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A Comprehensive Overview of Employee Ownership
Copyright © 2005 by The National Center for Employee Ownership (NCEO)

Introduction
On a rainy business trip to Florida recently, I got up early and put on my Gore-Tex running outfit to go our 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.

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. And 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 do not provide special tax benefits but give growing companies a way to compensate employees with 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 employees own, or have options to own, stock worth about $800 billion, or about 8% of all the stock in the U.S.

As of 2004, there are about 11,500 ESOPs in the U.S. covering over 10 million participants and controlling about $500 billion in assets. Of these, about 5% are in publicly traded companies and 95% in closely held firms. The median percentage ownership for ESOPs in public firms is about 10-15%. Most public firms maintain an ESOP along with other benefit plans. The median percentage ownership for private firms is about 30-40%, with about 3,000 companies now majority employee owned. While the typical firm has 20 to 500 employees, employees own a majority of the stock of such companies as Lifetouch (15,000 employees), Publix Supermarkets (109,000 employees), and Science Applications (39,000 employees). About half 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.

While ESOPs are the main vehicle for employee ownership, 401(k) plans are not far behind. By 2000, these plans owned about $250 billion in company stock, primarily in public companies. Based on various recent surveys, it appears about 60% of the corporate matching funds in public company 401(k) plans is in company stock, with a much smaller percentage in private firms. Employees can usually also choose to buy shares in their own company in public company 401(k) plans as well. Overall, in 2000, about 18% of all 401(k) assets were in the form on employer stock. While these plans own a great deal of company stock, they rarely own more than 10% of any one company, and few companies with employer stock in 401(k) plans really think of themselves as "employee ownership" companies.

Finally, a growing number of companies are providing stock options to most or all employees. PepsiCo, Starbucks, and Microsoft are among the better known examples. An estimated 15% to 20% of all public companies now do this, as well as perhaps thousands of private firms (no precise estimates are available). In one survey of electronics firms, just over half the responding companies said they provide options to most or all employees, with companies under 100 employees being the most likely to do so. A 2000 study by the NCEO concluded that at least 7 to 10 million employees now receive stock options through plans that offer stock to most or all employees. No reliable data are available on the value of all the outstanding employee options, but various surveys put it in the neighborhood of $500 billion as of early 2001 (although a majority of that is in the hands of senior management). Stock option companies are not motivated by tax incentives, but rather by the conviction that sharing ownership builds a stronger company.

Finally, as many as 15 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.

Employee Stock Ownership Plans (ESOPs)
What Is an ESOP?
An ESOP is a kind of employee benefit plan. Governed by ERISA (Employee Retirement Income Security Act), ESOPs were given a specific statutory framework in 1974. In the ensuing 12 years, they were given a number of other tax benefits. Like other qualified deferred compensation plans, they must not discriminate in their operations in favor of highly compensated employees, officers, or owners. To assure that these rules are met, ESOPs must appoint a trustee to act as the plan fiduciary. This can be anyone, although larger companies tend to appoint an outside trust institution, while smaller companies typically appoint a manager or create an ESOP trust committee.

The most sophisticated use of an ESOP is to borrow money (a "leveraged" ESOP). In this approach, the company sets up a trust. The trust then borrows money from a lender. The company repays the loan by making tax-deductible contributions to the trust, which the trust gives to the lender. The loan must be used by the trust to acquire stock in the company. Proceeds from the loan can be used by the company for any legitimate business purpose. The stock is put into a "suspense account," where it is released to employee accounts as the loan is repaid. However, for purposes of calculating the various contribution limits described below, the employee is considered to have received only his or her share of the principal paid that year, not the value of the shares released. After employees leave the company or retire, the company distributes to them the stock purchased on their behalf, or its cash value. In practice, banks often require a second step in the loan transaction of making the loan to the company instead of the trust, with the company reloaning the proceeds to the ESOP.

In return for agreeing to funnel the loan through the ESOP, the company gets a number of tax benefits, provided it follows the rules to assure employees are treated fairly. First, the company can deduct the entire loan contribution it makes to the ESOP, within certain payroll-based limits described below. That means the company, in effect, can deduct interest and principal on the loan, not just interest. Second, the company can deduct dividends paid on the shares acquired with the proceeds of the loan that are used to repay the loan itself (in other words, the earnings of the stock being acquired help pay for the stock itself). Again, there are limits, as described below in sections on the rules of the loan and contribution limits.

The ESOP can also be funded directly by discretionary corporate contributions or cash to buy existing shares or simply by the contribution of shares. These contributions are tax deductible, generally up to 25% of the total eligible payroll of plan participants.

How ESOPs Are Used
The ESOP can buy both new and existing shares, for a variety of purposes.

• The most common application for an ESOP is to buy the shares of a departing owner of a closely held company. Owners can defer tax on the gain they have made from the sale to an ESOP if the ESOP holds 30% or more of the company's stock (and certain other requirements are met). Moreover, the purchase can be made in pretax corporate dollars.
• ESOPs are also used to divest or acquire subsidiaries, buy back shares from the market (including public companies seeking a takeover defense), or restructure existing benefit plans by replacing current benefit contributions with a leveraged ESOP.
• The use of ESOPs first envisioned by ESOP creator Louis Kelso was to buy newly issued shares in the company, with the borrowed funds being used to buy new capital. The company can, in effect, finance growth or acquisitions in pretax dollars while these same dollars create an employee benefit plan.
• The above uses generally involve borrowing money through the ESOP, but a company can simply contribute new shares of stock to an ESOP, or cash to buy existing shares, as a means to create an employee benefit plan. As more and more companies want to find ways to tie employee and corporate interests, this is becoming a more popular application. In public companies especially, an ESOP contribution is often used as part or all of a match to employee deferrals to an 401(k) plan.

Rules for ESOP Loans
ESOPs are unique among benefit plans in that they can borrow money. Typically, a lender will loan to the company, with the company reloaning the money to the ESOP. The ESOP then uses the loan proceeds to buy new or treasury shares of stock (when the ESOP is used to finance growth) or existing shares (when the ESOP is used to buy shares of current owners). Of course, the ESOP itself does not have any money to repay the loan, so the company makes tax-deductible contributions to the plan that the plan then uses to repay the lender. This means, in effect, the company can deduct principal and interest on the loan, provided the requirements described below are met. The ESOP can borrow money from anyone, including commercial lenders, sellers of stock, or even the company itself. Any loan to an ESOP must meet several requirements, however. The loan must have reasonable rates and terms and must be repaid only from employer contributions, dividends on shares in the plan, and earnings from other investments in the trust contributed by the employer. There is no limit on the term of an ESOP loan other than what lenders will accept (normally five to ten years), and the proceeds from the sale of shares to the ESOP can be used for any business purpose. Shares in the plan are held in a suspense account. As the loan is repaid, these shares are released to the accounts of plan participants. The release must follow one of two formulas. The simplest is that the percentage of shares released equals the percentage of principal paid, either that year or during whatever shorter repayment period is used. In such cases, however, the release may not be slower than what normal amortization schedules would provide for a ten year loan with level payments of principal and interest. The principal only method usually has the effect of releasing fewer shares to participants in the early years. Alternatively, the company can base its release on the total amount of principal and interest it pays each year. This method can be used for any loan, but it must be used for loans of over 10 years.

In either case, it is important to remember that the value of the shares released each year is rarely the same as the amount contributed to repay the principal on the loan. If the price of the shares goes up, the amount released will be higher, in dollar terms, than the amount contributed; if it goes down, the dollar value of the amount released will be lower. The amount contributed to repay the principal on the loan is what counts for determining if the company is within the limits for contributions allowed each year and for the purpose of calculating the tax deduction. The value of the shares released, however, is the amount used on the income statement, where it counts as a compensation cost.

Limitations on ESOP Contributions
First, it is important to understand that in a leveraged ESOP, the amount the company is considered to have contributed to the ESOP or that is defined as an "annual addition" to an employee’s account is based on the amount of principal paid off each year attributable to each employee’s account. The actual addition to an employee’s account, however, is the value of the shares released, but this value is not the one used for contribution and annual addition testing.

Congress was generous in providing tax benefits for leveraged ESOPs, but there are limits. Generally, companies can deduct up to 25% of the total eligible payroll of plan participants to cover the principal portion of the loan and can deduct all of the interest income they pay. Eligible pay is essentially all the pay, including employee deferrals into benefit plans, of people actually in the plan, of $205,000 per participant or less (as of 2004; this figure is indexed for inflation). However, company contributions to other defined contribution plans, such as stock bonus, 401(k), or profit sharing plans, generally must be counted in this 25% of pay calculation. (In 2004, however, the IRS issued a private letter ruling stating that the 25% contribution limit for repaying an ESOP loan is separate from and in addition to the 25% limit for other defined contribution plans; this applies only to C corporations.) On the other hand, "reasonable" dividends paid on shares acquired by the ESOP loan can be used to repay the loan, and these are not included in the 25% of pay calculations. If employees leave the company before they have a fully vested right to their shares, their forfeitures, which are allocated to everyone else, are not counted in the percentage limitations. If the ESOP does not borrow money, the annual contribution limit is now also 25% of covered pay (it had been 15%). Again, contributions to other plans reduce this amount. There are several limitations to these provisions, however. First, no one ESOP participant can get a contribution of more than 100% of pay in any year from the principal payments on the loan that year that are attributable to that employee, or more than $41,000 (as of 2004; this number is indexed for inflation in $1,000 increments), whichever is less. In figuring payroll, pay over $205,000 per year (as of 2004) does not count toward total contribution limits. Second, if there are other qualified benefit plans, these must be taken into account when assessing this limit. This means that employee deferrals into 401(k) plans, as well as other employer contributions to 401(k) plans, stock bonus, or profit sharing plans are added to the ESOP contribution and cannot exceed 100% of pay in any year.

Third, the interest is excludable from the 25% of payroll contribution limit only if not more than one-third of the benefits are allocated to highly compensated employees, as defined by the Internal Revenue Code (Section 414(q)). If the one-third rule is not met, forfeitures are also counted in determining how much an employee is getting each year. If the company sponsoring the ESOP is an S corporation, interest is also not deductible.

Using Dividends to Repay the ESOP Loan
The 1986 tax act allowed companies to take a tax deduction when using "reasonable" dividend payments to repay the ESOP loan. These payments do not count against the contribution limits described above. While the term "reasonable" has never been defined, most consultants believe it is a percentage of share value consistent with what other companies in the industry would pay given similar levels of profits. Many companies are using preferred stock in their ESOPs to allow for higher dividend payments. Whatever kind of stock is used, the amount of the dividends must be allocated to employee accounts. Companies normally allocate these amounts in the form of shares released from the suspense account.

Companies can also "pass through" dividends directly to employees. Typically, companies would pay dividends on allocated shares (whether in a leveraged or nonleveraged plan). These dividends are also tax-deductible to the company. Finally, dividends that are voluntarily reinvested by the employee back into company stock in the ESOP are also tax-deductible to the company. It is possible to combine this arrangement with a 401(k) plan in such a way that the employee can do this on a pretax basis, something that is done mostly in publicly traded companies.

How ESOP Shares Get to Employees
The rules for ESOPs are similar to the rules for other tax-qualified plans in terms of participation, allocation, vesting, and distribution, but several special considerations apply. All employees over age 21 who work for more than 1,000 hours in a plan year must be included in the plan, unless they are covered by a collective bargaining unit, are in a separate line of business with at least 50 employees not covered by the ESOP, or fall into one of several anti-discrimination exemptions not commonly used by leveraged ESOPs. If there is a union, the company must bargain in good faith with it over inclusion in the plan.

Shares are allocated to individual employee accounts based on relative compensation (generally, all W-2 compensation is counted), on a more level formula (such as per capita or seniority), or some combination. The allocated shares are subject to vesting. Employees must be 100% vested after five years of service, or the company can use a graduated vesting schedule not slower than 20% after three years and 20% per year more until 100% is reached after seven years. A faster vesting schedule applies where the ESOP contribution is used as a match to employee 401(k) deferrals. There, "cliff" vesting must be complete in three years and graduated vesting must start after two years and be completed no later than after six years.

When employees reach age 55, and have 10 years of participation in the plan, the company must either give them the option of diversifying 25% of their account balances among at least three other investment alternatives or simply pay the amount out to the employees. At age 60, employees can have 50% diversified or distributed to them. When employees retire, die, or are disabled, the company must distribute their vested shares to them not later than the last day of the plan year following the year of their departure. For employees leaving before reaching retirement age, distribution must begin not later than the last day of the sixth plan year following their year of separation from service. Payments can be in substantially equal installments out of the trust over five years or in a lump sum. In the installment method, a company normally pays out a portion of the stock from the trust each year. The value of that stock may go up or down over that time, of course. In a lump sum distribution, the company buys the shares at their current value, but can make the purchase in installments over five years, as long as it provides adequate security and reasonable interest. ESOP shares must be valued at least annually by an independent outside appraiser unless the shares are publicly traded. Closely held companies and some thinly traded public companies must repurchase the shares from departing employees at their fair market value, as determined by an independent appraiser. This so-called "put option" can be exercised by the employee in one of two 60-day periods, one starting when the employee receives the distribution and the second period one year after that. The employee can choose which one to use. This obligation should be considered at the outset of the ESOP and factored into the company's ability to repay the loan.

ESOP Voting Rules
Voting is one of the most controversial and least understood of ESOP issues. The trustee of the ESOP actually votes the ESOP shares. The question is "who directs the trustee?" The trustee can make the decision independently, although that is very rare. Alternatively, management or the ESOP administrative committee can direct the trustee, or the trustee can follow employee directions.

In private companies, employees must be able to direct the trustee as to the voting of shares allocated to their accounts on several key issues, including closing, sale, liquidation, recapitalization, and other issues having to do with the basic structure of the company. They do not, however, have to be able to vote for the board of directors or other typical corporate governance issues, although companies can voluntarily provide these rights. Instead, the plan trustee votes the shares, usually at the direction of management. In listed corporations, employees must be able to vote on all issues. Voting rights are more complicated than they seem. First, voting is not the same as tendering shares. So while employees may be required to vote on all issues, they may have no say about whether shares are tendered. In public companies, this is a major issue. Almost all public companies now write their plans to give employees the right to direct the tendering, as well as voting, of their shares, for reasons to be explained below. Second, employees are not required to be able to vote on unallocated shares. In a leveraged ESOP, this means that for the first several years of the loan, the trustee can vote the majority of the shares, if that is what the company wants to do. The company could provide that unallocated shares, as well as any allocated shares for which the trustee has not received instructions, should be voted or tendered in proportion to the allocated shares for which directions were received.

What this all means is that for almost all ESOP companies, governance is not really an issue unless they want it to be. If companies want employees to have only the most limited role in corporate governance, they can; if they want to go beyond this, they can as well. In practice, companies that do provide employees with a substantial governance role find that it does not result in dramatic changes in the way the company is run.

ESOP Valuation
In closely held companies and some thinly traded listed companies, all ESOP transactions must be based on a current appraisal by an independent, outside valuation expert. The valuation process assesses how much a willing buyer would pay a willing seller for the business. This calculation is performed by looking at various ratios, such as price-to-earnings, at discounted future cash flow and earnings, at asset value, and at comparable companies, among other things. It is then adjusted to reflect whether the sale is for control (owning a controlling interest in a business is worth more than owning a minority interest, even on a per share basis) and marketability (shares of public companies are worth more than closely held firms because they are easier to buy and sell). ESOP company shares have better marketability than non-ESOP firms, however, because the ESOP provides a market, albeit not as active a one as a stock exchange.

ESOP Tax Benefits for the Selling Shareholder
One of the major benefits of an ESOP for closely held firms is section 1042 of the Internal Revenue Code. Under it, a seller to an ESOP may be able to qualify for a deferral of taxation of the gain made from the sale. Several requirements apply, the most significant of which are:

1. The seller must have held the stock for three years prior to the sale.
2. The stock must not have been acquired through options or other employee benefit plans.
3. The ESOP must own 30% or more of the value of the shares in the company and must continue to hold this amount for three years unless the company is sold. Shares repurchased by the company from departing employees do not count. Stock sold in a transaction that brings the ESOP to 30% of the total shares qualifies for the deferral treatment.
4. Shares qualifying for the deferral cannot be allocated to accounts of children, brothers or sisters, spouses, or parents of the selling shareholder(s), nor to other 25% shareholders.
5. The company must be a "C" corporation. If these rules are met, the seller (or sellers) can take the proceeds from the sale and reinvest them in "qualified replacement securities" within 12 months after the sale or three months before and defer any capital gains tax until these new investments are sold. Qualifying replacement securities are defined essentially as stocks, bonds, warrants, or debentures of domestic corporations receiving not more than 25% of their income from passive investment. Mutual funds and real estate trusts do not qualify. If the replacement securities are held until death, they are subject to a step-up in basis, so capital gains taxes would never be paid. Increasingly, lenders are asking for replacement securities as part or all of the collateral for an ESOP loan. This strategy may be beneficial to sellers selling only part of their holdings because it frees the corporation to use its assets for other borrowing and could enhance the future value of the company.

It is also important to note that people taking advantage of the "1042" treatment cannot have stock reallocated to their accounts from these sales if they remain employees. Other 25% shareholders and close relatives of the seller also cannot receive allocations from these sales.

Financial Issues for ESOP Participants
When an employee receives a distribution from the plan, it is taxable unless rolled over into an IRA or other qualified plan. Otherwise, the amounts contributed by the employer are taxable as ordinary income, while any appreciation on the shares is taxable as capital gains. In addition, if the employee receives the distribution before normal retirement age and does not roll over the funds, a 10% excise tax is added.

While the stock is in the plan, however, it is not taxable to employees. It is rare, moreover, for employees to give up wages to participate in an ESOP or to purchase stock directly through a plan (this raises difficult securities law issues for closely held firms). Most ESOPs either are in addition to existing benefit plans or replace other defined contribution plans, usually at a higher level of pay.

Determining ESOP
Feasibility Several factors are involved in determining if a company is a good ESOP candidate:

• Is the Cost Reasonable? ESOPs typically cost $20,000 and up, depending on complexity and the size of the transaction. This is usually much cheaper than other ways to sell a business, but more expensive than other benefit plans.
• Is the Payroll Large Enough? Limitations on how much can be contributed to a plan may make it impractical to use to buy out a major owner or finance a large transaction. For instance, a $5 million purchase would not be feasible if the company has $500,000 of eligible payroll because annual contributions could be no larger than $125,000 (25%) per year, not enough to repay a loan for that amount. It may be possible to go over this amount somewhat, however, through the use of deductible dividends. Companies can also set up the loan so that the bank loans to the company on one term (say seven years) and the company reloans the money to the ESOP on another (say 12 years), meaning that the principal payments are stretched out longer and the percentage of pay required each year is smaller.
• Can the Company Afford the Contributions? Many ESOPs are used to buy existing shares, a non-productive expense. Companies need to assess whether they have the available earnings for this.
• Is Management Comfortable with the Idea of Employees as Owners? While employees do not have to run the company, they will want more information and more say. Unless they are treated this way, research shows, they are likely to be demotivated by ownership.

Repurchase Considerations
One of the major issues ESOPs must face is the obligation that companies sponsoring them provide for the repurchase of shares of departing employees. The legal obligation rests with the company, although it can fund this by making tax-deductible contributions to the ESOP, which the ESOP uses to repurchase the shares. Most companies either do this or buy the shares back themselves and then recontribute them to the ESOP (and take a tax deduction for that). Either way, shares continue to circulate in the plan, providing stock for new employees. Some companies, however, buy back the shares and retire them or have other people buy them (a manager, for instance).

The repurchase obligation may seem like a reason not to do an ESOP (people often ask, "You mean we have to buy back the shares continually"). In fact, all closely held companies have a 100% repurchase obligation at all times. An ESOP simply puts it on a schedule and allows the company to do it in pretax dollars. Nonetheless, repurchase can be a major problem if companies do not anticipate and plan for it. A careful repurchase study should be done periodically to help manage this process.

ESOPs in S Corporations
While ESOPs in S corporations operate under most of the same rules as in C corporations, there are important differences.

First, interest payments on ESOP loans count toward the contribution limits (they normally do not in C companies). Dividends (S corporation "distributions") paid on ESOP shares are also not deductible.

Second, and most importantly, sellers to an ESOP in an S corporation do not qualify for the tax-deferred rollover treatment.

On the other hand, the ESOP is unique among S corporation owners in that it does not have to pay federal income tax on any profits attributable to it (state rules will vary). This can make an ESOP very attractive in some cases. It also makes converting to an S corporation very appealing when a C corporation ESOP owns a high percentage of the company's stock.

For owners who want to use an ESOP to provide a market for their shares, generally it will make sense to convert to C status before setting up an ESOP. Where selling shares is not a priority, or where the seller either does not have substantial capital gains taxes due on the sale or has other reasons to prefer staying an S corporation, an S ESOP can provide significant tax benefits. However, owners must keep in mind that any distributions paid to owners must be paid pro-rata to the ESOP. The ESOP can use these distributions to purchase additional shares, to build up cash for future repurchases of employee shares, or just to add to employee accounts.

While the S corporation rules make an ESOP very attractive, legislation passed in 2001 makes it clear that these rules are not meant to be abused by companies seeking to create the ESOP primarily to benefit a few people. For instance, some accountants promoted plans in which a company would set up an S corporation management company owned by just a few people that would manage a large C corporation. The profits would flow through the S corporation, which would then not be taxed.

The rules Congress enacted are complicated, but boil down to two essential points. First, people who own more than 10% of the company (including ESOP shares), or who own 20% counting their family members, are considered "disqualified" persons. The ESOP ownership is defined to include synthetic equity as well, such as options. Second, if these disqualified people together own more than 50% of the company's shares (counting their synthetic equity), then they cannot get allocations in the ESOP without extraordinary tax penalties. Congress also directed the IRS to apply this onerous tax treatment to any plan it deems to be substantially for the purpose of evading taxes rather than providing employee benefits.

Steps to Setting Up an ESOP
If you have decided an ESOP is worth investigating, there are several steps to take to implement a plan. At each point, you may decide you have gone far enough and that an ESOP is not right for you.

1. Determine whether other owners are amenable. This may seem like an obvious issue, but sometimes people take several of the steps listed below before finding out if the existing owners are willing to sell. Employees should not start organizing a buyout unless they have some reason to think the parent firm is willing to sell (it may not be, for instance, if its goal is to reduce total output of a product it makes at other locations). Or there may be other owners of a private firm who will never agree to an ESOP, even if it seems appealing to the principal owners. They could cause a good deal of trouble down the road.
2. Conduct a feasibility study. This may be a full-blown analysis by an outside consultant, replete with market surveys, management interviews, and detailed financial projections, or it may simply be a careful business plan performed in-house. Generally, full scale feasibility studies are only needed where there is some doubt about the ESOP's ability to repay the loan. Any analysis, however, must look at several items. First, it must assess just how much extra cash flow the company has available to devote to the ESOP, and whether this is adequate for the purposes for which the ESOP is intended. Second, it must determine if the company has adequate payroll for ESOP participants to make the ESOP contributions deductible. Remember to include the effect of other benefit plans that will be maintained in these calculations. Third, estimates must be made of what the repurchase liability will be and how the company will handle it.
3. Conduct a valuation. The feasibility study will rely on rough estimates of the value of the stock for the purpose of calculating the adequacy of cash and payroll. In public companies, of course, these estimates will be fairly accurate because they can be based on past price performance. In private companies, they will be more speculative. The next step for private firms (and some public companies as well) is a valuation. A company may want to have a preliminary valuation done first to see if the range of values produced is acceptable. A full valuation would follow if it is. Doing a valuation before implementing a plan is a critical step. If the value is too low, sellers may not be willing to sell. Or, the price of the shares may be too high for the company to afford. The valuation consultant will look at a variety of factors, including cash flow, profits, market conditions, assets, comparable company values, goodwill, and overall economic factors. A discount on value may be taken if the ESOP is buying less than 50% of the shares.
4. Hire an ESOP attorney. If these first three steps prove positive, the plan can now be drafted and submitted to the IRS. You should carefully evaluate your options and tell your attorney just how you want the ESOP to be set up. This could save you a considerable amount of money in consultation time. The IRS may take many months to issue you a "letter of determination" on your plan, but you can go ahead and start making contributions before then. If the IRS rules unfavorably, which rarely happens, normally you just need to amend your plan.
5. Obtain funding for the plan. There are several potential sources of funding. Obviously, the ESOP can borrow money. Banks are generally receptive to ESOP loans, but, as with any loan, it makes sense to shop around. Sellers or other private parties can also make loans, but do not qualify for the interest income exclusion. Larger ESOP transactions can also tap the bond market or borrow from insurance companies. Another source of funding is ongoing company contributions, outside of loan repayments. While ESOPs must, by law, invest primarily in employer securities, most ESOP experts believe they can temporarily invest primarily in other assets while building up a fund to buy out an owner. A third source is existing benefit plans. Pension plans are not a practical source of funding, but profit sharing plans are sometimes used. Profit sharing assets are simply transferred in part, or entirely, into an ESOP. Many ESOP companies do this, but it must be done cautiously. If employees are given no choice in the switch, trustees of the plan must be able to demonstrate that the investment in company stock was prudent; if they are given a choice, there could be a securities law issue. Finally, employees can contribute to the plan, most commonly by wage or benefit concessions. Most ESOPs do not require these, but they are necessary in some cases. Clearly, this is an issue that must be handled very carefully.
6. Establish a process to operate the plan. A trustee must be chosen to oversee the plan. In most private companies, this will be someone from inside the firm, but some private and most public companies hire an outside trustee. An ESOP committee will direct the trustee. In most companies, this is made up of management people, but many ESOP firms allow at least some nonmanagement representation. Finally, and most important, a process must be established to communicate how the plan works to employees and to get them more involved as owners.

401(k) Plans
Section 401(k) plans allow employees to defer part of their pay on a pretax basis into an investment fund set up by the company. The company usually offers at least four alternative investment vehicles. Because the law requires that participation in the plans not be too heavily skewed towards more highly paid people, companies generally offer a partial match to encourage broad participation in these voluntary plans. This match can be in any investment vehicle the company chooses, including company stock. There is a limit of 25% of eligible pay that the company can contribute to the plan on a taxdeductible basis. This limit is reduced by other employer contributions to defined contribution plans.

While ESOPs have received the lion's share of attention as the vehicle of choice for employee ownership, 401(k) plans actually now hold almost as much company stock as ESOPs do. Most of the "own company stock" investments in 401(k) plans are in larger companies. In companies with fewer than 200 employees, only 2% is in company stock; it is 8% in companies under 1,000 employees. This increases to 17% for companies with 1,000 to 5,000 people and 32.4% for companies over 5,000. These data also reveal how much of 401(k) assets are in larger companies in general. In companies with over 1,000 employees, a Hewitt Associates study found that 25% of employee contributions to 401(k) plans are in company stock, while about 70% of employer matches are in the form of company stock. Collectively, about 18% of 401(k) assets are in company stock, which, as of 2001, would be worth about $250 billion.

While these numbers add up to impressive absolute amounts, employees rarely own more than 10% of a company through a 401(k) plan. Moreover, research at the National Center for Employee Ownership has found few companies that provide stock in this way think of themselves as "employee ownership companies." Instead, companies simply see this as a convenient or financially favorable investment option.

The continued growth of 401(k) plans suggests, however, that they must be taken seriously as employee ownership vehicles. Over the next decade, if current trends continue, employees could often own 20% or more of many large, public companies. While it is only speculation, we think that at some percentage of ownership, corporate management may start realizing that it would be to its advantage to start thinking of itself as a substantially employee owned company, just as employees will start realizing how much their retirement benefits depend on company performance.

There are several factors that favor the use of a 401(k) plan as a vehicle for employee ownership in public firms. From the company's perspective, its own stock may be one of the most cost-effective means of matching employee contributions. If there are existing treasury shares or the company prints new shares, contributing them to the 401(k) plan may impose no immediate cash cost on the company; in fact, it would provide a tax deduction. Other shareholders would suffer a dilution, of course. If the company has to buy shares to fund the match, at least the dollars being used are used to invest in itself rather than other investments. From the employee standpoint, company stock is the investment the employee knows best and so may be attractive to people who either do not want to spend the time to learn about alternatives or have a strong belief in their own company. Balanced against these advantages, of course, must be an appreciation on both the part of the employee and the company that a failure to diversify a retirement portfolio is very risky.

There are several factors that favor the use of a 401(k) plan as a vehicle for employeeownership in public firms. From the company's perspective, its own stock may be one ofthe most cost-effective means of matching employee contributions. If there are existingtreasury shares or the company prints new shares, contributing them to the 401(k) planmay impose no immediate cash cost on the company; in fact, it would provide a taxdeduction. Other shareholders would suffer a dilution, of course. If the company has tobuy shares to fund the match, at least the dollars being used are used to invest in itselfrather than other investments. From the employee standpoint, company stock is theinvestment the employee knows best and so may be attractive to people who either donot want to spend the time to learn about alternatives or have a strong belief in their owncompany. Balanced against these advantages, of course, must be an appreciation onboth the part of the employee and the company that a failure to diversify a retirementportfolio is very risky.

For closely held companies, 401(k) plans are less appealing, although very appropriate insome cases. If employees are given an option to buy company stock, this can oftentrigger securities law issues most private firms want to avoid. Employer matches makemore sense, but require the company to either dilute ownership or reacquire shares fromselling shareholders. In many closely held businesses, the first may not be desirable forcontrol reasons and the second because there may not be sellers. Moreover, the 401(k)approach does not provide the "rollover" tax benefit that selling to an ESOP does, andthe maximum amount that can be contributed is a function of how much employees putinto savings. That will limit how much an employer can actually buy from a seller througha 401(k) plan to a fraction of what the ESOP can buy.

401(k) contributions cannot be leveraged either, so a sale of company stock would haveto proceed slowly in annual increments. For example, if a company can get 60% of itsworkforce to participate in a 401(k) plan, and they put up 5% of pay (a reasonable butfairly high amount in practice), the company might match this on a dollar for dollar basis,but this would still only come to perhaps 4% of payroll (assuming 401(k) participants tendto be higher paid than nonparticipants).

Despite these limitations, 401(k) plans, and their new, simpler cousins, SIMPLE plans(plans for employers under 100 employees that are much like 401(k) plans but withstricter rules and easier administration), are attractive as ownership vehicles in caseswhere a company simply wants employees to become owners, but has no need to buyout owners or use the borrowing features of an ESOP. A company can simply matchemployee deferrals with company stock or make a straight percentage of pay contributionto all employees eligible to be in the plan in the form of company stock.

Employee Ownership and Employee Motivation
During the early 1980s, the National Center for Employee Ownership conducted an exhaustive investigation of how employees react to being owners. We surveyed over 3,500 employee owners in 45 companies. We looked at hundreds of factors in an effort to determine whether it mattered to employees that they had stock in their company, and if so, when. The results were very clear. Employees did like being owners. The more shares they owned, the more committed they were to their company, the more satisfied they were with their jobs, and the less likely they were to leave. Naturally, some employees in some companies liked being owners more than others. Individual employee response to ownership was primarily a response to how much stock they got each year. After that, employees responded more favorably if they had ample opportunities to participate in decisions affecting their jobs, worked in companies whose management really believed in the concept of ownership and not just the tax breaks, and were provided regular information about how the ownership plan operated.

By contrast, the size of the company, the line of business, demographic characteristics of the employees, seniority, job classification, presence or absence of voting rights or board membership, percentage of the company owned by employees (as opposed to the size of the annual contribution), and many other factors did not have any impact. Employees looked at the employee ownership plan and asked "how much money will I get from this?" and "am I really treated like an owner?" If they liked the answers to these questions, they liked being an owner.

Employee Ownership and Corporate Performance
In 2000, Douglas Kruse and Joseph Blasi of Rutgers University analyzed all the ESOPs set up between 1988 and 1994 for which data were available. They then matched these companies to comparable non-ESOP companies and looked at the sales and employment data for the paired companies for three years prior to a company setting up an ESOP to the period three years after. They found that when they indexed out for the performance of the competitor companies, the ESOP companies grew 2.3% to 2.4% faster after setting up their plan than would have been expected otherwise. That seemed to give strong evidence that ESOPs do make a significant and positive contribution to corporate performance.

Impressive as these findings were, however, they did not indicate what it was about employee ownership that caused the improved performance or whether the improved performance was accounted for by just a subset of ESOP companies with particular characteristics. Other research, however, suggests that it is the combination of employee ownership and employee involvement that really makes the difference.

Knowing the answer to whether employee ownership motivates employees seems to provide the answer to whether ownership improves corporate performance. Not so. In most companies, labor costs are under 30-40% of total costs. Motivation on its own, presumably, makes employees work harder. We often ask managers just how much more work they think they could hope to get from more motivated employees, based on an eight-hour day. Fifteen minutes is a typical response. That comes to just 3% more time. Three percent times even a high estimate of 40% for labor costs results in just a 1.2% savings, assuming everyone will be more motivated, which is, of course, far from true.

While a 1% improvement can be a lot of money, it is not what distinguishes the really successful companies from the mediocre ones. The star performers are those that react to their environment in creative, innovative ways, providing better value to their customers than competitors. How is that achieved? Through processing information and acting on it intelligently. In most companies, information gathering is limited to a group of managers. The generation of ideas is similarly limited. So is decision-making. The assumption is that only these people have the talent, and perhaps motivation, to carry out these tasks.

In fact, no one has more daily contact with customers than employees, at least in most companies. No one is closer to the day-to-day process of making the product or providing the service than the employees. And, employees often do have useful ideas they could share with management.

Thus, for a company to use employee ownership effectively, it needs to do more than motivate people to work harder at what, after all, may not be the most efficient or effective thing to do. Instead, it must enlist employee ideas and information to find the best ways to do the most important things. To do that, companies need to get employees involved. Managers should seek their opinions. Employee task forces, ad hoc and permanent, should be established to solve problems. Quality circles and employee involvement teams can be set up. Individual jobs can be enhanced and supervision limited. Suggestion systems can be implemented. This all may seem like common sense, and it is. It is not very common practice in most companies, however.

Data indicate that it is becoming common in employee ownership companies. In a 1987 General Accounting Office report, about one-third of all ESOP firms had some degree of employee participation. By 1993, a study of Ohio firms by the Northeast Ohio Employee Ownership Center and Kent State University found that about 60% of the companies now had active employee involvement programs, such as autonomous work teams, total quality management, or similar programs. The incidence of participation roughly doubled after the initiation of an ownership plan. These participative firms, the GAO reported, showed a strong improvement in productivity when they combined their ESOPs with participative management practices.

In a study by the National Center for Employee Ownership published in the Sept/Oct 1987 Harvard Business Review, we found that participative ESOP firms grew 8% to 11% faster with their plans than they would have without them. In both the NCEO and GAO studies, no other factors had any influence on the relationship between ownership and performance. Three other recent studies confirmed both the direction and magnitude of these findings. Only participation can translate the motivation of ownership into the reality of a fatter bottom line. Participation is not enough on its own, either, as hundreds of studies have shown. One reason is that few participation programs last more than five years in conventional companies. By contrast, over the last decade we have not found a single ESOP company that has dropped its program.

The structure of participation varies from company to company, but basically boils down to employees forming groups to share information, generate ideas, and make recommendations.

At United Airlines, for instance, employee task teams were formed soon after the employees purchased the company. Over the ensuing two years, the teams took apart every aspect of the business, making recommendations for often substantial changes. The teams were appointed to include a broad cross section of employees, but anyone could volunteer to join one. The ideas helped generate hundreds of millions of dollars in cost savings and new revenues. Ironically, when the teams completed their work, management backed away from the idea of participation, causing the airline some wellreported difficulties in the years that followed. The ESOP is now frozen and both most managers and employees feel that it was not a success. United shows clearly that just setting up an ESOP, and even starting off in the right direction, is not enough. Companies must commit to a long-term ownership culture program.

Stone Construction Equipment Company in Honoeye, NY is a good example. It set up an ESOP set up in the late 1970s was having little impact. Then the company hired a new president, Bob Fien, who started a participative management program. Eventually, all employees were trained in "just-in-time" management and organized into work cells that schedule and control their own work flow and have considerable input into the design and organization of their jobs. Stone had been limping along and had developed a reputation for poor quality; by 1991, the company had made so much progress Industry Week named it one of America's top 10 manufacturers.

At Springfield ReManufacturing in Springfield, Missouri, employee owners are taught to read detailed financial and production data. Meeting in work groups, they go over the numbers then figure out ways to improve them. Employees are sometimes given 90-page financial statements to digest. Springfield's stock went from 10 cents a share when it started its ESOP in 1983 to $21.00 in 1994. Employment increased over 500%. Other approaches include employee advisory committees to management, eliminating levels of supervision while giving non-management employees more authority, meetings between management and randomly selected groups of employees, suggestion boxes, and anything else companies can imagine to get people involved.

This "high-involvement" management style has, of course, become conventional wisdom, if still unconventional practice, at many companies. Is ownership really essential to make it work? There are no conclusive data on this, but there is good reason to believe that ownership, if not essential, is at least highly desirable. First, ownership is a cumulative benefit. Each additional year, an employee has more and more at stake in how well the company performs. It is not unusual in mature plans for the appreciation in share value and employer contributions to add up to 30% to 50% or more of pay in a year. In profit sharing or gain-sharing, both of which are paid periodically and almost always amount to a small portion of total compensation, the benefit always remains relatively minor. Second, ownership has a stronger emotive appeal. People may be very proud to say they are an owner; few would brag to friends they are a profit-sharer. Finally, only ownership encourages people to think about all aspects of a business, not just short term profits or some efficiency measure. This is especially important in companies moving towards open-book management systems.

Conclusion
The continued growth of employee ownership reflects, above all, a changing view of the role of employees in the workplace. To be sure, for some time companies have been saying that "people are our most important resource." This was little more than rhetoric, however, for all but a handful of companies. Investors, capital, technology, and, above all, top management, were really seen as the keys to the company's future. Employees would be laid off or have their compensation limited before these other assets were harmed. Increasingly, however, companies are coming to the view that attracting and retaining good people at all levels, then giving them the authority to make more decisions about more things, is essential to being an effective competitor. In large part, this is a function of technology. The vast amounts of information, and the speed with which it can be processed, leaves companies with little choice but to get more people involved in more things. As people are asked to take more responsibility for the company, it simply makes sense for them to be rewarded accordingly.

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