Observations on Employee Ownership
An ESOP for the Tribune Company? Things to Know in Assessing the Transaction
April 2007The proposal by Sam Zell to use an ESOP to purchase the Tribune Company has now been accepted (see the Tribune's press release). The deal must still pass a variety of regulatory approvals, however, including a determination by the independent trustee of the ESOP (GreatBanc Trust) that the transaction structure and the price paid for the shares are fair to ESOP participants.
The proposed transaction is complicated. It appears, however, that when all the dust settles, the ESOP will end up with at least 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 might be purchased by the ESOP, sold to other investors, or sold in a public offering or sale of the company.
The ESOP will be governed by an independent trustee who, under the law, must make decisions for "the exclusive benefit of plan participants." This is defined to mean that the trustee should seek to maximize the long-term value of plan assets; it does not mean the trustee should become the advocate for employees on issues such as pay, layoffs, or other work-related issues.
Transaction StructureInitially, Sam Zell will invest $250 million in cash. Of this, $200 million is a loan to the company to purchase shares, plus $50 to buy shares. One month later, the ESOP will borrow 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 will then borrow enough money to do a self-tender offer at $34 per share to buy half the outstanding shares, including those currently held by an existing ESOP at the Tribune. If the company obtains all the needed regulatory approvals, a process that will take many months, debt will be used to take the company private at $34 per share. Zell's $250 million in stock will be bought with additional debt, but Zell will 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 will be 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 will come from existing employee plans or contributions. If the deal does not go through, shareholders will be guaranteed the $34 per share plus 8% annual growth, compounded daily, in any final transaction.
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.
When the Tribune Company converts to S corporation status, another tax benefit will kick in. 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 current retirement plans will be changed somewhat. For most employees, the current plan involves a company contribution to the 401(k) plan that can be as much as 4% of pay if an employee defers 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 can have different arrangements. With the ESOP, the company will contribute 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. So employees will generally receive more from the company overall, but they will be somewhat less diversified.
The deal will involve a great deal of debt, and one question is whether this will mean future layoffs, asset sales, cuts in compensation, or changes in business strategy that might compromise the editorial integrity of the papers. It should be noted, of course, that any proposed transaction for the Tribune, with or without an ESOP, would likely involve as much or more debt, and that many of these transactions end up with assets being sold, employees being laid off, and/or compensation being reduced.
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 will be 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).
Will the ESOP Help 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. The considerable debt the company will assume may limit the value of these deductions, at least for the immediate future, unless strong profits are forthcoming.
A more important issue 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.