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Employee Ownership and Corporate Performance

Over the years, the NCEO has reported on new research on employee ownership and corporate performance. Now that a substantial body of work exists on the subject, we thought it would make sense to summarize it in one place. The research comes to a very definite conclusion: the combination of ownership and participative management is a powerful competitive tool. Neither ownership nor participation alone, however, accomplishes very much.

The findings apply mostly to ESOP companies. As of yet, little work has been done on the impact of broad-based stock option plans on corporate performance. The findings also seem to apply primarily to closely held companies. Research indicates that public companies generally do not view employee ownership as much more than another corporate benefit. For this and other reasons explored below, the relationship between employee ownership and corporate performance in public companies is ambiguous.

The 2000 Rutgers Study

In the largest and most significant study to date of the performance of ESOPs in closely held companies, in 2000 Douglas Kruse and Joseph Blasi of Rutgers University found that ESOPs increase sales, employment, and sales/employee by about 2.3% to 2.4% per year over what would have been expected absent an ESOP. ESOP companies are also somewhat more likely to still be in business several years later. This is despite (or perhaps because of) the fact that ESOP companies are substantially more likely than comparable companies to offer other retirement benefit plans along with their ESOP.

Kruse and Blasi obtained files from Dun and Bradstreet on ESOP companies that had adopted plans between 1988 and 1994. They then matched these companies to non-ESOP companies that were comparable in size, industry, and region. They then looked for which of these companies had sales and employment data available for a period three years before the plan's start and three years after. The sales and employment growth data were then compared for each year for each paired company. They also checked the companies' filings with the Department of Labor to determine which of the companies had other retirement-oriented benefit plans. Finally, they looked to see what percentage of the companies remained in business in the 1995 through 1997 period.

The process yielded 343 ESOP companies and 343 pairs for the overall sample. However, missing data meant that employment data were available only for 254 ESOP companies and 234 pairs, 138 ESOP companies and 77 pairs for sales, and 115 ESOP companies and 65 pairs for sales/employee (some pair companies could be used for more than one ESOP company).

The results showed that ESOP companies perform better in the post-ESOP period than their pre-ESOP performance would have predicted. The table below shows the difference in the pre-ESOP to post-ESOP period for ESOP companies on sales growth, employment growth, and growth in sales per employee:

Difference in Post-ESOP to Pre-ESOP Performance
Annual sales growth	+2.4%
Annual employment growth	+2.3%
Annual growth in sales per employee	+2.3%

It might be assumed that sales per employee would not go up by 2.3% per year since sales and employment growth differences were about the same, but, the researchers explain, the differing compositions of the samples for the measures makes such a simple comparison misleading. The relative growth numbers might seem small at first glance, but projected out over 10 years, an ESOP company with these differentials would be a third larger than its paired non-ESOP match.

The 1986 NCEO Study

The first study to show a specific causal linkage between employee ownership and corporate performance was by Michael Quarrey and Corey Rosen of the NCEO. The study looked at the performance of employee ownership companies for five years before and after they set up their employee stock ownership plans (ESOPs). It indexed out market effects by looking at how well employee ownership companies did relative to competitors in the pre- and post-ESOP periods, then subtracted the difference. For example, if a company were growing 3% per year faster than its competitors in the pre-ESOP period, and 6% per year faster in the post-ESOP period, there would be a +3.0% difference attributable to the ESOP, other things being equal.

The study found that ESOP companies had sales growth rates 3.4% per year higher and employment growth rates 3.8% per year higher in the post-ESOP period than would have been expected based on pre-ESOP performance. When the companies were divided into three groups based on how participatively managed they were, however, only the most participative companies showed a gain. These companies grew 8% to 11% per year faster than they would have been expected to grow, while the middle group did about the same, and the bottom group showed a decline in performance.

Participation alone, however, is not enough to improve performance. A large number of studies show that the impact of participation absent ownership is short-lived or ambiguous. Ownership seems to provide the cultural glue to keep participation going.

The New York and Washington Studies

Economist Gorm Winther and colleagues in New York and Washington State followed up the NCEO study, using the same research design but different samples, one of 25 employee ownership firms in New York State and one of 28 employee ownership companies in Washington State. In both studies, employee ownership per se had little or no impact on corporate performance, but a substantial impact when combined with participative management. In Washington, companies that combined ownership and participation grew in employment 10.9% per year more than would have been expected. Sales grew 6% per year more. The New York results used correlations and cannot be compared directly, but the results were in the same direction. In Washington, majority employee-owned firms that were participatively managed did even better.

The Washington study also found that the synergistic effect of ownership and participation was not diminished even when the control group companies had no employee ownership, but had profit sharing and participation programs.

The GAO Study

In 1987, the U.S. General Accounting Office (GAO) did a before and after study using a similar methodology, but covering 110 firms and focusing on productivity and profitability. The measures the GAO used were controversial because they assumed that employee ownership firms did not increase overall compensation when they set up an ESOP. In fact, it appears that about half of all ESOP companies do increase compensation, and few decrease it. The GAO results are probably too conservative because of this assumption.

The GAO study found that ESOPs had no impact on profits, but that participatively managed employee ownership firms increased their productivity growth rate by 52% per year. In other words, if a company's productivity growth rate were 3.0% per year, it would be 4.5% after an ESOP.

The Impact of ESOPs on Employee Compensation

One reaction to the above findings might be that employee ownership companies do better because they substitute stock for wages or benefits. A 1998 study by Peter Kardas and Jim Keogh of the Washington Department of Community, Trade, and Economic Development, and Adria Scharf of the University of Washington, Wealth and Income Consequences of Employee Ownership, shows that, in fact, employees are significantly better compensated in ESOP companies than are employees in comparable non-ESOP companies. Using 1995 employment and wage data from the Washington State Employment Security Department, and 1995 data on retirement benefits from a survey of companies and from federal income tax form 5500, the study matched up 102 ESOP companies with 499 comparison companies in terms of industrial classification and employment size. In terms of wages, the median hourly wage in the ESOP firms was 5% to 12% higher than the median hourly wage in the comparison companies, depending on the wage level of those being compared. The study found the average value of all retirement benefits in ESOP companies was equal to $32,213, with an average value in the comparison companies of about $12,735. Looking only at retirement plan assets other than ESOPs, the ESOP companies had an average value of $7,952, compared to $12,735 for non-ESOP companies. Given that the typical ESOP is actually about 20% invested in diversified assets other than company stock, employees in ESOP companies would have had about as much in diversified assets as employees would have in all assets in non-ESOP companies. In ESOP companies, the average corporate contribution per employee per year was between 9.6% and 10.8% of pay per year, depending on how it is measured. In non-ESOP companies, it was between 2.8% and 3.0%.

Public Companies and Employee Ownership

The data for public companies are much more ambiguous. A 2006 study by Robert Stretcher, Steve Henry, and Joseph Kavanaugh (the study was in submission as of this writing) looked at 196 publicly traded U.S. ESOP companies during the years 1998 through 2004. Each ESOP company was matched to a comparable non-ESOP company. The ESOP companies had returns on assets that were higher than the matched non-ESOP companies in all seven years, net profit margins that were higher in all of the five years where comparable data were available, and better operating cash flows in three of the five years where data were available. All of these findings were statistically significant (not likely to have occurred at random). ESOPs outperformed matched companies in all seven years on net cash flow to sales, in six of seven years for market to book ratio, and four of the seven for return on equity. They grew more slowly in sales and employment, but the results were only statistically significant in some years. The ESOP firms also generally did better on operating cash flow to sales and operating cash flow to employees ratios, but the results were not statistically significant.

The differences in the overall sample comparisons on key measures was substantial, with ESOP companies showing a 3.8% return on assets compared to a negative 2.72% for the matched companies. On return on equity, the ESOP companies averaged 14.3% per year, compared to 7.2% per year for non-ESOP companies. Sales and employment growth rates present a more confusing pattern, with many years not statistically reliable or appearing to have outlier results that skewed the means. Generally, however, ESOP companies grew less than half as fast as matched non-ESOP companies.

The authors note that net income is better for ESOP companies as well, although they put less emphasis on this measure because net income is determined in part by accounting practices and tax effects. Operating cash flow, they argue, presents a better picture. When operating cash flow to sales ratios are computed, ESOP companies do about the same as non-ESOP companies, but when operating cash flows to assets ratios are examined, ESOP companies do better, suggesting strongly that ESOP companies get a better return on each dollar invested because employee behaviors change.

A 1999 study by Hamid Mehran of Northwestern University for Hewitt Associates found that ESOPs in 382 publicly-traded companies increased the return on assets (ROA) 2.7% over what would otherwise have been expected. The study looked at the companies' financial returns for two years prior to the plan's implementation and four years after. Each company was compared to industry norm ROA figures for both periods. Mehran also found that for the 303 ESOP companies surviving the entire four year post-ESOP study period, ROA was 14% higher than the comparison group scores, while for the 382 companies as a group, ROA was 6.9% higher for the four-year period. Over 60% of the companies experienced an increase in their stock price in the two-day period following public announcement of the ESOP, with the average increase for all companies at 1.6%. This suggests that the stock market now reacts positively to ESOPs, a change from the pattern in the 1980s when ESOP announcements were often seen as an indicator that a company was trying to prevent a hostile takeover.

A different result was found in a study by Olubunmi Faleye, Vikas Mehrotra, and Randall Morck of 225 public companies with broad-employee ownership of 5% or more of a company's stock (When Labor Has a Voice in Corporate Governance, National Bureau of Economic Research Working Paper (No. 11254). The authors concluded that productivity, Tobin's Q (a ratio of the market value of a firm's securities to the replacement costs of its tangible assets), long-term investment, operating risk, and growth were all worse in employee ownership companies than public companies in general. The study looked at 100 ESOPs and 115 companies with other plans; plans had to be in place for at least five years prior to 1995. Data were gathered for 1995 through 2001. The authors do not control for this variable, although we know that the airline, steel, and banking industries are heavily overrepresented among public company employee ownership plans during the study period.

In 1992, Douglas Kruse and Joseph Blasi of Rutgers University, and Michael Conte of the University of Baltimore, created an "Employee Ownership Index" (EOI). The EOI tracked the average percentage increase in stock price of all publicly traded companies with a public record of 10% or more employee ownership and more than $50 million in market value. The EOI was subsequently maintained for some time by American Capital Strategies, an investment bank based in Bethesda, MD, and was published quarterly in the NCEO's Journal of Employee Ownership Law and Finance. The EOI grew 193% from 1992 through 1997, while the Dow was up 145% and the S&P 500 140%. The authors did not attribute any causal relationship to these numbers, however.

Other studies look at before and after results, with mixed conclusions. Donald Collat, in a 1995 study, found that public companies that did not set up their ESOPs in response to a takeover threat saw their operating margins improve 2.1% per year compared to their pre-ESOP performance. The study looked at companies for three years before and after the ESOP, indexing for market effects. Takeover threat ESOPs, however, saw a decline of 3.3%. In a 1996 study, Mary Ducy, Zahid Igbal, and Aige Akhigbe found that ESOP companies show a decline in operating cash flow of .2% to 2.1% in post-ESOP performance, also using a three years before, three years after measure, and again indexing for market effects. While these are the most thorough of several studies on public company ESOPs, others come to a similarly mixed conclusion.

Finally, a 1998 study by Margaret Blair, Douglas Kruse, and Joseph Blasi found that companies that are publicly traded and at least 20% or more owned by an ESOP are more organizationally stable than comparable non-ESOP companies. Looking at companies between 1983 and 1996, the study found that 74.1% of the ESOP companies remained as independent operations while only 37.8% of the comparison companies did (these figures changed to 59.3% and 51.1% for the period 1983 through 1997, however). None of the ESOP companies went bankrupt, but 25% of the comparison companies did.

These mixed results are probably explained by three factors. First, a 1997 NCEO study found that public companies generally seem to view employee ownership solely as a benefit plan, not part of an explicit organizational culture, as many closely held companies do. Second, ESOPs in public companies tend to own a much smaller percentage of company stock than ESOPs in closely held companies. Some studies have indicated this is a factor in how effective ESOPs are. Finally, in many cases, public company ESOPs simply replaced existing plans where the company contributed company stock to a 401(k) plan. Now the company used an ESOP to make this contribution instead. Hence, the "before" was really not much different from the "after," so not much could be expected to change.

Broadly Granted Stock Options and Stock Prices

In 2005, James Sesil and Yu Peng Li published a paper titled "Executive and Broad-Based Stock Options: Evidence From U.S. Panel Data" (Rutgers University Working Papers). They looked at 291 companies with broad-based option and executive option plans for which a start date could be identified for both plans (these dates could be different). They then looked at productivity, growth, and capital intensity changes for three years before and after the plans' start dates. To control for characteristics of the firms, the researchers use a fixed effects model, a statistical technique that holds constant heterogeneous factors of the company (things that do not change over time, such as industry). To measure productivity, an augmented Cobb-Douglas function was used. This is a model in which productivity is seen (in this augmented version) as a function of capital, labor, broad-based options, executive options, and a variable created to control for quality of management and human resources practices (it is not clear how this variable was constructed, however). The Cobb-Douglas function assumes that labor and capital returns vary proportionately to one another.

The table below provides the results for productivity, growth, and capital intensity in terms of the mean changes before and after the plans. Generally, the executive plans would have been established well before the broad-based plans.

Mean productivity, growth, and capital intensity changes in three years before and after plan introduction

Variable	Broad-based plan, before adoption	Broad-based plan, before adoption	Executive-only option plan, before adoption	Executive-only plan, after adoption
Output/employee in dollars	$265,575	$318,925	$231,188	$403,071
Employment	19,190	20,446	14,433	30,365
Capital; intensity (million $)	$1,497.0	$1,915.0	$1,428.4	$4,563.9

The table indicates that the impact of the two kinds of plans was positive in each case, with more of a productivity impact from executive plans. Looking at the Cobb-Douglas function to estimate how changes occur over time, the researchers found that the impact of broad-based plans occurs primarily immediately after the plan's introduction then levels off over five years. Executive plans, however, show continual improvement over the period. The researchers suggest, however, that this may be because executive plans tend to award grants annually or more often, while employee-only plans often make awards either only once or at periods less than annually. They did not assess how frequently this pattern occurs, but anecdotally, the NCEO would estimate that only about half the broad-based plans would provide annual and bi-annual grants during this time frame (they have become more common in recent years). Sesil and Li suggest that the continual reinforcement of regular grants may be critical to the incentive effect.

In a 2003 study by Watson Wyatt ("Stock Option Accounting and Total Return to Shareholders: Has the Market Already Factored an Expense Into Today's Stock Price"), the researchers (who were not identified) looked at 800 companies drawn from the S&P 1500 that had footnoted options expenses. While the report focused on shareholder reactions to options expensing, the authors of the study also found that "over the last three years, for the options that are allocated to broad employee groups [this term was not defined by the study], an increase of one percentage point (i.e., from 78% of the options to 79% of the options) is associated with a nearly one percent increase in the firm's market value. This is equal to nearly $15 million in market capitalization for the median firm in our sample." As a result, the authors concluded, "companies with high levels of participation in stock option plans create greater shareholder value than companies with low participation."

In a 2003 study by Eric Hager of the University of British Columbia, shareholder reaction to announcements of stock options grants was analyzed to determine how shareholders reacted to announcements for broad-based options grants. Announcements were excluded that did not indicate employees received stock options, but were included if employees only or employees received options in addition to managers, executives, directors and/or consultants. The study, "Do Employee Stock Option Grant Announcements Affect Shareholder Value?", was published in the summer 2003 issue of the NCEO's Journal of Employee Ownership Law and Finance.

Hager looked at companies in Canada and the U.S. For companies to be included in the study, there had to be sufficient trading data available for the period from 120 days prior to the announcement to one day after. There also had to be a clear announcement of actual grants being made, rather than the announcement of a stock option plan. Hager points out that the announcement of a plan can be misleading because a plan may make a certain number of employees eligible for a grant but actually only make grants to a much smaller number. So Hager instead looked at actual grant practices. A total of 91 announcement grants were suitable for inclusion in the event study for Canada and 54 in the U.S. The U.S. grants were from 1993-2002 and Canada from 1995 through 2002. Hager used a standard event-study methodology to extract abnormal returns to shareholders, that is, returns greater or less than what would have been predicted in the day following the announcement based on how a model accounting for other companies in the industry performed.

For Canadian companies, Hager found that returns were up 2.13% over what would have been expected for broad grants, and 2.33% greater when more than 1% of the equity was granted. The results were not affected by looking at grants only after 9/1/00, when the markets began to fall sharply. For U.S. companies, Hager found that returns were up 1.78% over what would have been expected for broad grants when more than 1% of the equity was granted, but there was no significant relationship when less was granted. Again, the results were not significantly affected by looking at grants only after September 1, 2000. The findings for the broad-based grants were statistically significant (that is, not likely to be a result of random variation).

Other Studies

Several other studies are suggestive but not as able to show causal relationships as these four. A 1990 study by the Michigan Center for Employee Ownership and Gainsharing and Michigan State University asked executives to indicate if employee ownership had had an impact on sales, profits, productivity and other measures. The results were very positive. They were the most positive, however, in companies that scored high on participative management measures. Majority employee owned companies also did better. In addition, the study found that the incidence of employee participation programs, such as work teams and advisory councils, increased 50% to 100% after an employee ownership plan was set up.

A 1993 Northeast Ohio Employee Ownership Center study also found dramatic increases in participation after an ESOP was set up, with the incidence of programs like team based management and participation training programs doubling in most cases. The study did not provide before and after data, but it did find that employee owned companies outperformed competitors on job growth measures 49% of the time, did the same 50% of the time, and did worse only 1% of the time.

Broadly Granted Stock Options and Corporate Performance

To date, there have been few assessments of the impact of broad-based stock option plans on corporate performance. The first thorough study was done in 2000 by Douglas Kruse, Joseph Blasi, and Jim Sesil of Rutgers University, and Maya Krumova of the New York Institute of Technology, using data provided by the NCEO. The study was published in our book Stock Options, Corporate Performance, and Organizational Change.

The study sample was drawn from the 1998 NCEO Current Practices in Stock Option Plan Design study. That study sent surveys to 1,360 companies that were identified as possibly having broad-based option plans, which we defined as plans in which more than 50% of full-time employees would actually receive options. We received 141 responses. For the Rutgers study's purposes, 105 companies provided usable data. The authors used a before and after approach to the data to reduce or eliminate sampling bias issues.

Results were based primarily on the 91% of the sample companies that were publicly traded. Data were gathered on productivity, return on assets, Tobins Q (a complex financial measure of return on assets that produced similar results to the return on assets measure and is not reported here), and total shareholder return. These were then compared to all non-broad based stock option companies in their industries of similar size (the full sample group) and to paired comparisons of matched non-broad based stock option companies (the paired sample).

Because few companies had discrete plan start dates early enough to perform a comprehensive before and after analysis, the researchers, as a substitute, analyzed companies in the period 1985-87 and 1995-97, reasoning that few, if any, of the companies had option plans in the earlier period and most had them in the later period. Comparisons were made with non-stock option companies for the two periods and the difference subtracted. In effect, the earlier period results provide a baseline to measure the performance in the later period. If a stock option companies had productivity 3% greater than its peers in the earlier period and 6% greater in the later period, than it could be argued that the plan improved relative performance on this measure by 3%.

The study found that productivity rates did improve with the institution of a plan. The difference between productivity scores from the for the overall sample from the pre-plan period (1985 to 1987) to the post-plan period (1995 to 1997) was 14.8% when the comparison group was all non-option companies and 16.8% when looking just at paired comparisons. Sampling error can be strongly rejected as an explanation for these results.

Return on assets showed a similar pattern. Here the stock option companies showed an improvement of 2.5% on ROA relative to the full sample in the post-plan period compared to the pre-plan period. When just paired comparisons are used, the improvement was 2.05%. Again, sampling error is very unlikely to have caused these results.

Total shareholder return, however, showed no statistically significant difference in the relative performance during the two periods, meaning any measured change could simply reflect random sampling error. The researchers thus believe that the any value consequences of dilution caused by broad-based options seems counterbalanced by increased productivity.

Looking simply at how the companies did in the period 1992 to 1997, without trying to adjust for market effects, a similar pattern emerged. Productivity growth was 1% per year greater and return on assets 5.8% greater, but shareholder return was not statistically distinguishable.

In another useful study, in 2001, Wharton professors David Larcker, Christopher Ittner, and Richard Lambert looked at options and corporate performance, using data from 159 "new economy" companies providing detailed responses on their stock plans for an iQuantic/Buck (now simply Buck) Consulting survey. They found that the performance effects of option programs depended on how the options were distributed. The study, "The Structure and Performance Consequences of Equity Grants to Employees of New Economy Firms," was published by iQuantic/Buck in 2001, and is available on line at knowledge.wharton.upenn.edu.

The researchers looked at whether stock returns subsequent to option grants improved or declined in these companies, employing a statistical model in which "return" equaled the "continuously compounded stock price return in the 12-month period following grant." The results showed that deviations from the norm for how much equity is granted do not affect abnormal stock price movements (movements away from what would otherwise have been expected). On the other hand, who gets equity does make a significant difference. Larger than usual grants to executives (CEOs, vice-presidents, and directors) did not significantly affect stock prices. Grants to managers, "individual contributors" (critical non-management employees), technical employees, and exempt non-technical employees, by contrast, resulted in significantly greater than expected stock price growth. The researchers explained that the model suggests that, for instance, "for a 20% increase in the ratio of equity to salary for similar new economy companies, there was a 5.1% increase in annual returns if the grant was to technical employees; for non-technical employees, the return was 2.7%."

Looking only at non-exempt employees (hourly employees not exempt from the Wages and Hours Act), the study found a small negative relationship between stock price and grants of more than the benchmark amounts to these lower-level employees. These results are somewhat suspect, however, in that this group of companies had very, very few such employees (the iQuantic/Buck Web site indicated that only about 2% of the work force fell into this category).

One to the more persuasive studies was "Broad-Based Stock Options Before and After the Market Meltdown," by James Sesil of Rutgers and Maya Krumova of the N.Y. Institute of Technology (in submission for publication as of this writing). The study looked at two issues: 1) would stock options be less effective in times of declining share prices than rising prices? and 2) does the effectiveness of broad-based stock options depend on the size of the company (specifically, do employees react more positively in smaller companies where their individual efforts have a more visible effect)?

To analyze this issue, Sesil and Krumova studied companies providing broad-based stock options using NCEO lists. Companies were included only if they provided stock options to 50% or more of their non-management employees and were in business from 1995 through 2002. From this, two datasets were created, one of 463 companies for 1995-1997, a period of rising stock prices, and one of 367 companies for 2000-2002, a period of falling prices.

In the 1995-1997 period, they found that companies with broad-based options had productivity levels 20% to 33% higher than comparable firms. The smallest companies and largest companies registered at about a 20% differential; medium sized at 33%. In 2000-2002, medium and large-sized companies retained these differentials; the small company differential declined by a little more than 1%.

The results indicate that the declining stock market did not undermine the impact of broad options. Moreover, contrary to popular perception that the incentive effects of options should be lower in larger companies (because individual employee efforts seem to matter less), company size does not seem to be consistently related to performance.

Conclusion

Researchers now agree that "the case is closed" on employee ownership and corporate performance. Findings this consistent are very unusual. We can say with certainty that when ownership and participative management are combined, substantial gains result. Ownership alone and participation alone, however, have, at best, spotty or short-lived results.

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