Employee Stock Ownership: What Every Corporate Director Should Know

March 24, 2009

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Question 1:

How common is it for companies to share stock ownership with their employees?

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Answer:

Best available survey data* indicate:

– More than 35 million Americans now own employer stock or stock options

– This is almost 50% of the people employed at for-profit companies.

* http://www.nceo.org/library/eo_stat.html

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Most widely used ownership vehicles

Type of Plan Total Number of Employees*

• ESOPs 14 million• Employee stock purchase plans 11 million• Stock option plans 9 million• 401(k) plans 7 million• Restricted stock plans 4 million• Other 2 million

*Total on this page exceeds 35 million total on previous page because some employees are in multiple plans

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Question 2

Why are so many companies granting ownership interests to employees?

What are the companies and their original owners expecting to gain by it?

(Okay, that’s two questions, but who’s counting?)

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Answer

Two goals dominate:

1. Improving the performance of the company

2.Providing liquidity to shareholders of privately held companies

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Question 3

How can employee stock ownership improve corporate performance?

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Answer (part 1)

Practical, tactical benefits

Helpful in recruiting talent – Smaller firms can compete with well-funded big firms

Effective tactical incentive– Rewards are well aligned with owner’s goals

Improved cash flow– Employee compensation partly in non-cash equity– Non-cash equity awards create deductions that

reduce cash going to taxes

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Warning!

Most companies make poor use of employee stock ownership programs!

Most stop there (at Answer Part 1), and miss out on the full power of employee stock ownership to boost performance!

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Answer (part 2)

Employees who have a stake in the outcome will buy into a high-performance way of operating – if you create one.

High-performing employee ownership companies have a “business-centered culture” with high levels of - Collaboration- Teamwork- Responsibility- Commitment

Employee ownership + operations as usual =results as usual

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Question 4

What evidence is there that this approach actually produces improved performance?

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Summary of the Research

• Rutgers University study (2000)– Study of 686 firms, half with employee ownership, half without– Employee ownership increased company sales and sales per

employee by 2.3% per year

• University of Maryland study (1986)– Companies with employee ownership and employee

participation grew 8% to 11% faster than comparables without.

• Washington State study (1989)– Companies with employee ownership and employee

participation grew sales 6% faster than comparables without.

• City University of New York (2007)– Companies with employee ownership and employee had sales

per employee 8.8% higher than comparables without.

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More nimble, more innovative, more successful

“SAIC succeeded by creating an environment that allows individuals to make a difference – and to share in the resulting growth.”

Dr. J. Robert BeysterSAIC

“I know of not one company in Silicon Valley that has achieved real success without sharing equity with its employees.”

John Chambers, CEOCisco Systems

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Question 5

How can employee stock ownership provide liquidity to private company shareholders?

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The Entrepreneur’s Problem

The classic good/news bad news story, as delivered by an entrepreneur’s accountant:

“The good news is that your company has achieved success and is now worth a large sum.

The bad news is that 92% of your personal net worth is tied up in one asset.”

An ESOP is a vehicle that enables a private company owner to sell stock – a lot, or a little.

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Answer: the leveraged ESOP

Technical definition of an ESOP:

A qualified retirement trust that is authorized to borrow money in order to acquire investment assets

Practical definition of an ESOP:

A program by which a company’s stock can be purchased by a trust on behalf of the company’s employees using a bank loan arranged by the company.

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How a Leveraged ESOP Works…

Leveraged ESOP Transaction Structure

Typical Term LoanCompany

ESOP TrustShares Shareholders

Lender

(1)

(2)

(3b)

May Be Longer or Shorter Term

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Amortization is 100% Pre-Tax…Repaying the Loan

Loan Repaid Over Negotiated Period

Company

ESOP TrustSuspense Account Allocation

Lender

Contribution/Dividend

Debt Reduced over Whatever period

Makes sense

(2b)

(3)

(1)(2a)

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ESOP Benefits

• Shareholder can sell stock at fair market value

• Stock is purchased on behalf of employees – financed via bank loan

- company repays loan all on pre-tax basis (principal and interest)

- effect is that government pays approx 40% of purchase cost

• No adversarial party to negotiate against– Owner can choose how much to sell, when to sell, control other terms

• No new parties enter the ownership picture– Stock goes to employees (all participate in proportion to W-2 pay)

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ESOP Benefits (cont’d)

• Shareholders can sell stock tax free! (Tax Code Section 1042)

• Fully Tax-Deductible Financing

• In multi-owner situations, very attractive way to cash out one or more owners while leaving others in place

– Perfect solution for family-owned companies

– Perfect solution for companies owned by multiple co-founders

• Significant Improvement in:– Employee Morale and Productivity

– Retirement Benefits

– Company Cash Flow

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About the Beyster Institute

The Beyster Institute at the UCSD Rady School of Management was founded by Dr. J. Robert Beyster in 1986 as an independent non-profit advisory group. Dr. Beyster was the founder and then-CEO of SAIC, and was spurred to found the Institute by the many inquiries he received about SAIC’s highly successful system of employee stock ownership.

In 2004 the Institute became a part of the Rady School of Management. As a part of the University, the Institute continues to pursue its original role: to serve as a center of expertise on the effective use of employee stock ownership tools and principles, and to provide expert guidance and direction to business leaders who seek help in this area.