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Home > Reference Desk > News & Commentary >
In an April 9 story of the Wall Street Journal, the much-quoted Robert Willens of Lehman Brothers opined that ESOPs (employee stock ownership plans) were the "wave of the future" in merger and acquisition transactions. The tax benefits of ESOPs, he said, are just too appealing for the private equity world to pass by. Willens was reacting to the purchase of the Tribune Company by an ESOP and the fact that both Sam Zell's winning bid (for details, see here) and the other major contender, a private equity group led by Ron Burkle and Eli Broad, relied on a substantial ESOP to make their offers possible. Quick on the heels of that transaction, financier Kirk Kerkorian has (apparently) proposed using an ESOP as part of an effort to buy Chrysler. Employee ownership would be exchanged for union concessions on health care.
It seems that whenever a few highly publicized strategies happen, at least a few people predict they will become a trend (a phenomenon psychologists call "presentism," the overweighting of recent experience in predicting the future or interpreting the past). Presentism results in vastly more trends being predicted than occur, of course. Are ESOPs bound to be just another twinkling in the pundits' eyes or will they really make their way into the mainstream M&A arsenal? And if they do, what does experience tell us about whether that will be a good thing for companies and employees?
More details on how ESOPs work can be found elsewhere on our site. Basically, an ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. With an ESOP, a company sets up a trust fund. The company can contribute to the ESOP trust new shares of its own stock or cash to buy existing shares; alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits. So in this case, the company is able to use the ESOP to borrow money and repay it in pretax dollars, deducting both principal and interest. This is one of the key tax benefits that the many articles on this transaction are referencing.
Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.
When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues. In public companies, employees must be able to vote all issues.
There is a special tax benefit for ESOPs in S corporations. S corporations do not pay income tax directly. Instead, S corporation owners are taxed at their personal tax rates on their pro-rata share of company profits. Thus, a 30% owner must pay tax on 30% of the profits. S corporations typically issue a distribution to their owners to enable them to pay the tax. ESOPs, and only ESOPs among S corporation owners, do not have to pay any taxes on their share of the profits, at least for federal purposes (some states have different tax regimes for S corporations). If the ESOP is one of several owners, then it must receive its pro-rata share of distributions made to other owners for tax purposes, even if it does not pay taxes. The distributions are added to employee accounts. If the ESOP owns 100% of the company, there is no federal income tax. The theory here is that it would be unfair to tax the ESOP on its share of the earnings because the employees will be taxed on the eventual distributions they receive from the ESOP (just as they would in any benefit plan). S corporations are limited to 100 shareholders, but the ESOP is legally considered only one owner (the ESOP trust).
There are about 9,250 ESOPs covering over 10 million employees. Over 90% of these are in closely held companies. Most often, ESOPs are used to buy the shares of one or more owners, often in a series of transactions that eventually brings the ESOP to majority or 100% ownership. Almost all of these companies are profitable at the time of sale. Employees make wage concessions in return for ESOPs in less than one percent of all transactions. In some cases, but still a minority, companies reduce or eliminate contributions to 401(k) plans or profit sharing plans and replace these with contributions to the ESOP, usually at a much higher contribution level. However, almost all ESOPs maintain at least one diversified retirement plan and, overall, ESOPs contribute about as much to their non-ESOP retirement plans as comparable companies do to all of their retirement plans. In other words, ESOPs are typically add-on benefits for employees.
Only about 8% of ESOPs are in public companies. Here, the ESOPs are usually used as part or all of a match to a 401(k) plan. ESOPs in public companies rarely own more than 10% of the shares.
Increasingly, ESOP companies are buying other companies. Because of their tax benefits and stronger economic performance, many ESOP companies find themselves cash-rich. Many additional companies are thus becoming ESOPs by virtue of acquisitions, although they do not show up in the numbers of total ESOP companies.
While ESOPs have shown growing popularity in recent years and have been able to move into larger private company middle-market transactions, they have only rarely been used as part of large M&A deals, including those arranged by private equity firms.
In the 1980s, there was a "mini-boom" in ESOPs in M&A activity. WesRay Capital sold a number of the companies it owned to ESOPs, most notably Avis and Simmons Mattress Company. Avis did well and was later sold for a large premium; Simmons struggled, although it eventually recovered. In the hospital industry, an ESOP was used to buy smaller hospitals owned by HCA. The new company, HealthTrust, was so successful it eventually bought HCA, which, in turn, bought another large hospital chain that had been sold to an ESOP, EPIC Healthcare. EPIC did not do as well as HealthTrust, but did better than expectations and left employees with a good gain on their ESOP shares. Charter Medical was another hospital chain sold to an ESOP. Mired in a Medicare scandal and other problems, Charter ended up in bankruptcy. Leveraged ESOPs bought majority ownership in Cone Mills, Dan River, and Burlington Industries. Dan River was later sold at a profit to employees; Burlington went public, but the ESOP participants did not see much benefit and sued over the transaction; Cone Mills struggled and was sold out of bankruptcy. Polaroid used an ESOP to buy itself out to prevent a hostile takeover bid; it also ended up in bankruptcy due to a failed business strategy. Other large (and very successful) ESOP purchases around this time included Parsons Corporation and DynCorp.
Most of these companies were doing at least reasonably well when the ESOP took over. By contrast, ESOPs were also used to buy all or part of a number of troubled steel companies, most notably Weirton Steel, and about a dozen failing trucking companies. The steel company ESOPs usually were able to forestall more serious economic difficulties, with most of these companies outperforming their peers but eventually succumbing to the same pressures a the rest of the industry. The trucking company ESOPs were almost all last-minute attempts to save companies that were on their last legs (or wheels, in this case), and almost all failed soon after. In both these cases, the ESOPs were generally set up in exchange for wage concessions. Only a few involved a leveraged purchase of the company. A number of ESOPs were used in smaller failing companies where the plan did borrow money to buy the assets. About 60% of these succeeded, usually ultimately being sold at a profit to other companies.
This spurt of ESOP buyout activity in large companies came primarily, but not exclusively, from three sources:
In the 1990s, this activity died down. M&A activity in general slowed, massive changes in rust belt companies and the transportation sector shook out, and the players who became intrigued with ESOPs either moved on (WesRay disbanded) or became intrigued with a new approach. In 1995, an ESOP bought United Airlines, spurring speculation that many more companies would use that model, but none did. For more on what happened to United, see our article on United.
ESOPs quietly settled down to their active but less noticed role in private company transactions. Because these companies do not have traded shares, they rarely make the financial pages, leaving the impression that ESOPs had somehow "disappeared" when, in fact, they just returned to their normal applications after a brief period a five or six years of unusual activity in large M&A deals.
The thinking behind the current predictions that ESOPs will reemerge is based on interest in the Tribune structure where the tax benefits of ESOPs are able to make capital financing more affordable. That happens in two ways. First, contributions to the ESOP to repay a loan used to acquire shares in the new company are tax deductible, both for principal and interest. This is true for any level of ESOP ownership, but applies only to the debt the ESOP uses to buy stock. If the company is (or becomes) an S corporation and is 100% owned by the ESOP, as at the Tribune, there is an even better benefit: the company simply stops paying federal (and usually state) income tax, as described above. Management and investors, however, can get synthetic equity (warrants, stick appreciation rights, phantom stock, etc.), either in return for their investment in the transaction (as with Zell) or as an incentive (as with Tribune management).
While these tax benefits are alluring, investors must understand there are significant limits on how these plans can be used. First, the tax benefits only apply to the ownership the ESOP actually gets. So ESOPs require investors to share the benefits of the transaction with workers, something they have not been notably enthusiastic about traditionally. While deals can be structured, as at the Tribune, to provide investors with attractive potential returns, ESOP fiduciaries face very strict legal requirements for how this equity can be allocated. Independent fairness opinions are required, and the trustees of ESOP plans can be taken to court by plan participants and/or the government for failing to treat the ESOP appropriately. ESOP trustees have become much more sophisticated and demanding about how these deals are done than they were in the 1980s.
A second potential appeal is the idea that somehow workers will pay for the stock with concessions in benefits and/or wages, or that employees might use existing retirement assets to help fund the deal. At the Tribune Company, employees will no longer receive up to a 4% match to their 401(k) plan from the company but will get a 5% contribution in company stock. No existing plan assets are used to fund the deal, however, and a profit sharing plan is being replaced by a cash balance retirement plan at about the same funding level. At Chrysler, major changes in health benefits would be a precondition for the ESOP. At United, employees made large concessions to gain control of the airline.
There is a reason, however, why so few ESOPs impose significant reductions in wages or benefits in return for stock. Any such transition means the company starts off with a work force already worried and often angry about having to give something up for what may appear to be an effort to make someone else very wealthy. Whether that is justified in any particular case in not the issue; if employees feel it, motivation will suffer, and motivation is critical in companies that face significant debt and need serious attention by everyone to profitability. Moreover, most owners who sell to an ESOP have a level of concern about their employees' well-being that is more prominent than in usually found in the private equity market.
A third seemingly appealing possibility is the use of existing employee funds to help provide equity. In fact, this is a very difficult trick to pull off. Defined benefit pension funds are not a practical source except in very rare cases. Existing 401(k) funds can be moved, but this almost always requires employees to make individual investment decisions to do so. This may make sense in very specific transactions, such as the very successful employee buyout of Appleton Paper Company. The financial terms of that deal, and the alternatives if it were not done, made a compelling argument for employees. In most M&A transactions, however, employees would be taking too much risk with their retirement plans to invest much. In the post-Enron era, they will be very cautious, and plan trustees will be even more cautious in what they allow and what kinds of warnings they provide employees about the potential risks.
Finally, there is the issue of what kind of corporate culture emerges. Two decades of research on employee ownership and corporate performance have produced a remarkably consistent and robust result. ESOP companies grow about 2% to 3% per year faster in sales, employment, and productivity than they would be expected to grow absent an ESOP (the studies look at how ESOP companies performed relative to comparable non-ESOP companies before they had an ESOP and then again after, subtracting the difference to index out industry effects; the 2% to 3% differential reflects this pre-ESOP to post-ESOP change net of industry effects). That difference, however, is accounted for entirely by the companies that combine the ESOP with a high-involvement, open-book management approach. These companies get employees very involved in work teams, cross-functional groups, and other employee involvement structures. They share lots of information at all levels about all levels of corporate performance. They devolve as much day-to-day decision making as possible to employees, individually and in teams. These companies grow 6% to 11% per year faster post-ESOP than would be expected, while companies with top-down management approaches actually do worse post-ESOP. They have raised expectations, and then failed to meet them. High-involvement management on its own, by the way, does not have a sustained impact; it is the combination of ownership and participation that works.
Cultural transformation takes time, management commitment, and a deeply held philosophical belief that this kind of management works. The successful ESOP companies have top management who believe that culture is not just one important factor, but the important factor in determining how well the company will do. They get personally involved in the effort to create and sustain it and judge other managers on how well they help make this kind of ownership culture happen. Here too, this kind of commitment has not been a hallmark of most private equity groups, who prefer to focus on financial engineering with an eye towards a relatively quick exit through an IPO or subsequent sale.
In short, there are a lot of reasons to believe that ESOPs will not be the next big thing in M&A. If the Tribune deal looks good a year from now, and if Chrysler ends up with an ESOP, no doubt at least a few other similar transactions will be tried, and maybe even a few that are in less risky situations. My guess, however, is that ESOPs will not be a major player in M&A in large public companies but will show continued and (to people outside the ESOP community) surprising strength in acquisition activity among existing ESOP companies and ESOP purchases from owners in increasingly large privately held companies.
Corey Rosen can be reached at 510-208-1314.
Copyright © 2007 by The National Center for Employee Ownership (NCEO) (phone 510/208-1300; email nceo@nceo.org; WWW http://www.nceo.org/). All rights reserved.
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