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The Employee Ownership Update

Corey Rosen

August 27, 2004

(Corey Rosen)

ESOPs Strong in Closely Held Companies But Not Making Public Company Inroads

ESOP advisors continue to report very strong activity in new ESOPs in closely held companies. As the baby boomer generation retires, many owners of closely held businesses will look for transition strategies, and ESOPs seem well positioned to benefit from this development. Public companies, however, have not flocked to ESOPs, despite some prominent predications of that after the 2001 tax law changes. Those changes allowed ESOP participants to reinvest dividends paid on ESOP shares on a voluntary basis back into the ESOP. For public companies, this could provide a double benefit: the dividends would be tax-deductible, and the company would sell more shares. Employees could avoid the 15% tax on dividends passed through directly to them. Articles in the financial press, including the Wall Street Journal, quoted financial (but not ESOP) experts who predicted a boom in ESOPs in public companies.

So what happened? Part of the explanation is the fallout from Enron and similar scandals. That has made public company plan trustees more skittish about company stock in retirement plans. A number of interim decisions in lawsuits concerning company stock in 401(k) plans and ESOPs have ruled that companies cannot use securities law rules to avoid making disclosures to plan participants about potentially damaging corporate information. While few final decisions have been made in these lawsuits (although some have tentatively settled), the trend in interim decisions has been mixed about who is a fiduciary and what role company stock can play in a plan. While it appears that trustees continue to have considerable leeway in investing in company stock, this does not provide a free pass on assuring it is still a prudent investment.

But even without these legal developments, public companies still find ESOPs relatively unattractive because in a leveraged plan the company must take a charge to compensation for the value of shares as they are released to participants, even if this is much more than what the company paid for them. As a result, companies have tended more to favor simply contributing stock to 401(k) plans on a nonleveraged basis.

Percentage of Companies with Broad-Based Equity Plans Dropped Slightly in 2004

The percentage of public and private companies with one or more of any kind of equity compensation plans that specifically offered stock options to nonexempt employees dropped slightly in 2004 compared to 2003, falling to about 13% of the 996 companies responding to the annual WorldatWork Salary Budget Survey (885 of which were public), down from 15% in 2002. 885 of the respondents were public companies. While option usage fell, the use of other kinds of broad-based plans (phantom stock, restricted stock, performance shares, and stock grants) rose slightly, from a combined 5% in 2003 to 6% in 2004. Most of this change occurred in private companies, where stock options for nonexempt employees fell from 18% in 2003 to 10% in 2004, while the use of other kinds of plans increased from 5% in 2003 to 10% in 2004.

The use of all kinds of stock plans for nonexempt employees is down sharply, however, from its peak in 2001, when 28% of responding companies offered options to nonexempt employees. The number now stands about where it was in 1997. For management employees, there has been a decline in the prevalence of stock options, from a peak of over 90% in 2001 to 78% in 2004, but other kinds of stock award plans are up sharply.

...But New Survey Finds Pre-IPO Companies Still Favor Broad-Based Ownership

A new survey of over 120 pre-IPO technology companies shows that 96% of their employees get new-hire stock option grants and 85% get follow-on grants. At the same time, the use of equity awards in these companies has grown significantly in the last year, with stock options accounting for 18% of total company ownership in 2004, up from 14% in 2003. The data come from an annual compilation by the consulting firm Syzygy. Participants in the study either have paid to participate in the survey or are clients of law firms that pay Syzygy a fee. The Syzygy and WorldatWork findings are not necessarily at odds. Pre-IPO tech companies were a larger percentage of all companies around 2000 than they are today.

FASB Changes Options Accounting Rules on Amortization

Responding to criticism, the FASB has changed its approach to vesting issues when accounting for stock options. In FASB's exposure draft on options accounting, options with graded vesting would be treated as if employers had issued multiple awards. An expense would be recorded for all vesting increments at the same time, starting from the date of grant, rather than recording an expense for each increment sequentially. Critics said the result would be to move more of the expense to current expenses rather than over the life of the award. On August 19, however, the FASB changed course, reverting to the guidance under FAS 123, which allowed companies the choice to recognize the awards on a straight-line basis.

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