented matters. “Companies usually choose to establish an ESOP for economic or financial reasons,” says Jerry Vigdor, director in Philadelphia of CBIZ Inc., a nationwide provider of financial and benefits management services for businesses. “But once it is clear that the plan makes economic sense, the company has to make sure the plan will work well in its environment—for example, conducting financial feasibility studies and making sure that the current management team has the capabilities to run the company.”

Although companies can certainly roll out an ESOP without taking any steps to change the way they manage or communicate with their employees, doing so means missing a tremendous opportunity to use the ESOP to improve overall company performance and instill a sense of ownership within the employee population.

Done right, an ESOP can contribute greatly to a company’s success. Some research indicates such plans boost individual productivity. According to a study conducted by Douglas Kruse and Joseph Blasi of Rutgers University in 2000, companies with ESOPs that were studied had sales, employment and sales per employee figures that were 2.3 percent to 2.4 percent higher per year than companies without ESOPs. But these improvements don’t happen automatically. “The assumption about employee ownership is that an employee-owned company will automatically make more money, but that is not true,” says Rosen. “Employee ownership doesn’t change productive behavior at all.”

Instead, employee-owned companies must work to create a culture of ownership to generate significant changes in performance, to enhance the decisions people make about how work is done, and to get people to work intelligently and to share ideas and information. If the company operates with open-book management and freely shares information about finances and performance, it is important to find ways to break out those numbers into useable pieces. For example, performance information for shipping can be presented in a way that shows how on-time delivery affects the company’s overall profitability. “This is about more than just sending everyone the annual report,” says Rosen.

Getting To Know The Company


Recognizing the importance of getting employees to act like owners of the company, SAIC Inc. offers training that enables employees to become “certified employee owners,” according to Lynn Thompson, the San Diego-based engineering and technology company’s vice president for employee-owner relations. The program, which takes about three hours to complete, helps employees understand the ESOP and the company, including its stock programs, values and strategic vision. The course also explains how to read financial statements and discusses what it means to work in an employee-owned company.

Thompson estimates that 55 percent of the company’s 44,000 employees are certified employee owners. Participation varies widely by business unit, ranging from 25 percent to 90 percent of employees. Thompson attributes the variations to differences in the numbers of employees who work primarily off-site and the promotion of the program primarily to new employees.

Companies with ESOPs also can create structured ways to involve employees in the management of the company. When Grand Rapids, Mich.-based G&T Industries established its ESOP in 2005, it established an ESOP committee chaired by its head of HR. The seats are held by 10 employees who represent each company location that has at least 25 employees, according to Roland Grit, the company’s president and CEO. These ESOP committee members must have at least five years of service and be fully vested in the ESOP, and they must be nominated by the head of each business unit.

In addition to having fiduciary responsibility for the running of the ESOP, the committee has other duties involved in the running of the company itself. For example, two ESOP committee members serve on the company’s board of directors on a rotating basis, and the full ESOP committee must approve the appointment of the company’s board of directors.

The timing of communication is critical. Although it is a good idea to wait to announce the establishment of an ESOP until financing is in place and a firm decision has been made to go forward with the transaction, companies can use that time to prepare for an announcement. This includes developing a plan for communicating the decision and educating employees about ESOPs, how they work and why the company is establishing one. “It is important not to sell it, but to explain it,” says Rosen. “People need to understand it.”

That was the goal of G&T Industries’ management when it undertook a comprehensive and ongoing employee communication program. “We didn’t say anything about the ESOP to employees until the day we closed the transaction,” says Grit. “At that point, we talked to employees about why the company established the ESOP and showed a video from the founding partner of the company.” The focus of this communication was explaining what an ESOP is and how it works, as well as what the company wanted to accomplish by establishing the plan. The company has followed up on this communication with a monthly ESOP newsletter, as well as periodic on-site meetings and ESOP-related celebrations.

But even with this intensive communication effort, Grit admits that the full potential of the ESOP didn’t sink in for many employees until they received their first plan statement following the ESOP’s first annual valuation, which showed a substantial increase in the value of the company and each individual’s shares. “At that point, our culture began to change substantially,” says Grit. “We have a group of employees who are acting more like owners who, for example, salvage things that they used to throw away and focus on doing the right things to produce more consistent results.”

More Info, More Questions


Of course, this greater information sharing can be a challenge for management, says Grit. When G&T Industries wanted to acquire another company with 50 to 60 employees, Grit had to explain his rationale for the decision and how the transaction would actually create more value for the company and its shareholders rather than simply diluting existing values by bringing in more shareholders. “An ESOP requires you to be able to answer those kinds of questions,” he says. “And if you can’t explain, you shouldn’t do it.”

SAIC Inc. had to explain its rationale for taking a portion of this formerly private company through an initial public offering (IPO) last year. “Everyone had to understand the rationale and business reasons for the decision,” says Dede O’Donnell, the company’s group HR director. “We had a great deal of outreach to employees to explain what we were doing to get people to support what we were doing.”

During a series of town hall meetings at various locations, senior executives discussed how the capital raised through the IPO would fund the company’s next stage of growth. “This was a very important activity to get employees to be comfortable with the decision to take the company public,” says O’Donnell.

One of the key concerns about ESOPs is that they may tie up too much of employees’ retirement assets in company stock. In the wake of Enron Corp.’s stock price meltdown and eventual bankruptcy after disclosures of accounting fraud, SAIC Inc. needed to provide some strong communication to its employee-owners about “why we were different from Enron,” says O’Donnell.

However, companies can address those concerns by establishing an ESOP as a supplement to existing defined benefit and defined contribution retirement plans, not as a replacement. Fortunately, most ESOP companies have other retirement plans, according to statistics compiled by The ESOP Association, a Washington, D.C., association of 2,500 companies with ESOPs.

Joanne Sammer is a New Jersey-based business and financial writer. Her articles have appeared in a number of publications, including Business Finance, Consulting, Compliance Week and Treasury & Risk Management.

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