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The Employee Ownership Update

Corey Rosen

August 14, 2008

(Corey Rosen)

Cost Accounting Standards Board Finalizes ESOP Rules for Government Contractors

On May 1, the U.S. Cost Accounting Standards Board issued final rules for reimbursable costs for government contractors that have ESOPs. Since the 1980s, there has been considerable uncertainty about how the costs of funding an ESOP would be treated. Under the final rules, the term "ESOP" includes any defined contribution plan designed to invest primarily in employer stock. Under these rules, reimbursements will be for the market value of the shares at the time a contribution is made. In a leveraged ESOP, this means the cost basis of the shares when purchased, not the accounting value under the American Institute of Certified Public Accountants' Statement of Position (SOP) 93-6, which requires a compensation charge based on the value of the shares released at the time they are released. Under the new rules, the cost will be assignable to a cost accounting period only to the extent an allocation is made to participant accounts by the tax return filing date, including any permissible extensions. For leveraged ESOPs, the allowability of the costs will follow Federal Acquisition Regulation Part 31, which allows companies to charge the costs of principal and interest on an ESOP loan provided the stock is acquired at fair market value. The regulation does not distinguish in this regard between S and C corporations. Companies operating under an existing approved reimbursement procedure can retain that method or renegotiate under the new rules.

The rules also state that dividends used to repay a loan are allowed as a cost. However, there is some uncertainty about this as a Boston office of the Cost Accounting Standards Board recently denied reimbursement for dividends.

Study Finds Broad-Based Options in Venture-Backed Companies Both Common and Effective

Data on the extent and effectiveness of broad-based equity plans in closely held companies are scarce and based on samples too limited to be persuasive, but we recently came across one significant exception. In "Give Everyone a Prize? Employee Stock Options in Private Venture-Backed Firms" (2005, unpublished), John R.M. Hand of the Kenan-Flagler Business School looked at data from 2004 and 2005 provided by VentureOne, a provider of data on venture-backed firms. The sample consisted of 1,032 venture-backed companies responding to the survey for which adequate data were available. The study found the mean percentage of employees getting options was 89%, and 74% of the companies granted options to everyone. In other words, contrary to the conventional wisdom that broad-based equity awards have been disappearing in venture-backed companies, they are in fact almost universal.

Hand's study looks at whether granting options deeply into the organization is a good strategy for venture investors. He correlates the fraction of the firm's employees receiving shares and finds that granting options to more employees results in better performance than granting them more narrowly. The specific measures are too complex to describe here, but they essentially create a hypothetical optimal depth of options granted. Using that optimal depth, Hand concludes that firms that err of on the side of too many people getting options do better than those that err on the side of too few.

The argument here is that granting options too far down poses minimal risk because lower-level employees usually get smaller grants. In contrast, not granting far enough downthe ladder can create a substantial risk that potentially critical people will not be retained or motivated. So it is better to err on the side of caution.

ESOP-Owned EBO Group Creates Model for Engaging Employee Owners in Innovation

Innovation has become the defining feature of successful companies in today's market. People often think about business innovation in terms of high-technology, but any company can be innovative in ways large and small. For instance, ESOP-owned EBO Group in Sharon Center, Ohio, was facing a declining market for its large machinery for mining or tunneling. It found a new market in recycling equipment, but the real breakthrough came several years ago when the employee owners started a new venture in a new market with different technology-developing medical chairs that convert into stretchers. They quickly became the leading company in that industry. Now the employees are teaming up with Bowling Green State University to develop offshore wind turbines. They have also created a new solar business, and are working with a venture capital group to look at still other endeavors. EBO has discovered that by engaging employees at all levels, and tapping into local resources, companies can constantly redefine themselves to stay successful.

Winning Workplaces and the Wall Street Journal Host Conference Celebrating 2008 Top Small Workplaces

Winning Workplaces and the Wall Street Journal will hold their annual conference to honor the 15 top "winning workplaces" for 2008 in Chicago October 14-15. Last year, five of the winners were NCEO members, and employee ownership will again be on the agenda this year. The meeting offers an opportunity to learn from successful leaders of small business who have found innovative ways to engage employees, from open-book management to employee teams to innovative rewards systems and more. Notable speakers include Colleen Barrett, president emeritus of Southwest Airlines; Alan Murray, executive editor of the Wall Street Journal Online; and Trish Karter, CEO of Dancing Deer Baking Company, which gives options to all of its employees. Corey Rosen of the NCEO was one of this year's judges and will be speaking at the event. For details, go here.

New Equity Survey Open for Participation

NCEO member Stock & Option Solutions is conducting a brief equity compensation market research study. It will make the data available to the NCEO for analysis. The survey contains questions about technical resources, net exercise provisions, and biggest challenges in equity compensation. By participating in the survey, you will get a copy of the results and be entered in a drawing to win one of three $25 gift cards. Please complete the survey here.

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