Sustaining Employee Ownership for the Long Term: Beyster Institute Leading Companies Online Magazine July 2008

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Leading Companies Online Magazine

Sustaining Employee Ownership for the Long Term
By Martin Staubus, Beyster Institute Staff

Companies establish internal ownership (i.e., ownership by working employees) through a wide variety of approaches. Currently, for example, the ESOP-owned S corporation is receiving a good deal of attention (and use) as a system of employee ownership. But that structure has been legally permissible for only the past ten years. Many other structures for employee ownership were available before that time, and continue to be.

One structure that we encounter on a regular basis is one that has been popular at professional service companies, such as engineering firms. It is a system that is based, quite simply, on employee purchases of shares. As newly hired younger professionals become eligible for stock ownership, they are granted the opportunity to purchase shares of the company’s stock. These purchases by newer employees provide the liquidity needed by older employee-shareholders who are ready to retire and divest themselves of their company stock.

That, at least, is the intention. In practice, under this structure, successful companies tend to become victims of their own success. As the company becomes increasingly valuable, long-term, older employees who have risen to senior positions with the firm eventually accumulate large amounts of company stock with large aggregate values. While that is something of a success story as far as it goes, a problem arises when the value of the stock held by departing senior employees exceeds the purchasing capacity of younger incoming employees. In short, for departing employees to have liquidity within such a purchase-based system of employee ownership, the younger employees must be both able and willing to commit the necessary dollars of purchasing power. And almost inevitably, there comes a point where they are neither.

The Problem

A fundamental challenge for any system of internal stock ownership is to find a way to meet the obligation to provide liquidity to shareholders who want to divest shares of company stock. Where will that cash come from?

To identify solutions, a starting place is to recognize that there are a limited number of sources for that cash:

Cash belonging to employees
Cash belonging to the company
Government subsidies (via tax deductions) made available for this purpose
New (outside) investors
Sales of company assets
Sale of the company itself

Of these possible sources, some are plainly inconsistent with the notion of sustained employee ownership. Alternative 6, for example – a sale of the company – will certainly provide liquidity to shareholders, but it also inherently puts an end to internal ownership and control. Alternative 5 – a sale of selected company assets – may be implemented on a very limited basis, but is unlikely to be sustainable on an ongoing basis. So, too, alternative 4 – a sale of new shares to a private investor – is problematic on a number of fronts, not least of which is the impracticality of doing this on a regularly recurring basis.

Strategic approaches to supplying liquidity for a system of internal ownership, then, typically focus on the first three alternatives listed above. For many business leaders, the most appealing means of providing liquidity to current shareholders is to arrange for other employees to buy the shares from the shareholders who want liquidity. And indeed, as noted at the outset, many companies that are committed to internal stock ownership start out with an ownership system that relies exclusively on this liquidity mechanism.

As we have discussed, however, such systems tend to become increasingly problematic over time, with the stock value held by the “older generation” of employees outstripping the collective purchasing power of the incoming “younger generation.” When this happens, what’s next? As we continue through the list of possible sources of cash for shareholder liquidity, we find that there are only two other available sources remaining: the cash of the company; and tax subsidies.

As companies consider how to fashion a sustainable system of internal ownership, then, they will likely want to focus on systems that supply the cash for liquidity from the following sources:

Purchases by other employees
Cash made available through government tax subsidies
Free cash flows of the company

Let’s look at some ideas that may help with this challenge.

The Internal Stock Market

Many companies (SAIC and CH2MHill among them) have adopted a dynamic and highly effective system of employee ownership through the concept of the “internal stock market” that enables employees to buy and sell shares to and from each other. There are a number of ways to structure such an arrangement. What is feasible and appropriate will depend in large part on the size of the company and its ability to absorb certain fixed costs. The basic concept, however, is that administrative procedures are established to promote and facilitate the buying and selling of shares among employees.

In the cases of SAIC and CH2MHill, those companies registered their stock with the SEC so that employee stock transactions could be handled by a licensed brokerage (SAIC created its own subsidiary brokerage firm; CH2MHill contracted for services with an outside brokerage). Smaller firms, for which the costs of SEC registration and brokerage services are prohibitive, have obtained SEC approval for a simpler version of the internal market in which the company itself conducts sales of stock to employees wishing to purchase and then uses those sales proceeds to fund the purchase of shares from employees seeking to sell. The SAIC and CH2MHill systems offer quarterly opportunities to conduct such stock transactions. Since each quarterly trading opportunity requires a new valuation of the stock, there is an administrative cost to each trading period. Smaller firms, therefore, generally offer such trading periods at less frequent intervals.

Tax Subsidies to Support Employee Ownership

In 1974, Congress enacted a set of tax subsidies to support and encourage the ownership of company stock by the firm’s employees. These provisions of tax law were included in the landmark “ERISA” legislation, in a then-obscure section that created something called the employee stock ownership plan, or ESOP. The ESOP offers several forms of tax subsidization to support the practice of internal company ownership. The cornerstone subsidy, however, is the provision that enables a company to redeem shares from its shareholders on a pre-tax, deductible basis. This is significant, in that absent an ESOP, a company’s stock redemptions must be done on an after-tax, non-deductible basis.

As an example, consider the case of a company (for simplicity’s sake, a cash-basis taxpayer) that earns $1 million in net pre-tax earnings. This company wants to use all its available earnings for the repurchase of stock from shareholders. Because the $1 million in earnings are pre-tax in this example, the company would first have to pay income tax on that sum. The combination of federal and state corporate income taxes of course varies from state to state, but on average runs to about 40. Thus, the company in this example would pay $400,000 in total income taxes, leaving $600,000 available to fund the redemption of stock.

Now suppose the company, still wanting to redeem as much stock as possible, forms an ESOP. It can contribute the entire $1 million in earnings to the ESOP, thereby generating a $1 million tax deduction and eliminating its income tax liabilities. The ESOP will then use the entire $1 million it received from the company to redeem stock from shareholders. The result of using the ESOP, then, is that the amount of funds available for stock redemptions was increased from $600,000 to $1,000,000 – an increase of 67 percent in the cash available for share redemptions.

Cash Management Techniques to Smooth Cash Demands on the Company

While an effective internal stock market and the judicious use of tax subsidies can ease the demands on the company for cash to fund stock redemptions, those mechanisms will certainly not eliminate the need for company cash entirely. Even an ideally designed system of internal stock ownership will at least periodically demand cash contributions from the company (albeit at lower levels than would a less-well-designed system). As any CFO will appreciate, these cash demands will be harder to cope with if they are “lumpy” and easier to deal with if they are smoothed from year to year.

Three practices can help to manage and smooth such cash flow demands. First is the establishment of the internal market that allows and enables employees to sell shares prior to retirement. Under a system of stock ownership that provides no opportunity for shareholder sales prior to retirement, the retirement of a major shareholder necessarily presents a major cash flow challenge for the company, since the individual’s entire shareholdings will be presented for redemption all at one time. In contrast, where employee-shareholders have an opportunity to sell shares prior to separating from the company, they can (and typically will) begin to sell down and diversify their company shareholdings over several years leading up to their separation from employment. Thus the redemption of the individual’s shares is spread over a multi-year period.

The second cash flow smoothing practice is to pay selling shareholders for their stock in multi-year installments. If an employee holds stock worth, say, $500,000 at the time of his retirement, the company can redeem that stock by paying $100,000 initially, plus a note promising to pay $100,000 per year (with interest) for the next four years. By using this technique aggressively and variably (that is, only when needed), the company can limit the impact of stock redemptions on the financial health of the business.

The third cash flow smoothing practice is to use an ESOP to spread out the cost of redeeming large blocks of stock. A central feature of an ESOP is its ability to borrow cash for use in purchasing company stock. The company itself must give the ESOP enough cash each year to make its loan payments to the lender. But these payments are, once again, tax deductible (so 40 percent of the money sent to the bank consists of cash that would otherwise have been paid in taxes); and more to the point for our present topic, result in spreading the cash cost of redeeming a large block of stock over a multi-year period.

A Final Consideration

As you grapple with the challenge of addressing the liquidity demands associated with internal stock ownership, it is important to keep in mind that the means by which a company’s employees are able to sell their shares will also go a long way toward determining the system by which employees will acquire their shares. After all, the disposition of a share by one party is necessarily the acquisition of the share by another party. In effect, the issue of how employees should “divest” stock and the issue of how they should “acquire” stock are simply two sides of a single coin. The fact is that, to be successful and sustainable, a system of internal stock ownership must necessarily effectuate both dispositions and acquisitions of shares – and through the same mechanisms. As we work to design a system of employee ownership that assures sufficient liquidity to the employee-shareholders, then, it is essential that we not lose sight of the overriding need to create an ownership system that offers fair and appropriate provisions regarding the means by which employees will acquire shares in the first place and go on to participate in the company as inspired, committed and engaged employee-owners. Don’t kill the patient in order to save it!

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