Observations on Employee Ownership
The Tribune Company Transaction: Things to Know in Assessing What Happened
May 2009In 2007, Sam Zell used an ESOP to purchase the Tribune Company. The transaction was complicated. The ESOP ended up with majority ownership of the company, but Sam Zell will have stock warrants that can be exchanged for up to 40% of the shares. These warrants could be purchased by the ESOP, sold to other investors, or sold in a public offering or sale of the company. Management got synthetic equity rights worth another 8%. By 2008, the company was in Chapter 11 bankruptcy reorganization. What does this tell us about ESOPs in general and the Tribune deal in particular?
Transaction StructureInitially, Sam Zell invested $250 million in cash. Of this, $200 million is a loan to the company to purchase shares, plus $50 to buy shares. The ESOP borrowed money to buy $250 million worth of newly issued shares at $28 per share (the ESOP was able to negotiate for a lower price). The company borrowed enough money to do a self-tender offer at $34 per share to buy half the outstanding shares, including those held by an existing ESOP at the Tribune. The company was taken private at $34 per share. Zell's $250 million in stock was bought with additional debt, but Zell put in an additional $90 million in cash to purchase the right to buy 15-year warrants worth up to 40% of the company. Zell can purchase these warrants for $500 million, a price that will increase at $10 million per year up to $600 million. The result is a 100% S corporation ESOP, but with Zell having a potential claim on up to 40% of the fully diluted corporate value. Zell will also provide a $225 million subordinated note to the company. Thirty-eight executives, not including the CEO, will be given phantom stock rights over the next few years, potentially reaching 8% of the fully diluted value. No equity came from existing employee plans or contributions.
How ESOPs WorkMore 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. In the Tribune case, the ESOP will borrow money from the company. 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.
The Tribune Company converted to S corporation status, generating another potential tax benefit.. Unlike C 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).
Financial Issues for EmployeesThe existing retirement plans were changed somewhat. For most employees, the existing plan involved a company contribution to the 401(k) plan that could be as much as 4% of pay if an employee deferred at least 4% of his or her own pay into the plan, plus an additional variable contribution of up to 5% of pay depending on profits. While this is the most common arrangement, however, different properties owned by the Tribune Company had different arrangements. With the ESOP, the company contributes 5% of pay to the ESOP, to be held in Tribune stock, plus 3% per year to a cash balance retirement plan, a kind of hybrid pension/defined contribution plan. In a cash balance plan, an employee has an account that receives contributions each year, plus a credited rate of interest set by the company in accordance with federal guidelines. The employee is guaranteed to receive whatever is in the account at retirement, either in the form of a lump-sum distribution or an annuity, even if the value of the company's investments made to fund the plan declines. Insurance for this is provided by the Pension Benefit Guaranty Corporation.
In retrospect, the prior arrangement may have provided marginally more company contributions to the retirement plan than the new one, but only marginally, because we have to assume that the match would be at the lowest possible level (because there were no profits to trigger more) or may have been discontinued altogether. Whether all the added debt caused more layoffs than would have otherwise occurred is speculative; many other papers without this debt burden laid off similar numbers. But certainly the debt made things harder.
Governance IssuesEmployees in an ESOP are not required to be allowed to vote for the board of directors, although the company could provide that. The ESOP's trustee is the legal shareholder. In deals of this size, the trustee is usually an outside institution acting independently, although the company could name one or more insiders as trustees instead. Trustees of the ESOP must make their decisions with "with an eye single" to maximizing the value of plan assets over the long term. Their most critical assignment is to assure that the ESOP pays a fair price for the stock. To do that, they will hire outside appraisal experts both to opine on whether the stock price is too high and whether the percentage of ownership the ESOP is getting in return for what it is paying is fair relative to what other investors are getting for what they pay. In doing that, they must assess what an outside buyer would be willing to pay for the shares on a financial basis, assuming no synergies between the Tribune Company and the buyer, such as might exist if another media company bought it (synergistic buyers often will pay more than financial buyers).
Could the ESOP Have Helped the Tribune Succeed?Clearly, the ESOP brings a potential tax advantage to the company, but that advantage is of no value unless the company makes a profit, something the Tribune Company obviously has not done. A more important issue for ESOPs and corporate performance is what kind of corporate culture is created. 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.
United Airlines, a famously failed ESOP, is a disturbing example of a company that did not follow this "ownership culture" model, leading to a dysfunctional culture. By contrast, Southwest Airlines, which has a profit-sharing plan that functions much like an ESOP, very much does follow the model, much to the delight of customers and shareholders. Unfortunately, many in the financial world see these culture issues as "soft" and not really essential to the deal. In fact, they are at the essence of the deal, as any experienced ESOP executive will quickly note.
We have no indication that the Tribune Company made any serious effort to create anything like an ownership culture. At first, there seemed to be some optimism among employees for the new ownership, if only because the prior management was so much disliked. While our impression is only anecdotal, from what employees have told us, there was no effort to get employees seriously involved in day-to-day work-level decisions. The best culture, however, may have made no difference given the deeply troubled state of the newspaper business.
What's Next?The bankruptcy process could take many months. Zell has indicated he would like to preserve the ESOP structure and in some way restore some value to it. That would be unusual, however. In most bankruptcy cases involving ESOPs, the plan is dissolved. The shares may have some very small residual value or no value at all.
What Does This Tell Us About ESOPs?The short answer is not much. It is inaccurate and irresponsible to make generalizations about ESOPs—or any other business model—based on one example. Many other newspapers are now bankrupt too, as are many companies. No one seems to be suggesting that we should abandon the investor ownership model for business (albeit a few people have argued that a nonprofit model might be better specifically for newspapers) because all these companies have gone bankrupt.
Moreover, the Tribune deal was extremely atypical of ESOPs. Only a handful of ESOPs have been set up in deeply troubled companies, as the Tribune was when Zell and the ESOP bought it. Research on employee ownership that evaluates the overall experience with these plans (see the articles on this site, such as the one on corporate performance) paints a very positive picture.