Does employee ownership make a difference in the US?

Summary

Our examination1 of labour- management partnership in the US has looked at the different ways in which unions and management are working together to increase organisational prosperity. This final article in the series considers yet another manifestation of labour-management partnership: employee ownership.

Employee share ownership plans are considerably more popular in the US than in the UK. If a US owner sells all or part of his/her business to the employees, substantial tax savings can be made, which probably explains why thousands of US employers have done this. However, regardless of the reasons why employees acquire ownership of part or all of their organisation, the new situation can be used to increase employee motivation and participation.

And, in a few cases, the setting up of an ESOP can be used to save a company from crisis or extinction. This article examines two such cases - Bliss-Salem and United Airlines - and seeks to identify the impact of the ESOP on employee relations. We also look more broadly at evidence which shows that employee-owned companies perform better than their non-employee owned counterparts.

US industrial relations: Case studies 8 and 9

One method of obtaining worker participation is through property rights, in other words, employee ownership. This phenomenon is increasing rapidly in the US, from 1,600 employee-owned organisations in 1975 to over 10,000 now, though it is not primarily motivated by a desire to increase employee involvement. The main reason for the popularity of employee share ownership plans (ESOPs) is that they provide a highly tax efficient method for retiring family owners to sell their companies to the employees.

The overwhelming tax advantages of ESOPs for ex-owners are not likely to be highly motivating for the new employee-owners, but in a small minority of cases, the setting up of an ESOP has saved the company from extinction in a move largely masterminded by the employees. Where this has happened, workers' relief that they have retained their jobs together with the knowledge that it is now up to them to ensure the economic health of the organisation, has had a powerful effect on employee motivation and participation. Bliss-Salem and United Airlines are two such organisations.

Bliss-Salem: saved by an ESOP

Bliss-Salem currently employs 218 people, up from the 110 in December 1986 when the ESOP was set up, but down from the 600 workers employed in its heyday in the late 1960s. The firm was founded as EW Bliss, in Salem, Ohio, in 1857 as a manufacturer of metal fabrication equipment and rolling mills for the steel, aluminium, brass and copper industries. It prospered in the post World War II era, acquiring French, German and Australian subsidiaries, and was taken over in 1967 by the US conglomerate, Gulf and Western.

The late 1970s and early 1980s brought difficulties in the shape of high inflation, a stagnating domestic economy and new, aggressive foreign competitors. The recession of the early Reagan years (1981-84) made matters worse, and Gulf and Western responded first by selling off EW Bliss's overseas holdings and then by selling its US operations to Carlisle Capital in 1983. Carlisle cut employment from the 400 it had begun with to 100, and asked the remaining workers to accept wage and benefit cuts.

Union initiates ESOP

Local (branch) 3372 of the United Steel Workers of America, fearful for their jobs, managed to get Carlisle to open the books and found that the way the plant was being run, in terms of the withdrawal of revenue, meant that it would never make any money, even if employees worked for free. The union rejected Carlisle's demands for cuts, and suggested instead that Carlisle sell the plant to its employees. Carlisle was a willing seller but it still took 18 months for the buyout committee to raise the finance and recruit a chief executive.

Recovery

By 1996 Bliss-Salem had repaid the loans taken on by the ESOP, doubled employment and was making a healthy profit. The turnover in 1997 was $50 million (£31 million)1. Both management and union attribute this recovery to increased employee participation since the ESOP was set up - it seems to have had a dramatic effect on working practices and industrial relations. As the ESOP was masterminded by the union, it is not surprising that labour-management cooperation has been enshrined in the management structure since December 1986.

The hourly (unionised) and salaried (non-union) employees each nominate one member of Bliss's seven-strong board of directors. The other board members are the chief executive, a nominee from the international union (in UK terms a national union nominee), and three outside (non-executive) board directors who are elected by the employees. With the president of the local union (the hourly-paid workers' representative) on the board, the unionised workforce is directly involved in the company's long-term planning. This oversight or governance role for unions is probably one of the most valuable aspects of an ESOP, since it reassures workers that the board does not have any nasty surprises up its sleeve.

The employees have another channel of influence: the President's Council, which describes itself as an appointed coalition, consisting of two hourly and two salaried members, working together to monitor and give input to management concerning internal actions which would improve the performance of Bliss-Salem. The council meets monthly on its own but also attends the weekly departmental management meeting. In addition, the chief executive makes a presentation every other month to all employees - on a shift-by-shift basis - at which results of all aspects of the company's performance are discussed. Employees also receive quarterly written statements and can attend the company's annual general meeting which reports on earnings for the previous year.

The ESOP had an immediate impact on employee flexibility: there was an initial cut in wages and benefits to make the purchase feasible and job descriptions were reduced from 80 to 16. The number of grievances has plummeted and the firm has diversified production since becoming employee-owned. There are informal improvement policies in operation, alongside the organisation's mission statement commitment to "provide the highest measure of excellence in engineering, manufacturing, service and on-time delivery of metal processing and material handling equipment to enhance the quality and value of customers' end products". Improvements take place when employees bring forward ideas to their supervisors or members of the President's Council. The process is informal because this is believed to be most appropriate in a very traditional manufacturing environment staffed with individuals with many years' service.

100% owned

When Bliss's ESOP was set up it owned 80% of the company; the remaining 20% was reserved as a stock-option purchase plan for management and key employees. Shares of stock are allocated on the basis of hours worked. Each year, all current employees receive an equal amount of ownership from the stock released that year in line with that year's loan payment.

New employees have to wait before they can join the ESOP or become fully vested. To be eligible to join the ESOP, an employee must have worked 1,000 hours and be 21 years old. Their account then begins receiving stock allocations. If, however, they leave the company before they have completed three years' service, they forfeit all the stock in their account. After only three years' service they forfeit 80% of the stock if they leave, after four years' 60%, after five years' 40%, after six years' 20% and after seven years' service no stock will be lost if they leave.

The employee owners, the management team, and observers at the Ohio Employee Ownership Center (see box), all believe that the ESOP has not only saved Bliss-Salem in the most obvious sense, but is a driving force for quality and productivity which will take the organisation from strength to strength.

ESOP is only part of the strategy at United Airlines

United Airlines (UAL) is the world's largest air carrier and has been America's biggest majority employee-owned company since 1994. It now employs around 90,000 people. Like the airline industry as a whole, the company's fortunes are extremely sensitive to business recessions and new technology, while competition from low-cost short-haul carriers has eaten into its profits.

Towards the end of the 1980s, United took a number of steps to ensure its survival and growth, including taking delivery of 289 new aircraft between the end of 1987 and mid-1994. The competitive picture was still unclear, though, and the company felt it had three options to deal with the troubled outlook:

  • accept the status quo;

  • take unilateral management action to radically reshape the airline. Activities under consideration included establishing separate, short-haul regional carriers, outsourcing pilot training and selling the engine shop; or

  • work with employees to reduce costs and increase competitiveness.

    The status quo was not a serious option. Airlines failing to adapt to the changing marketplace (Eastern and Pan Am, for example), have suffered financial losses and gone bankrupt. But radically reshaping the airline would have caused great turmoil and job loss, on top of the 8,000 jobs that had already been cut, so the company felt that it had to pursue the third option.

    United, however, was, in 1994, a traditional, hierarchical, heavily unionised organisation, and it would clearly not be easy to secure radical changes in working practices and reduced labour costs, without offering something pretty substantial in return. The ESOP provided the quid pro quo for workers giving up high wages and employee-focused, rather than customer-directed, working practices.

    Adversarial industrial relations

    Another part of this picture was that industrial relations at United throughout the 1980s had been very adversarial. There was a three-week strike in 1985, for example. A previous chief executive had obtained concessions from the unions in order to "grow" the airline, and then spent the money on acquisitions, which the unions considered a serious breach of trust. United employees have long memories and this incident is still repeatedly brought up to demonstrate that senior management cannot be trusted.

    An ESOP, from which employees would gain substantial rights and financial benefits in the form of dividends and rising share prices, was thus the way of obtaining concessions from employees. It was just a starting point, though, for the real changes that needed to be made to modernise working practices and bring labour costs in line with those of the rest of the industry.

    The current senior vice-president - people at United, Bill Hobgood, has some rather unusual views on the impact of the ESOP on the organisation. On the one hand he cites the benefits of employee involvement in corporate governance (three seats out of 12 on the board), which, he says, reassures workers that they know what's going on, which in turn results in greater trust and an increased sense of security. The ESOP also provides a tool for communicating the need for change, and has led to greater interest from all employee groups in organisational change.

    On the other hand, he believes that in some ways the ESOP has been rather a distraction from the necessary task of dramatically changing working methods and the organisational culture, because managers can't or won't understand why employees don't immediately start to act like owners, and why a union member cannot be turned into a board member overnight. Other impediments to reinventing the workplace through union-management partnership are set out in the box.

    Bill Hobgood also believes that the financial incentives of an ESOP are too remote from day-to-day working life to make much difference, while fluctuations in the value of stock caused by factors entirely outside employees' control, such as the current collapse in Asian economies, are dispiriting.

    New developments

    An ESOP on its own changes little, but United has accrued substantial benefits since 1994 as a result of using it to push the agenda for improvement, though in terms of labour relations, there is still a long way to go. Benefits - actual and anticipated - include:

  • a reduction in labour costs between $500 million and $600 million (between £307 million and £369 million) a year since 1994, expected to total $5.18 billion (£3.18 billion) by the year 2000;

  • earnings in the year 2000 are expected to be $300 million (£184 million) greater than they would have been without the employee buyout;

  • efficiency has improved by 11%;

  • employee complaints are down by 50%;

  • profit margins are up by 7.5%;

  • market share has increased by 1%;

  • 7,000 additional workers have been hired;

  • stock values have risen by 120%; and

  • revenues have increased by 7%.

    Task teams

    Since the ESOP was formed, multifunctional teams have been set up to find ways to improve organisational effectiveness. Employee task teams have been instituted to bring employees from different divisions, authority levels and geographic regions together to solve specific problems or improve processes.

    Teams, which consist of 15 to 25 employees, involve technical and subject experts and volunteers from divisions that have a direct stake in a specific project, as well as representatives from all three unions. Over 3,000 employees volunteered to take part in these teams, and the final step in the selection process for the teams was an assessment, by interview, of applicants' interpersonal and problem-solving skills.

    Several waves of employee task teams have been set up since the ESOP, and these have achieved the following:

  • changes in flight scheduling;

  • improving company communications, especially with regard to employee benefits;

  • developing training materials on employee dependability;

  • making policies on subsidised travel for workers more flexible; and

  • establishing more flexible work schedules for employees.

    Employees and management also worked together to test the company's new innovative ticketing system - this involved an employee team with members from seven different departments - and to make suggestions for a new aeroplane design.

    Labour-management partnership

    So where does labour-management partnership fit into this picture of adversarial industrial relations being incorporated into formal employee ownership? Clearly, one of the expectations that arises when an ESOP is set up is that the parties will change their behaviour because of the new power arrangement: employees will start to behave like owners, and management will defer to the new owners, the workers.

    In practice, changes are much more subtle than this. Workers very gradually bring an ownership approach to issues along with attitudes implicit in their membership of trade unions. Management still has the responsibility for managing but begins to give up a little bit of power and involves workers in decision-making, while at the same time being quite hostile to the union mentality, as distinct from the ownership frame of mind. The situation at United is complicated by the fact that the 28,000 flight attendants are not part of the ESOP.

    Ironically, the most progress towards labour-management partnership has probably been made by the company and the Association of Flight Attendants, despite their non-ESOP status. When Bill Hobgood started work with United at the beginning of 1997, he was immediately given an ultimatum by the flight attendants that he must accelerate the contract negotiations., which had been dragging on for some time.

    Bill Hobgood undertook to accelerate the negotiations in return for union agreement to:

  • participate in joint training in interest-based bargaining;

  • the person who conducted the training to stay involved throughout the subsequent contract negotiations; and

  • total sharing of information and data.

    The responsibility for the negotiations was also transferred from the HR function to the vice-president of on-board services, supported by HR.

    The union agreed and the subsequent process was extremely effective, resulting in an unprecedented 10-year pay deal, with the training and negotiations being completed in a three-month period. The main issue had been that the wages bill for this employee group was $100 million higher than it would have been if UAL had been paying the same wages as its main competitors. Agreement was reached to attain parity with the top four airlines by the end of a 10-year period, although wages were to go up slightly in the meantime. The pilots' amendable date is June 2000, and it is hoped to use the same process to get the contract agreed in advance of that date.

    There are a number of other, lower-profile, issues that are being negotiated with the unions at present, but the interest-based approach is not being used, which, the company says, is a mistake.

    New programmes

    A number of new, joint, labour-management training programmes have been introduced over the last few years. There is a three-day training course in problem-solving which, it is hoped, everyone will attend in due course, though only a minority have done so to date. There is also a one-day event called Mission United during which people discuss and seek to advance core values, profitability and on-time performance. There is a greater emphasis on employee development and 360Þ feedback has been introduced. Pilots are now developed by a process jointly managed and delivered by the union and management.

    The greatest advances, however, says Bill Hobgood, have been made in making existing systems work better. There have been alternative dispute resolution procedures in place for pilots and flight attendants for some years now, and these have been very successful in cutting down the number of grievances that have gone to formal arbitration. These procedures have essentially transferred responsibility for resolving grievances to the local level, on the basis that decisions will not create a precedent for either the company or the union unless both parties wish this to happen.

    Information sharing, problem solving, skill building, mutual trust and respect can, it seems, be just as, if not more, useful in making traditional industrial relations work better than in attempting to construct an entirely different kind of relationship.

    Improve what you've got

    Bill Hobgood's advice to organisations thinking of trying to increase labour-management cooperation is to start with what you've got, and have lived with, and make it better bit by bit. For example, at the beginning of 1996 the pilots' union - ALPA - and the company's negotiating committee sat down together to describe and analyse the current and desired state of the collective bargaining relationship. Although the two bodies themselves had a good working relationship, including a substantial degree of trust, problems were sometimes caused by other parties or issues. These problems included:

  • the company and ALPA sometimes interfered with their committees' ability to pursue options;

  • the parties did not always respect each other's right to disagree;

  • the negotiation process was not always confined to the bargaining table;

  • task team members, both company and union, often believed that they could alter the contract through the task team process;

  • tentative agreements were sometimes rejected for inconsequential reasons, or to get more;

  • financial considerations trumped all others; and

  • the direction given to both parties was often too specific and/or limited to permit an interest-based approach.

    The agreed solutions to these problems included:

  • the company and the union should strive to give negotiators broad goals and objectives and avoid excessive specificity on the "how" or the content of the agreement;

  • constraints on the bargaining authority of either committee, and the nature of the ratification process for each side should be defined at the outset of negotiations;

  • parties should maintain a coherent and timely decision-making process;

  • once an issue is before the negotiating committees, discussions should be confined to the negotiation process;

  • the negotiating committees remain the only official vehicle for changing the contract;

  • integrity in the ratification process should discourage "cherry picking" or "another bite of the cherry" manoeuvres; and

  • the financial and competitive aspects of any question should be balanced with quality-of-life issues.

    It can be argued that efforts of this kind to improve existing ways of working would be helpful to any organisation. "Change efforts", the alternative way of proceeding, "generally encourage unrealistic expectations", Bill Hobgood says, and certainly organisations which are not used to operating strategically, and cannot bring massive resources to bear on changing their systems radically, would do well to consider United's approach, at least as a first step.

    1£1 = $1.627 at the time of going to press.

    1IRS Employment Trends 652, 654, 656, and 660.

    Employee ownership + participation = best performance

    Surveys carried out in two US states - Ohio1 and Washington2 - in the mid 1990s show that employee-owned firms with participative management structures significantly outperform their competitors (in employment and sales revenue growth) immediately after the establishment of employee ownership and over the long term. More specifically, participative employee-owned firms outperform both non-participative employee-owned firms and non-employee owned companies which use participative techniques or which combine them with profit-sharing plans.

    US federal ESOP law requires only minimal voting and information rights be provided to ESOP shareholders in privately ("closely held") companies. There are no requirements for training or employee involvement. Since most ESOPs are put in place to obtain tax advantages for retiring owners, the motivation to involve employees in managing a company once an ESOP is in place are far from clear. And it is certain that employees do not suddenly start to think or behave like owners even when they are owners. Information, training and a participative structure are required to bring this about.

    Intuitive sense

    Some observers believe that involving employee owners makes intuitive sense, which may be why half the 167 Ohio ESOP companies responding to the 1992-93 survey conducted by the Northeast Ohio Employee Ownership Center at Kent State University had significant levels of employee participation, providing full voting rights to ESOP participants. More than half the firms had also implemented one or more programmes for direct employee involvement on the shop floor. About one in three of these groups reported to joint labour management steering committees. Training in "ownership education" rose dramatically, while problem-solving and group process training also rose sharply after an ESOP was put in place.

    The Ohio survey asked managers whether they believed that their ESOP had had any impact on 15 issues, ranging from absence to working conditions. It found that 60% of companies scoring high on employee participation measures believed that the ESOP had had a strong positive impact on the firm's performance, while only 27% of managers in firms with low levels of employee participation said this. More objectively, nearly four in 10 companies with high participation reported increased profits since the ESOP was put in place, compared to around one in four of those with medium participation, and one in five of those with low levels of participation.

    The Washington state survey of 40 ESOPs, carried out in 1993-94, though smaller was more rigorous than the Ohio study in that it compared the financial results of participative and non-participative ESOP firms with those of similar, non-ESOP firms. Unlike the Ohio survey the data it used were not therefore self-reported.

    Growth in employment and revenue

    For the period 1988-91 Washington employee-owned companies overall showed an average annual employment growth 4.6% higher than their competitors. These results, however, were driven by the 12% annual growth of the more participative firms. For the same period employee-owned firms had a 1% edge in annual revenue growth over their competitors. Again these results were driven by the 6.4% gain made by the participative companies. Employee-owned firms which did not use participative management actually performed worse than the non-employee owned competitors. Companies which were both majority-owned by their employees and participative had annual employment and sales growth of 15% and 10% above their competitors respectively.

    The study also found that encouraging participative management or profit sharing in non-employee owned businesses as a means to improve performance is not particularly effective. Firms using profit-sharing and participation only slightly outperform similar companies which do not use these techniques, and did much worse than participative employee-owned competitors.

    1Further information on the Ohio study is available from Dan Bell, Ohio Employee Ownership Center, 309 Franklin Hall, Kent State University, Kent, Ohio 44242, USA, tel: 001 330 672 3028, fax: 001 330 672 4063.

    2Further information on the Washington study is available from Jim Keogh, Employee Ownership Program, Washington State Department of Community Trade and Economic Development, 906 Columbia SW, Olympia, WA 98504-8300, USA, tel: 001 206 586 8984.

    Ohio Employee Ownership Center

    The Ohio Employee Ownership Center, which began life in 1987 as the Northeast Ohio Employee Ownership Center, is one of five centres which are supported by the State of Ohio to encourage labour-management cooperation and economic development.

    It originated in a series of research projects conducted between 1984 and 1986 by Dr John Logue of Kent State University's Political Science department. These explored the impact of employee ownership on Ohio's economy. Dr Logue's expertise in this area led to him receiving a steady stream of requests for advice from those thinking of setting up an ESOP. The establishment of the centre meant that advice could be given in a timely fashion in a crisis.

    The centre's brief is to provide outreach, information and preliminary technical advice to employees, retiring owners, union locals and community organisations interested in exploring employee ownership. The information and outreach aspect of the centre's work is designed to promote the use of employee ownership in a variety of circumstances. The centre deals with about 40-50 possible ESOPs each year. The centre becomes directly involved with about 20 of these, of which five or six are employee buy-out attempts.

    Advice is free up to the point that the ESOP is set up. After this the centre is able to provide training, which the new employee-owned company pays for. The company can also join a network of employee-owners, to which it pays membership dues but through which it can obtain access to training workshops and in-company training in areas such as supervision, involvement, and finance for non-managers.

    The state now provides about 30% of the centre's running costs. A further 25-30% is paid by the companies who obtain services from it and the remaining 40% comes from grants for research and international projects. See note below for details of how to contact the Ohio Employee Ownership Center .

    United Airlines: reinventing the workplace through union-management partnership

    Possible impediments

  • Most change efforts ignore the political character of collective bargaining;

  • management either doesn't understand or ignores the union's political structure;

  • conflict is inevitable;

  • by any measure, the reinventions cannot be termed a partnership;

  • company and union leadership are reluctant to let go of their previous positions;

  • there is inadequate capacity within hourly and salaried ranks to assume new and broader responsibilities;

  • management leadership has a quarterly performance mindset;

  • management often underestimates the investment in time and money;

  • few union leaders are elected on the basis of being pro-involvement;

  • processes must be leadership (typically management) driven;

  • the union can support or block but cannot initiate;

  • processes cannot in and of themselves correct a poor collective bargaining relationship;

  • efforts are activity-focused rather than outcome-focused; and

  • the supervisor's role is ill-defined.

    How to make new workplace systems survive

  • Collectively bargain change efforts;

  • focus energy on conflict-resolution systems; and

  • focus on real performance-profitability, institutional security and job security.

    Source: Bill Hobgood, senior vice-president - people, United Airlines and 30-year Federal Mediation and Conciliation Services arbitrator and conciliator.

    United Airlines: employees cut wages and benefits to buy the company

    In the early 1990s, after four consecutive years of losses, and four previous attempts by employees to buy the business, United Airlines' (UAL) management sought a concessions-for-equity transaction as a way to lower costs and become more competitive with low-fare, no-frills airlines. In 1994, employee groups (except the Association of Flight Attendants) completed a $5 billion (£3 billion) purchase of 55% of UAL stock.

    At the time of the employee buyout, United's labour costs were 46% higher than those of Southwest Airlines, one of its principal competitors. United decided to set up an "airline within an airline", with new entry-level wages and work rules, which would enable it to compete effectively with low-cost operators, and agreement to this and wage cuts throughout the organisation formed the "investment" that employees made to buy the airline.

    United's 8,000 pilots, represented by the Airline Pilots Association (ALPA), invested the most: a 15.7% wage cut; a decrease from 9% to 1% in the company's pension contribution; a cut in holidays for pilots with less than 10 years' service; and agreement to the proposed pay and working practices in the airline within an airline, which were fixed for 12 years. There were to be no normal contract wage negotiations for five years and nine months, although an arbitrator could make an award of no more than 5% at the beginning of the fourth and fifth years if the airline did particularly well.

    For this the pilots received 46.23% of the stock from the ESOP, equivalent to 25.4% of the company, and a promise of no layoffs of pilots employed at the time the ESOP was formed, along with job guarantees if the airline were to be sold.

    The company's 23,000 employees represented by the International Association of Machinists invested: a 9.7% wage cut and cancellation of an agreed 5% pay increase; elimination of the paid lunch break; and the same restriction on normal collective bargaining, and the opportunity to arbitrate a pay increase, as the pilots. In return, the machinists received 37.13% of the shares in the ESOP (20.4% of the airline), pension increases each year from 1995 to 1998, and agreed provisions on job security.

    United's 25,000 non-union salaried and management employees invested an 8.25% wage cut; a redefinition of when the shift differential began; changes to sick pay; elimination of overtime-paid meal breaks; a reduction in guaranteed hours for part-timers from 20 to 16; job cuts; and the same restrictions on future pay increases as the pilots and machinists. These employees received 16.64% of the ESOP (9.2% of the company) and assurances on job security in return for this investment.

    In addition, each of the three employee groups acquired the right to nominate one director to the reconstituted 12-member UAL board of directors. The remaining seats on the board are filled by five public directors, elected by public shareholders, and four independent directors, elected by the independent directors sitting on the board at the time the ESOP was put in place.

    Shares are allocated to pilots and management and salaried employees on the basis of the individual's earnings and the earnings of the relevant employment group. Thus, for example:

  • individual earnings divided by earnings of all pilots = individual pilot's percentage of shares; and

  • individual pilot's percentage of shares, as a proportion of all shares released = individual pilot's number of shares.

    By contrast, shares are allocated to employees represented by the International Association of Machinists on the basis of their "investment credit", the difference between their pay and benefits before and after the ESOP, rather than their earnings as a group.

    It was hoped that United's 28,000 flight attendants, represented by the Association of Flight Attendants, would become part of the ESOP, but this has not happened.

    Employee share ownership plans in the UK

    Employee Share Ownership Plans (ESOPs) are far less popular in the UK than the US; there are only 230 statutory ESOPs (those which qualify for the full range of tax relief) in the UK compared to over 10,000 in the US. This may be because US ESOPs are "less strictly regulated but sometimes more fiscally favoured", according to ProShare, the non-profit making organisation which promotes share-based investment1.

    Another important difference between ESOPs in the two countries is that ESOPs represent a longer-term investment in the US than in the UK. Here, shares acquired by means of an ESOP can be sold at any time, with the disposal protected from income and capital gains tax if the shares are held for at least three years. In the US, shares can only be sold when the employee leaves the organisation, and ESOPs there are thus often thought of as a form of pension provision for employees. In both countries, employers' capital and interest repayments on loans taken out to buy shares for ESOPs are tax deductible.

    In the UK an ESOP consists of two elements: a collective vehicle to hold shares on behalf of employees generally (a trust), and a scheme for distributing shares from the trust to individual employees. The ESOP is unlimited in the proportion of the company equity capital which it can acquire, and the trust can borrow in order to finance its share purchases. The Employee Share Ownership Centre1 defines an ESOP as "an arrangement sponsored by an employer company involving a discretionary employee benefit trust which is capable of borrowing in order to acquire employer shares for allocation to all or most employees."

    Statutory and case law ESOPs

    There are two kinds of ESOPs in the UK, statutory ESOPs, which attract tax privileges, and case law ESOPs, which may not. A statutory ESOP conveys entitlement to three specific tax reliefs:

  • tax relief for the company in respect of its costs for setting up the ESOP;

  • a tax relief for the company for payments made to the trust to enable it to acquire shares, to service and repay any loans, and to meet its expenses; and

  • a capital gains roll-over relief for those who sell their shares to the trust (if the latter has at least a 10% holding in the company).

    In return a statutory ESOP must observe a number of requirements:

  • have at least 50% employee trustees;

  • distribute the shares to employees, whether directly or through an approved scheme;

  • offer to distribute shares to all employees on a fair and similar basis (such as in proportion to wages and salaries, hours worked or service, or a combination of such elements); and

  • distribute the shares within 20 years of acquisition.

    The case law ESOP can be used for whatever purpose the company may choose, but it does not bring any express tax reliefs, though the company may be able to obtain tax relief for its payments to the trust. It can be used to benefit all or any selected directors or employees, but the ESOP is not obliged by law to distribute its shares to individual directors or employees.

    Distributing shares

    An ESOP must set up at least one employee benefit trust (EBT), which acquires the shares, but it can then distribute them in a number of ways:

  • by selling to an Inland Revenue approved all-employee profit-sharing scheme. This achieves distribution on a tax-free basis to employees defined as participants in the scheme;

  • by supplying them to employees exercising options under an Inland Revenue approved savings-related share option scheme, where employees save between £5 and £250 a month for three, five or seven years, and then use the proceeds to buy shares from the EBT at a discounted option price, fixed at the beginning of the scheme, or to employees exercising options under an Inland Revenue approved company share option plan where shares can be bought at a future date at current prices;

  • through SOFA - share options for all (employees) - schemes. Here share options are nominally granted to all employees, and when the options are exercised after at least three years, gains are passed to employees in the form of shares from the employee benefit trust;

  • by selling them at market value to willing employee beneficiary purchasers; and

  • by gifting or selling them at some price below market value, direct to employee beneficiaries. Employees will be liable to income tax on the benefit they thereby receive.

    1Further information on ESOPs can be obtained from ProShare, Library Chambers, 13-14 Basinghall Street, London EC2V 5BQ, tel: 0171 600 0984, and The Employee Share Ownership Centre, 2 Ridgmount Street, London WC1E 7AA, tel: 0171 436 9936.

    Further reading:

  • "Employee ownership: we're the bosses now" (case studies of Tower Colliery and Brighton Transport ESOPs), IRS Employment Trends 587, July 1995.

  • "A share in the firm" (case study of Tullis Russell ESOP), IRS Employment Trends 589, August 1995.

  • "Bus pay 2: the key players" (includes details of Stagecoach's ESOP), Pay and Benefits Bulletin 424, May 1997.

  • "We're all in this together: profit sharing schemes", Pay and Benefits Bulletin 444, March 1998.

    Employee ownership in the US

    Setting up an employee stock ownership plan (ESOP) in the United States works as follows:

    1.Owner desiring maximum capital gains tax relief agrees to sell between 30% and 100% of the company to the ESOP.

    2.The ESOP borrows funds from a commercial lender.

    3.The ESOP uses the loan proceeds to purchase the shares in the company from the owner.

    4.The owner can then invest the sale proceeds in qualified replacement properties (US domestic stock) as part of a retirement fund.

    5.Any shareholder who has owned shares for at least three years can sell them to an ESOP which owns at least 30% of company stock and obtain relief from capital gains tax.

    6.If the company issues new stock and sells it to the ESOP, then the company can use the proceeds for any company purpose.

    7.The company makes annual cash contributions to the ESOP in amounts sufficient to pay off the loan.

    The following example shows the tax advantages to a retiring owner and the company of setting up on ESOP. An owner wants to sell a corporation worth $4 million (£2.5 million). If he or she sells to an outsider there will be a $1 million (£615,000) tax bill. If he or she sells at least 30% of the company to an ESOP, for each $1 million received there will be a $280,000 (£172,000) saving in federal capital gains tax and the $1 million can be reinvested in other US stocks on a tax-deferred basis (as applies to UK pension contributions). Meanwhile if the $1 million is borrowed by an ESOP to buy the owner out, the corporation deducts $1 million of principal repayment from its taxable income, which, depending on its tax rate, could save around $340,000 (£209,000). There is thus a total saving of $620,000 (£381,000) in federal tax, or, more accurately, loss of federal tax revenue for the Government, with the company saving $340,000 and the owner $280,000.

    In cases where an ESOP is set up to save a company in crisis from closure, the tax advantages are much the same but the benefits are more useful to employees who, through an ESOP, can borrow money cheaply to buy an organisation without swamping it with debt. However, only 3% of ESOPs are employee-led and carried through at a time of crises.

    In both cases, ESOPs may be special kinds of pension plans: on the one hand they allow the retiring owner to take money out of the company and use it as a retirement fund; while on the other, the ESOP acquires value from the increasing value of the company's shares (independently valued if it is a private company), which accrues to employees when they retire. In an ESOP, employee ownership is indirect, with shares held in trust. However, while the ESOP itself is a retirement plan, with the company stock held in the ESOP providing the employees' retirement assets, the owner can use the proceeds of the sale for any purpose.

    Paying off the loan

    When the company makes the annual cash contributions to the ESOP to pay off the loan, the payments are made as part of payroll, as a kind of profit-sharing bonus. An ESOP is thus a profit-sharing defined (pension) contribution plan. The proceeds of conventional US profit-sharing plans can be invested for retirement, tax-free, but only 10% can be invested in the employer's stock. An ESOP can invest the entire proceeds in the employer's stock, and indeed must invest at least 50%. The logic of an ESOP is that as the company grows and prospers it will pay off the loan, and the value of the stock will rise, so that when an employee retires their shares can be sold, generally back to the company, releasing funds for retirement.

    Acquiring full rights in an ESOP, a process known as vesting, usually only occurs after a number of years of employment. For example, employees may acquire nothing in years one and two, and 20% each year in the following five years, so that after seven years the employee will indirectly own 100% of the shares allocated to him or her, on the basis of the stock allocation formula.

    Allocating stock to employees

    For the ESOP to qualify for tax advantages, there must be a fair method of allocating stock to employees. The possibilities are:

  • giving every employee the same number of shares;

  • allocating shares on the basis of the equivalent of P60 earnings (called W-2 in the US), with some restrictions on very high earnings;

  • allocating shares on the basis of hours worked;

  • extra allocations for seniority;

  • some combination of these factors, such as 30% equal allocation, 70% on P60 pay.

    How do employees realise the value of their shares?

    Employees receive their shares when they retire or leave the company. Their estate receives the shares if they die while they are in employment. But if the company is privately owned (closely held, in US terminology), to whom can employees sell their shares? The law provides that the company must begin to buy the shares back from the employee within one year of retirement and can do so over a five year-period, thus taking six years altogether.

    If an employee leaves voluntarily or is dismissed, the company can begin to buy the shares back after five years and can complete the transaction over the next five years, taking 11 years in all. If the loan used to buy the shares is still outstanding, the company can wait until the end of the loan period to make a payout to dismissed employees.

    The price of the stock is determined by an independent valuation which is carried out every year. Some ESOPs only give the cash value of shares to departing employees. Some give stock which can only be sold back to the company or the ESOP. Some give stock and the employees must give the company first refusal. Others give stock which can be sold to anyone. The company must, within two years, give employees two opportunities to sell their stock to it. After this the company has no obligation to buy it.

    Where the company is publicly owned, as is the case with United Airlines, and shares can be sold on the open market, the employer has no obligation to buy the shares from the employee, and the employee has no obligation to sell to the company.

    Companies may experience cash-flow problems if a number of long-serving employees retire within a short period of time, so companies are allowed to give such individuals either a lump-sum payment for their stocks, or to phase payment over a period of five years.

    What are the issues confronting managers of US employee-owned companies?

    Employee-owned companies tend to be small - a consequence of the fact that before becoming employee owned they were either family owned or had gone through a period of decline. The management issues facing such organisations thus tend to be entirely different from those of the much larger US companies discussed elsewhere in this series.

    Smaller firms are much more concerned with the day-to-day requirements of doing business and meeting production requirements, and therefore have less time and inclination to develop and implement long-term strategies. But the absence of long-term strategies means that there is no driver for new employee-relations policies. This may explain why a meeting of employee-owned companies held in October 1997 and attended by Industrial Relations Services revealed that the managers are preoccupied with two different kinds of problem:

  • the technicalities of ESOPs, in terms of making sure that extremely accurate records of payments into the ESOP and employee accounts are kept. Investigations of many years' duration into an ESOP by the US equivalent of the Inland Revenue - the IRS - are not uncommon and are a constant worry; and

  • how to achieve the kind of employee involvement that they believe possible.

    ESOP takes a back seat

    Obstacles to the latter include the fact that ESOPs take a back seat in organisations when everyone is busy, and that a certain amount of negativity to ESOPs is encountered among employees mainly because it represents change. All the managers know that establishing trust and openness, and sharing information with employees are prerequisites for obtaining increased employee participation. But having a strategy for achieving this state of affairs is more problematic, probably because elaborate employee-relations strategies are largely unknown in small companies.

    These difficulties are not being experienced by every company, of course. Some have fairly sophisticated policies. Using the ESOP as an aid to recruitment, so that new employees have a definite and positive view about the ESOP before they even start work, had been found to be particularly helpful, for example. But the impression given at the meeting was that at least some of the managers are not at all sure how to attain the employee-involvement benefits that the ESOP promises, in theory at least.

    The relationship between employees and managers in an ESOP fundamentally resembles that in much larger organisations which espouse labour-management cooperation. But size does matter: smaller organisations' inability to achieve the desired level of employee involvement suggests, as do our other US case studies, that a well-thoughtout strategy, substantial resources, effective management, and a highly trained and capable workforce are required to make the most of this approach. This is not to denigrate the efforts of ESOP firms though. As the surveys show, ESOP companies which do achieve high levels of employee participation do considerably better than their competitors.