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A Detailed Overview of Employee Ownership Plan Alternatives



On a rainy business trip to Florida recently, I got up early and put on my Gore-Tex running outfit to go out for my morning jog. After showering, I threw my Crest Toothpaste into a bag and hurried over to Starbucks for coffee and a pastry. I needed to catch my Southwest Airlines flight soon, but I left my razor at home, so I rushed into the Publix Supermarkets and picked one up. It was going to be a long day, but I felt good that all the products and services I'd used so far had come from companies where the employees were substantial or principal owners.

I have to say my story is a fable, but it could have happened. But what has happened to employee ownership is no fable. There are now over 25 million employees who own stock in their companies through employee stock ownership plans (ESOPs), broadly granted stock options, or 401(k) plans with heavy concentrations of employer stock.

Why Employee Ownership Is Popular

There are a number of reasons for the popularity of employee stock plans. ESOPs provide attractive tax benefits. They allow companies to borrow money and repay it in pretax dollars. They provide a way for owners of closely held businesses to sell all or part of their interests and defer taxation on the gain. The ownership of an S corporation held by an ESOP is not subject to the requirement for other owners to pay their pro-rata share of taxes on corporate earnings. ESOPs also they make it possible for companies to provide an employee benefit simply by contributing tax-deductible shares of their own stock, among other benefits. Broadly granted stock options, restricted stock, stock appreciation rights, and phantom stock do not provide special tax benefits but give growing companies a way to compensate employees with equity or the equivalent of equity rather than more cash. Putting company stock in 401(k) plans provides a less expensive way for companies to match employee deferrals than matching in cash. Employee stock purchase plans (often called Section 423 plans, although not all such plans fall under this part of the tax code from which the name derives) allow employees to put aside part of their paychecks to buy stock, usually at a significant discount.

Just as important, however, are potential productivity gains. Studies consistently show that when broad employee ownership is combined with a highly participative management style, companies perform much better than they otherwise would be expected to do. Neither ownership nor participation accomplishes these significant gains on its own. Companies want employees to "think and act like owners." What better way to do that than to make them owners?

Finally, employees are beginning to expect equity, at least in some sectors. In technology firms, for instance, it is increasingly the norm to offer all employee stock options or other equity because companies that don't have a hard time attracting good people.

As a result of all this, during the last decade, the number of companies sharing ownership broadly with employees has grown substantially. While precise numbers are not available, we estimate that as of 2014 about 9 million employees had stock options, restricted stock, phantom stock, and/or stock appreciation rights. Data for the filing year 2014 from the Department of Labor shows there are 6,669 ESOPs in the U.S. covering over 14 million participants and 10.8 million active participants. They control close to 1.3 trillion dollars in assets. Of these, 8% are in publicly traded companies and 92% in closely held firms.

Percent ownership is difficult to determine precisely because this number is not reported. We estimate the median percentage ownership for ESOPs in public firms is about 5%. Most of these public firms maintain the ESOP along with other benefit plans. The median percentage ownership for private firms is about 30-50%, with about 4,000 companies now 100% employee owned by ESOPs (a percentage that is increasing steadily). While the typical firm has 20 to 500 employees, employees own a majority of the stock at a number of companies with thousands or tens of thousands of employees. About two-thirds the ESOPs in private firms are used to buy out an owner; the rest are typically used as a primary employee benefit plan, sometimes in conjunction with borrowing money for capital acquisition.

For some time, 401(k) plans were also heavily used to acquire employer stock, mostly in public companies. About 19% of 401(k) assets were held in employer stock in 2001, but that number fell to about 8% by 2013 in the wake of the accounting scandals at Enron et al. and, later, the stock market crash. Employees decided (wisely, we think) to be more careful about diversification in plans primarily designed for retirement. ESOPs and individual equity plans, meanwhile, remain good vehicles for asset building.

A significant number of companies provide stock options or other kinds of individual equity to most or all employees. Google, Southwest Airlines, and, Starbucks are among the better known examples. Finally, about 11 million employees participate in employee stock purchase plans, almost entirely in public companies. Typically, these plans allow employees to put aside payroll deductions for 6 to 12 months. Accumulated deductions can (but do not have to be) then used to buy stock, typically at 15% off the lowest of either the price at the end of the deduction period or the beginning. These plans have no special tax benefits for companies, but offer employees the potential to treat gains as capital gains. Unfortunately, there are no good data on the exact number of participants or the size of their holdings, but it would clearly be much less than 401(k) plan assets in company stock.

Because ESOPs are the most complicated and most powerful employee ownership tool, we will start this overview with an explanation of how they work, followed by a discussion of stock options and 401(k) plans.

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