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[Date Prev][Date Next][Thread Prev][Thread Next][Date Index][Thread Index] Who pays for ESOP shares?
Here is my "Who Pays...?" paper as an EM. I will send it separately as a Word
file for the paper bank.
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Who Pays for ESOP Shares?
ESOP Analysis and Evaluation
David Ellerman
World Bank*
*The findings, interpretations, and conclusions expressed in this paper are
entirely those of the author and should not be attributed in any manner to the
World Bank, to its affiliated organizations, or to the members of its Board of
Directors or the countries they represent.
Table of Contents
ESOP Analysis and Evaluation
The Ideology of the ESOP Movement
Labor-based Aspects of Conventional ESOPs
The Basic Contribution of the ESOP Idea
Who Pays for ESOP Shares?
Technical Analysis of "Who Pays for ESOP Shares?"
The No-Dilution Argument
ESOP Loan = Direct Loan + Diluted Sale
What About the No-Dilution Argument?
The Case of a Non-Leveraged ESOP
An ESOP Loan--Compared to What?
Analysis with Non-Negligible Worker Shares
Analysis of the Leveraged ESOP Buyout Transaction
Numerical Example of Buyout Analysis
Non-Tax Benefits of ESOPs
References
The Ideology of the ESOP Movement
ESOPs are certainly touted as "worker capitalism"--although the reality is
interestingly different from the advertisements. But first we should consider
the ideologies surrounding ESOPs.
The originator and popularizer of the leveraged ESOP was Louis Kelso. Kelso's
"two-factor theory" is particularly bizarre. When today's economists talk about
"productivity," they are referring to labor productivity. Kelso apparently
inferred that capitalist economists think that labor is the only productive
factor (never mind over a century of criticism of the labor theory of value by
the same economists). Kelso has discovered another productive factor, capital,
so there are really two productive factors, labor and capital. Kelso announced
this discovery in a book Two-Factor Theory (Kelso and Hetter, 1967), and his
theories are often referred to as "Binary Economics" (see Kelso, 1988a).
How does all this relate to ESOPs? Kelso claims that capital is much more
productive than labor, and that if labor was really paid according to its
productivity, the workers would not receive a living wage. Thus the economy is
askew; labor is being paid more than it is worth so that workers can survive,
and capital is underpaid. Kelso's solution is to give workers a capital income,
to make them "capital workers" in addition to labor workers. Then labor and
capital can each be paid what they are worth, workers will do well on their two
incomes, and the economy will finally be set aright.
To professional economists, Kelso's theories have all the earmarks of a
self-taught credit-crank, and they treat him accordingly.
The U.S. today has so-called ESOP plans that give some tax loophole advantage
to certain kinds of profit-sharing trusts. Louis Kelso, a San Francisco
lawyer, has made extensive claims for such innovations. Often John-Law
schemes, in which somehow, out of bank loans, equity is created from thin air,
get involved in the profit-sharing Gospel. Those few economists who have
audited the economic theories underlying the proposals and the claims made for
them have generally not rendered favorable verdicts on them. I must concur in
these negative appraisals. (Samuelson,1977, n. 3, p. 16)
Indeed, anyone who announces in the twentieth century that they have discovered
the productivity of capital is not likely to be met with a chorus of hosannas
from the economics profession. While economists have treated the two-factor
theory as beneath comment, ESOPs have nevertheless grown to cover about 10 per
cent of the workforce in a decade and a half. Something is happening that
requires attention.
In the circles of ESOP promoters, Kelso's "two-factor theory" and "binary
economics" is all very politely ignored, and treated only as the idiosyncratic
indulgence of the founding father of the ESOP concept. Senator Russell Long and
other ESOP advocates such as Jeffrey Gates use a populist or redistributive
approach. ESOPs cut workers in on a "piece of the action." ESOPs help correct
the obscene maldistribution of income and wealth in America. When people get
rich, it is usually through the appreciation of equity capital, not through
wages and salaries. When profits are made and reinvested in companies, that
accrues to the existing equity holders, and does not create any new equity
owners. The ESOP changes that. Some of the reinvested profits flows to the
workers through their ESOP. The workers can thus cut into the otherwise
"closed-loop" financing system; some of the flow of new value is redirected to
them. Since the closed-loop system exemplifies the logic of capitalism--to
those who have capital, the profits shall be given--ESOPs must initially violate
that logic in order to cut into the loop. This non-capitalist feature of ESOPs
will be considered in the next section on the labor-based aspects of ESOPs.
Ownership of a corporation legally includes control of the corporation. The
redistributive theme of cutting workers in on a piece of ownership is rather
silent about cutting workers in on a proportional part of control. The ESOP
movement is sometimes characterized as being "democratic" in a spread-the-wealth
sense. Many of the ESOP boosters are in fact anti-democratic in the original
sense of the word "democratic" pertaining to self-governance. Sometimes the
whole question of workplace democracy is passed off with simplistic "Not all
Indians can be chiefs" remarks as if all workers would be managers or "chiefs"
in a democratic firm. That is hardly the real reason for managers' antipathy
since after over two centuries of political democracy, they are well aware that
democracy does not mean that "all Indians are chiefs." Rarely do those who have
management power desire to be accountable--particularly to those who are
managed.
There is another reason why the ESOP movement has not faced up to the real
question of democracy. It is a total captive of the Fundamental Myth that
governance rights are part of property ownership. ESOP ideology is the ideology
of ownership.
One can construct an excellent political analogue by considering a government
where the franchise was based on land ownership. Indeed, before the political
democratic revolutions in the West, political sovereignty over people's lives
was sometimes interpreted as being based on property rights in land. The
monarch was the ultimate owner and ruler of the land. Some power was delegated
to lesser nobilities who had "tenancy" and thus governed various regions of the
country. The ownership of land was equated with political sovereignty over the
people on the land. The landlord was the Lord of the land. By substituting
capital for land, that interpretation of pre-democratic political government
becomes one of the intellectual origins of the Fundamental Myth which interprets
governance rights over workers as part of the "ownership of the means of
production."
Given such an ownership-based system of political government, one could imagine
two strategies for the transition to political democracy:
(1) a broadened ownership rights strategy, or
(2) a broadened human rights strategy.
In the approach of "broadened ownership" (to use a common ESOP phrase), the
equation between land ownership and political sovereignty would not be
challenged. Instead, the idea would be to "democratize" and broaden the
ownership of land, to "give the little guy a piece of the action." By becoming
small landholders, some people would then gain a small measure of political
control over their lives.
In the broadened human rights approach, the idea would be to sever the
connection between land ownership and political control so that the rights to
govern the people residing in a community could be transformed into personal
rights assigned to the functional role of residing in that community.
While there was some weakening of the grip of traditional landed property by the
development of numerous small holders, the political democratic revolutions of
the eighteenth and nineteenth centuries ultimately took the human rights
approach and did not stop short with "broadened ownership." There are good
reasons for this. The right to democratic self-determination should be a human
right, not a property right which must be "purchased" from its prior "owners."
>From a practical viewpoint, it is a will-o'-the-wisp to think that political
democracy could be approximated by keeping the rights to govern people's lives
as property rights.
It is a fundamental fact that property rights can be concentrated into a few
hands, while personal rights are automatically decentralized on a one-per-person
basis. As long as political power was based on property ownership, it would be
futile to expect the broadened ownership of small landholders to fundamentally
challenge the historical concentrations of property and power. Political
democracy was only established by removing the question of political sovereignty
from the whole arena of property rights through universal suffrage without
property qualifications.
That analogy captures the redistributive impulse in ESOP ideology. The
redistributive impulse is well-intended. But it usually contains no clue that
the road to democracy lies not in redistributing property but in separating the
governance rights off from property ownership and in restructuring those rights
as personal rights attached to the functional role of being governed. That is
the road already taken by political democracy, and that is the road ahead for
economic democracy.
Labor-based Aspects of Conventional ESOPs
Progressive ESOP commentators (including the author) have sometimes drawn an
over-simplified contrast between "worker-capitalist" conventional ESOPs on the
one hand, and worker cooperatives and democratic ESOPs on the other hand. Yet
one of the great ironies in the ESOP phenomenon is that in spite of the constant
drumbeat of worker capitalist ideology amongst conservative ESOP boosters, even
the conventional ESOPs have a number of significant labor-based characteristics.
In a pure worker capitalist firm, the workers would individually own the shares
and the shares would be freely salable. Some workers or managers might buy
shares, other might not. The correlation between work in the firm and ownership
would be "accidental." In a democratic firm, the workers hold the membership
rights as personal rights inherently correlated together with work in the firm.
The annual patronage is allocated to the capital accounts of the workers in
accordance with their labor often as measured by wages or salary. The capital
rights embodied in their internal capital accounts are built up while working in
the firm and are paid off when the workers leave the firm.
In an ESOP, the shares are not individually owned as salable property; they are
held in a trust. The trust prevents a worker from selling his or her shares
while working in the firm. It is also not an individual decision to become an
owner. As loan payments are made on an ESOP loan, the typical arrangement is
for shares to be allocated to the accounts of all the currently employed workers
in the firm. Moreover, the shares are usually allocated between the accounts in
accordance with the workers' wages or salaries. If that initial distribution of
shares was not labor-based, then capitalless workers could never cut into the
closed-loop system of capitalism. And when the workers leave the firm and can
then sell the shares freely, the usual arrangement is for the firm to buy back
the shares.
Thus the conventional ESOP, not to mention the democratic ESOP, already
implements significant parts of the legal structure of the democratic firm.
This is not surprising in view of the legislative history of the ESOP. It is a
variation on a pension plan. Participation in a pension plan is correlated with
employment in the firm. Firms do not make pension contributions for people not
working in the firm, and there are non-discrimination clauses which require that
the pension contributions are not restricted to only certain workers. The
shares purchased with the pension contributions are not individually salable by
the workers; the shares are held in a trust. And the pension contribution for
each worker is proportional to the worker's labor as measured by pay. All these
labor-based characteristics of pension plans carry over to ESOPs giving them
their strong labor-based flavor in spite of the "official" worker-capitalist
ideology.
The labor-based characteristics of American ESOPs have given ESOPs some
advantages over worker capitalist firms and even over traditional stock
cooperatives. When the connection between ownership and work is accidental,
then the workers and their shares are "soon parted." Worker capitalist firms
that are successful don't remain worker-owned very long. Sooner or later there
is a share-selling stampede and the workers sell out in favor of managers or
outsiders. Thus there are few worker capitalist worker-owned companies. The
ESOP in turn is rather stable. Some management-dominated ESOPs have sold out
but that has been relatively rare.
The non-discriminative aspect of the ESOP also addresses another of the old
problems in worker-owned companies, the degeneration into two classes of
owner-workers and non-owner-workers. Traditional stock cooperatives, such as
the plywood cooperatives in the Pacific Northwest, have had a degeneration
problem as new workers could not afford to buy the shares of departing workers.
Mondragon-type worker cooperatives in the United States are structured with
membership attached to work in the firm. After a probationary period, the
up-or-out rule requires that workers either be accepted into membership or have
their contract terminated. But that up-or-out rule in American co-ops is
typically only embedded in the by-laws, not in a state or Federal statute. Thus
greed can set in and the current members can change the by-laws to close off
membership to new workers. For ESOPs, the non-discrimination clause is part of
Federal law.
The degeneration question is related to the old question of why more firms
aren't set up as worker-owned firms in the first place. One important reason
can be understood by reviewing the virtues of financial leverage. If the
residual claimants of an investment project anticipate future profits resulting
from more capital, they will want to raise the funds by borrowing as opposed to
sharing the anticipated profits with new equity-holders. Financial leverage
gears up the return of the current equity-holders.
The same logic holds for renting people as for renting capital. The employment
relation is the legal instrument for human leverage. The people involved in
starting up a new company of course anticipate that it will be profitable.
Therefore it is in their interest to hire the additional people needed in the
company as opposed to allowing them in as members. Thus the people who control
the legal form of a new company will tend to choose the capitalist form (with
themselves as the owners) instead of the democratic form of organization.
The same phenomenon can be observed in the political sphere. The leaders of
successful revolutions or coups are in a position to determine the new form of
government, and they rarely choose a democracy that could vote them out in a few
years. Marxism has been the choice of many revolutionaries in part because it
provides a covering ideology for non-democratic government. Capitalist
entrepreneurs and Marxist autocrats have more in common than first meets the
eye.
The Basic Contribution of the ESOP Idea
What do ESOPs do; what is their basic contribution to worker ownership? Why
haven't workers previously cut into the closed-loop financing system? Workers
can't just buy companies; they don't have the cash. But why can't they get the
credit? Why can't they take out loans backed by the value of the assets to be
purchased with the loan money? There are several reasons. If a buyout was
totally leveraged in that fashion, then in the face of difficulties the workers
could "walk away" with little or no loss leaving the bank to try to auction off
the assets to recover on its loan. Thus banks look beyond asset value to
"equity" put in by the borrowers--money that would be lost if the borrowers
defaulted on the loan. Workers usually don't have that type of equity.
Moreover, the cash demands of running a business extend beyond owning the plant
and equipment. They need operating capital to pay the initial expenses and
salaries until the revenues start to come in. Borrowing that money may be even
more difficult particularly with uncertainty about the market for the product.
There is also prejudice against worker buyouts on the part of many traditional
lenders ("That's not labor's role.") but it is not the deciding factor. "Banker
bashing" is the easy excuse used by those who are unwilling to examine the more
objective reasons why workers have traditionally had great difficulty financing
buyouts.
One alternative is for the workers to only buy part of a company--a company that
is already operating and showing profits. What is the collateral for the loan,
and how will the workers make the loan payments? If the workers put up little
or no equity, then the purchased stock might be the collateral. But how can
workers make the loan payments? The dividend stream over the term of the loan
would in general be quite inadequate to pay off the principal and interest on
the loan (since stock may be valued at the discounted value of all future
dividends). Moreover, the company can't declare greater dividends on the worker
shares without paying the same on all shares. In addition, dividends are
twice-taxed income, once at the corporate level and once at the individual
level.
Some other collateral and some other method of payment is needed to pay off the
loan for the worker share purchase. Here the ESOP idea makes its true
contribution.
Basic ESOP Idea:
Use the borrowing power of the company itself to take out
the loan to buy worker shares, and pay the loan off as a
labor expense deductible from taxable corporate income.
The ESOP does address the traditional problem of the workers getting credit
because the earning power of the company itself backs up the loan. And it
addresses the problem of paying off the loan since the company itself pays off
the loan--and with pretax income. That basic ESOP package has been further
"sweetened" by additional ESOP legislation (see Blasi, 1988)--which may or may
not survive future congressional efforts to reduce tax breaks.
To evaluate the uniqueness of the ESOP contribution, one might compare an ESOP
with traditional benefit plans. The idea of a company increasing worker share
ownership and treating it as a deductible expense is not new; that was the
purpose of a stock bonus plan where deductible bonuses to the worker were paid
in stock. Deductible cash contributions to a trust with the workers as
beneficiaries are also not new; that occurs in the usual defined contribution
pension plan. An ESOP differs from a stock bonus plan in that it can be
leveraged; it can take out a loan to buy shares. An ESOP differs from a pension
plan because it buys shares in the employer company (whereas pensions must be
diversified). The leveraging feature is crucial because that makes the ESOP
into a financial tool. Relaxing the diversification requirement allows the ESOP
to be a financial tool for employee ownership (of the employer company).
Who Pays for ESOP Shares?
Worker shares and employer tax breaks? Are ESOPs totally "win-win"? Who pays
for the shares in the ESOP?
The analogy or "picture" used by ESOP boosters is that of a loan that is
invested in some productive project which in turn yields the cash flow to pay
off the loan. By this picture, it appears that no one else pays for the shares;
they are created out of pure credit and good investments. The new capital is
"self-liquidating"; it pays for itself out of new profits.
This new capital is self-liquidating, meaning that it is designed to pay for
itself out of the increased profits flowing from expanded production. What
keeps most people from acquiring self-liquidating capital is lack of access to
long-term credit. (Speiser, 1985, p. 429)
Kelso paints a similar picture using "in effect" metaphors.
In effect the employees are buying the stock and personally repaying the
price, because from the moment that stock is purchased it is theirs. The
corporation gives its guarantee to the bank that it will make a certain
scheduled level of payment necessary to enable the trust to pay off its loan.
These payments are, in effect, dividends which amount to a relatively full
payout of the earnings of the assets represented by that stock. (Kelso, 1988b,
p. 5)
But this lovely picture is inaccurate on two crucial points.
Firstly, the loan to buy the stock is not collateralized by just the stock but
by the earning power of the company. It is by no means clear that earning power
and loan repayment power is based on "capital" as opposed to "labor." American
union leaders involved in ESOP deals have been quick to point out that their
members usually must take a cut in pay and benefits (and perhaps relax the work
rules). Even if employees do not take a pay cut in the beginning, lenders
realize that in the event of difficulties, employees are more willing to finance
debt repayments with pay cuts if they are the beneficiaries as in the ESOP
arrangement.
Secondly the loan is not paid off by the cashflows thrown off by the stock
investment; the dividend stream is quite inadequate to pay off a term loan. The
company is obliged to pay off the loan with appropriately timed contributions
channeled through the ESOP back to the bank. Those ESOP contributions must be
made whether or not the return from the firm's investment of the loan proceeds
would pay off the loan. Thus the picture of pure credit being used to finance a
self-liquidating investment is only a "picture."
Another pollyanna description of the ESOP transaction is the no-dilution
argument that there is no dilution since the shares are purchased at their full
market value. This argument would be fine if the loan used to purchase the
shares at their full value were paid off by a third party. But the company
itself is paying off the loan to the ESOP that was used to purchase the shares.
ESOP descriptions often involve a type of "shell game" of switching between two
quite different interpretations of the transaction. The front-end is described
as an equity injection--a purchase of shares at full market value. And the
back-end of the transaction is described as paying off a loan with pretax
dollars. But if the front-end is described as shares being purchased with
money borrowed by another party (the ESOP), then it should be added that the
corporation itself pays off the other party's loan with the ESOP contributions.
And if the back-end of the transaction is described by paying off a loan with
pretax dollars, then it should be added that the company has already "paid for"
the cash injection (the loan) with the transfer of shares to the ESOP. But
ESOP descriptions often focus on either the front-end equity injection or the
back-end tax-favored loan payments without giving the effect of the whole
transaction.
A stark way to state the argument is that a company pays twice for the funds
received in an ESOP loan, once by issuing the shares and once in paying back the
loan. One transaction is a quid pro quo, and the other transaction is
tax-advantaged. Thus instead of 100% dilution (the second time the funds are
paid for), the dilution is reduced by the amount of the tax break. In a 40% tax
bracket, the ESOP shares are paid for 40% by the tax break and 60% by dilution.
The question of "Who pays for ESOP shares?" can be answered precisely if a
number of "extreme-case" assumptions are made: the worker shares do not result
in lower wages or lower wage demands; the worker shares do not lead to any
increase in productivity or efficiency; the firm could have gotten the same loan
on the same terms without using the ESOP; and there are no other tax or non-tax
advantages associated with putting the loan through the ESOP. Under those
assumptions, the ESOP shares are paid for by the combination of dilution of the
existing shareholders and the tax break associated with paying the loan off with
pretax dollars.[see below for numerical examples and algebraic arguments]
Fortunately, the extreme-case assumptions usually do not hold. There are some
tax breaks that apply specifically to ESOP loans in the United States so that
the company usually cannot get the loan on the same terms. Sometimes ESOPs are
established as part of an explicit wage concession bargain. Even more often,
there seems to be implicit bargains or expectations that future wage demands
will be tempered if an ESOP is installed. And lastly, there is good evidence
that ESOPs do improve productivity particularly when coupled with concrete
worker participation programs inside the firm (see Quarrey, Blasi, and Rosen,
1986; Blasi, 1988). The combination of these factors would decrease the part of
the ESOP shares paid for by dilution of the existing owners--by increasing the
tax breaks and by having the workers make a contribution through wage
concessions and productivity enhancements.
Do these other factors completely counterbalance the dilution effect? In view
of the rapid spread of ESOPs, one must conclude that for many firms, the
dilution is either counter-balanced, or there are non-economic factors that
outweigh any remaining dilutive effect such as the owners' desire to reward the
workers and/or to induce the workers to more closely identify with the firm.
Technical Analysis of "Who Pays for ESOP Shares?"
The No-Dilution Argument
One of the important arguments concerning the question of "Who pays for ESOP
shares?" is the no-dilution argument. Since shares are purchased by an ESOP at
their full (appraised or market) value, it is argued that no dilution is
involved. To see the flaw in the argument, let us consider a loan to a
corporation both with and without an ESOP. Since the dilution is of less
practical concern in an employee-owned company with majority or more employee
ownership, it may be assumed that any ESOP shares constitute a small minority of
the outstanding shares. The numbers are only illustrative. The loan is for the
same amount, say $200, in both cases (with and without an ESOP). The annual
interest rate is 15%. The loan is, for simplicity, paid back in one $230
principal and interest payment at the end of the year. In order to make the tax
break significant, assume the earnings before interest and taxes or EBIT are
$1,030 and assume the corporation is in the 50% tax bracket.
The corporation without an ESOP cannot deduct the $200 principal payment on the
loan, only the $30 interest payment. The corporate income tax is 50% of $1000
(1030 - 30) or $500. The remaining $500 goes to the owners (e.g., as retained
earnings or as dividends).
Non-ESOP Corporation
EBIT $1030
- Interest -30
Taxable Income $1000
- Income Tax (50%) -500
Increase to Equity $500
With a leveraged ESOP, the $200 loan proceeds were used by the ESOP to purchase
$200 of newly issued shares at their full value from the company, and then the
proceeds were used in the same manner by the corporation. We make the
assumption (which can be relaxed later) that the earnings EBIT are the same
regardless of whether or not the loan is channeled through an ESOP. At the end
of the year, the same $230 for the loan was paid in the form of an ESOP
contribution and deducted from the same $1030 EBIT so the taxable income is now
$800. The tax is $400 so the remaining $400 was the increase in owner's equity.
ESOP Corporation
EBIT $1030
- ESOP Contribution -230
Taxable Income $800
- Income Tax (50%) -400
Increase to Equity $400
When the loan was channeled through the ESOP (as opposed to the non-ESOP loan),
the workers obtained $200 worth of shares in the company. Who ultimately paid
for them? Were the previous owners diluted in the total transaction (loan and
payback through the ESOP) in spite of the shares being purchased at full value?
The questions can be answered by comparing the situations without and with the
ESOP. The government tax receipts were decreased by $100 (= 500-400) so $100 of
the $200 worth of employee shares was paid for by the tax break. The other
shareholders' equity increase was $400 with the ESOP as opposed to $500 without,
so the other $100 of the $200 of worker shares was paid for by the reduced
increase in the shareholders' equity. Actually the previous non-ESOP owners
would receive slightly less than the $400 since a proportionate part of those
capital gains (or dividends) would go to the ESOP shares. But we will ignore
this additional loss to the other owners by assuming that the new ESOP shares
are a negligible portion of the total shares.
Thus we have the answer to the question of who pays for the $200 of ESOP shares.
If the corporation is in the 50% tax bracket, 50% or $100 is paid for by the tax
reduction and 50% or $100 is paid for by the reduction in what would otherwise
be the shareholders' equity.
If the company had been in a 30% tax bracket, then 30% of the $200 or $60 would
be paid for by the tax reduction and 70% or $140 would be paid for by the
relative reduction in equity.
Non-ESOP Corporation (30%)
EBIT $1030
- Interest -30
Taxable Income $1000
- Income Tax (30%) -300
Increase to Equity $700
ESOP Corporation (30%)
EBIT $1030
- ESOP Contribution -230
Taxable Income $800
- Income Tax (30%) -240
Increase to Equity $560
The difference in tax receipts if $60 and the difference in equity is $140 which
again sums to the $200 of worker shares. The general result is that for $S
worth of worker shares and 100t% taxes, the tax break accounts for tS and the
reduction in relative equity is (1-t)S which sums to S.
ESOP Loan = Direct Loan + Diluted Sale
Under our assumption of no change in earnings between the ESOP and no ESOP
cases, for every $100 of loan that a corporation channels through an ESOP (as
opposed to a direct non-ESOP loan) at 50% taxes, the owners lose $50, the IRS
loses $50, and the employees gain $100.
Is that dilution? Yes, the effect is exactly that of dilution (but repackaged
as part of a complicated transaction). This has been pointed out in the
literature, e.g., "Perhaps the most serious problem is the dilutive effect which
an ESOP can have on the pre-existing ownership." [Hartman et al. 1977, 44]
To see this clearly, consider the first situation where the $200 loan was not
channeled through an ESOP. Suppose then that an ESOP was established but that
the Government simply agreed to give $100 of the $500 tax payment to the ESOP if
the company would sell $200 worth of shares to the ESOP in return for that $100
tax refund. That certainly would be dilution by any definition since the $200
worth of shares were sold at half price for the $100 tax refund (passed through
the ESOP). In general, the Government gives $tS to the ESOP which passes it
through to the company in return for $S worth of shares.
That is the net effect of the more complicated transaction (loan through ESOP to
buy shares with loan repayment back through ESOP). That is, the Government got
$400 taxes (=500-400), the owners' equity increased by $400 (=500+100-200), and
the workers got $200 worth of shares. Thus we can see what has really happened,
when stripped down to the economic essentials, in the whole complicated loan
transaction through the leveraged ESOP. In effect, the Government took $tS part
of the tax bill and donated it to the ESOP which used it to purchase $S worth of
shares from the company. Thus the $S worth of shares are paid for the $tS tax
break and the $(1-t)S dilution.
It is easy to misunderstand this argument about the economic essentials of the
leveraged ESOP transaction. I am not saying that the government actually gives
$100 to the ESOP which then purchases shares at half price. I am saying that if
the normal non-ESOP direct loan (the first situation described above) was
accompanied by this tax-donation and the diluted share-sale, then the end
results are exactly the same as with the leveraged ESOP loan (the second
situation above). Hence the net effect of channeling the loan through an ESOP
as opposed to a direct non-ESOP loan is exactly that tax donation and diluted
sale.
What About the No-Dilution Argument?
The no-dilution argument is clearly mistaken. But where is the error? How can
there be dilution since the shares were actually purchased at full market value
by the ESOP? That argument would be fine if the shares were purchased and the
loan was paid off by some third party. But it is the corporation itself which
pays off the loan with the deductible ESOP contributions. The $200 ESOP
contribution expense reduces the owners' equity by $200 but half of that is
counterbalanced by the $100 reduction in the tax bill. As was pointed out about
a quarter century ago in the Harvard Business Review, the "net effect is that,
in the case of a 50% taxpayer, the addition to net worth is half that of a
straight equity issue to third parties." [Reum and Reum 1976, 139]
ESOP descriptions often involve a type of 'shell game' of switching between two
quite different interpretations of the transaction. The front-end is described
as an equity injection; a purchase of shares at market value. And the back-end
of the transaction is described as paying off a loan with pretax dollars. But
both descriptions leave out a crucial bit of information. If the front-end is
described as another party (ESOP) using borrowed money to inject equity into the
company, then it should be added that the company itself is paying off the loan
(with the loan payments packaged as ESOP contributions to get the tax break).
And if the back-end is described as paying off a loan with pretax dollars, then
it should be added that the company has already 'paid for" the cash injection
('loan') with the transfer of shares to the ESOP.
To put it simply, the company 'pays' for the cash twice, once with the shares
transferred to the ESOP and once with the loan payments. One of the times is a
straight quid pro quo transaction and the second time is a dilution attenuated
by the tax break.
The Case of a Non-Leveraged ESOP
It is also useful to consider a third situation which utilizes a non-leveraged
ESOP. The loan is to the corporation rather than the ESOP. But when the $200
principal payment is made at the end of the year, a simultaneous contribution of
$200 worth of new shares is made to the ESOP. That yields a deduction of $200
from taxable income so the principal payment is in effect covered by the ESOP
contribution. The interest payment is already deductible from taxable income.
The only real difference between the leveraged and non-leveraged ESOP examples
is that, in the latter case, the ESOP shares do not capture any of the $400
capital gains (since the ESOP got the shares only at the end of the year). But
we have already assumed that the new ESOP shares were a negligible portion of
the whole ownership so that effect would be negligible.
The results concerning "Who pays for ESOP shares?" are, of course, the same. It
is even clearer in the non-leveraged case that the $200 worth of ESOP shares are
being paid for with the $100 tax break with the remainder being a $100 dilution.
This case of the non-leveraged ESOP reveals a surprising conclusion. The loan
itself is actually irrelevant to the transfers between the government, the
owners, and the employees (no matter how important it is for other reasons).
Forget the loan in the non-leveraged case. Instead of issuing $200 worth of new
shares to cover the loan principal payment, just issue $200 worth of shares to
the ESOP anyway. The end results are the same: the tax bill decreases by $100,
the owners' equity is diluted by $100, and the workers have $200 worth of shares
in the ESOP. The loan itself may have been a good idea or not, but in any case
it was irrelevant to the net effects of the ESOP.
The non-leveraged ESOP example is thus useful as an antidote to the remarkable
Pollyanna descriptions of ESOPs as creating employee equity out of "pure
credit." Not only is the employee equity fully paid for by the tax savings and
owner dilution (possibly with counterbalancing worker concessions to be
considered below), but credit, "pure" or otherwise, has nothing essential to do
with the ESOP effects. The loan may independently be a good idea, but all the
ESOP effects can be obtained without it.
An ESOP Loan--Compared to What?
When a certain investment or financial transaction is being analyzed, one should
always ask the basic question: "Compared to what?". What is the benchmark of
comparison? The real point of comparison is the best alternative. In
economics, this is called the opportunity cost doctrine. The real economic cost
of employing resources to do plan A is the value foregone by not choosing plan
B, the best alternative use of the same resources.
Since the transfer of shares to an ESOP is usually presented in the context of
an ESOP loan, it is often said that the shares are paid for by the profits from
the investment of the loan proceeds. But the best alternative for the owners is
not to have no loan but to have a direct non-ESOP loan (which assuming no
effects on labor productivity or wage concessions, would yield the same EBIT
such as $1030 in the example). When the ESOP loan is compared to that
alternative, then we have seen that the net effect on the owners is the transfer
of shares to the workers in return for the tax savings. It is only the
pseudo-comparison of the ESOP loan with no loan at all which makes it appear
that the shares are being paid for by the productivity, the procreativity, and
the self-liquidating aspects of capital. Actually, the capital "doesn't know
the difference" between the ESOP loan and the direct non-ESOP loan so it is
equally productive in both cases, so the worker shares are paid for by other
means in the ESOP case.
Analysis with Non-Negligible Worker Shares
We now relax the condition that the worker shares of value S are a negligible
portion of the total outstanding shares. Let E be the portion of employee
shares of value S in the total shares outstanding (after the issue of these
shares to the ESOP). If i is the interest rate on the loan, then iS is the
interest on the ESOP loan so let EBT be the EBIT after the interest is
subtracted, i.e., EBT = EBIT - iS (where any other debt in the same in the ESOP
and non-ESOP cases so it is ignored or set to zero). As before, t is the tax
rate. In the first example, EBIT = 1030, EBT = 1000, and t = 0.5. When the
loan was direct and not channeled through an ESOP, then the increase in the
non-ESOP owners equity was (1-t)EBT. When the loan was channeled through the
ESOP, then the increase in the non-ESOP owners' equity for the year's operations
is (1-t)(EBT-S) when we treated the worker shares as being of negligible
proportion but now we must multiply by 1-E to obtain (1-t)(EBT-S)(1-E). Thus
the reduction in non-ESOP owners' equity between the direct loan and ESOP loan
cases is:
(1-t)EBT - (1-t)(EBT-S)(1-E) = (1-t)S + (1-t)(EBT-S)E.
The first term of (1-t)S was the previous dilution effect and the second term
(1-t)(EBT-S)E gives the additional loss due to a portion of the year's profit
going to the non-negligible ESOP shares (E was in effect zero in the previous
analysis). Moreover the ESOP shares bought for S at the beginning of the year
are worth S + (1-t)(EBT-S)E at the end of the year. Hence we again have the
result that the value of the ESOP shares are the end of the year is the sum of
the tax break tS and the dilutive effect on the original pre-ESOP shareholders:
S + (1-t)(EBT-S)E = tS + (1-t)S + (1-t)(EBT-S)E.
All this analysis so far has been for the case where the ESOP gets new shares
issued by the company. Suppose that E is almost one meaning that the new shares
have totally swamped the original shareholders. Setting E equal to one for the
calculation, we see that the year-end value of the ESOP shares is tS + (1-t)EBT,
and that the loss in equity to the original shareholders has been the year's
after-tax profits of (1-t)EBT in comparison with the direct non-ESOP loan.
Again the value of the worker shares is equal to the tax break and the equity
loss to the non-ESOP shareholders.
Analysis of the Leveraged ESOP Buyout Transaction
Now we move the algebraic analysis of the buyout transaction where the ESOP
shares of value S are not new shares but are purchased from the existing
shareholders and that these shares represent the proportion E of the total.
Since the loan money does not go to the company in this case, we may take the
non-ESOP benchmark of comparison to be no loan at all. However since we are
analyzing the effects on the non-ESOP shareholders, we must take account of the
fact that they received the loan proceeds of S at the beginning of the year. We
assume they invest it and receive the interest iS at the end of the year. We
assume heroically that the interest income is taxed at the same rate so their
after-tax income from S is (1-t)iS.
For the non-ESOP case, the original shareholders have the increase in wealth at
the end of the year of (1-t)EBIT (where EBIT = EBT since there is no ESOP loan
and we are ignoring other debt). With the ESOP loan of S to purchase proportion
E of their shares, their portion of the year-end profit is
(1-t)(EBIT-(1+i)S)(1-E) where the (1+i)S is the ESOP contribution made at the
yearend which is deductible from the EBIT. These non-ESOP shareholders also
receive the (1-t)iS after-tax income from the buyout proceeds. Hence the
reduction of their wealth or dilutive effect between the two cases is:
(1-t)EBIT - [(1-t)(EBIT-(1+i)S)(1-E) + (1-t)iS]
which, after some algebra, reduces to:
dilution = (1-t)S + (1-t)[EBIT - (1+i)S]E.
The ESOP shareholders would receive the value of the shares S plus their portion
of the year's after-tax profit:
Year-end ESOP Shares = S + (1-t)[EBIT - (1+i)S]E.
In the no-ESOP case, the government tax revenue was tEBIT, and in the ESOP case,
it was:
t[EBIT - (1+i)S] + tiS = tEBIT - tS.
Thus the drop in tax revenue was tEBIT - [tEBIT - tS] = tS as before. Hence the
year-end value of the ESOP shares is again the sum of the tax break and the
dilution:
S + (1-t)[EBIT - (1+i)S]E = tS + (1-t)S + (1-t)[EBIT - (1+i)S]E.
It is useful to check the limiting case of the 100% buyout when E = 1. Then the
change in income for the bought-out non-ESOP shareholders is:
dilution effect = (1-t)EBIT - (1-t)iS = (1-t)EBT.
Under conditions of certainty (we are ignoring risk) and economically rational
shareholders, this dilution effect would be zero or negative since the
shareholders would not sell if it would reduce their income.
The 100% ownership of the ESOP shares gets share value S plus the full yearend
after-tax profits for a total of:
S + (1-t)[EBIT - (1+i)S] = tS + (1-t)EBIT - (1-t)iS = tax break + dilution
effect.
If the dilution effect was negative, then the tax break would in effect be
shared between the ESOP and the original shareholders.
Numerical Example of Buyout Analysis
We might consider a numerical example to illustrate the algebra in the case of
the buyout transaction. Let us take the following data:
S = 400
E = .6 (60% buyout)
i = 0.10 (10% interest)
t = 0.30 (30% tax rate for corporate and individual income), and
EBIT = 100.
In the no-ESOP case, the after-tax profit going to the shareholders is 70% of
100 or $70. With the 60% buyout, they receive S = $400 which they invest at
interest for the after-tax income of 70% of 10% of $400 or $28. The after-tax
corporate net income is 70% of EBIT-(1+i)S or 70% of 100-440 = -340 or -$238
(implicitly taking loss carry-forwards into account). The original shareholders
bear 40% of those losses or -$95.20. Hence the net change in the original
shareholders income between the two cases is:
70 - [-95.20 + 28] = $137.20 = dilution effect.
The government tax revenues go from $30 to -102+12 = -90 for a total drop of tS
= $120.
The ESOP workers get shares originally worth $400 and their 60% share of the
$238 losses are $142.80 so their yearend share value is 400-142.80 = $257.20.
This is equal to the sum of the tax break of $120 and the dilution effect of
$137.20, i.e., 120 + 137.20 = 257.20.
Non-Tax Benefits of ESOPs
The burning question through all the analysis is: why would economically
rational shareholders suffer any positive dilution effect? This is where our
assumption of the same EBIT between the non-ESOP and ESOP cases can be relaxed.
Let us go back to the original example of EBIT = 1030 with a $200 ESOP loan to
buy new shares at 15% interest with a 50% corporate tax rate. The non-ESOP
direct loan case would be as before:
Non-ESOP Corporation
EBIT $1030
- Interest -30
Taxable Income $1000
- Income Tax (50%) -500
Increase to Equity $500
Now we assume that in return for channeling the loan through an ESOP, the
workers agree to a one-year-only concession in labor costs of $200. Then with
other things the same, the EBIT increases by 200 to $1230 so the ESOP
calculation is as follows.
ESOP Corporation
EBIT $1230
- ESOP Contribution -230
Taxable Income $1000
- Income Tax (50%) -500
Increase to Equity $500
Then there is no dilution effect and no reduction in tax revenue; the worker
shares are entirely paid for by the concession. In this case, the ESOP
transaction puts no strain on economic rationality. Since the workers are now
part shareholders, there may be some effect on motivation and productivity which
would yield additional benefits to all shareholders. It might also be noted
that the alternative to paying for ESOP shares with tax breaks and dilution is
solely based on employees changing the EBIT: concessions and productivity
improvements. The productivity of capital has nothing to do with it as that is
the same between the ESOP and non-ESOP cases. It is part of the secret of the
relative success of the ESOP movement that the tax financing and dilutive
effects of ESOPs have been so well hidden behind an incredible fog of rhetoric
about the prodigious productivity of capital--as if the same productivity was
not available to non-ESOP firms.
The dilution argument fits well with the popularity of ESOPs in public
companies. There is the separation of ownership and control. The management
has something to gain from an ESOP (aligning employee interests with enterprise
interests, and protection from takeovers)--particularly if the ESOP is
management-dominated as so many are--and they do not bear the brunt of the
dilution.
In some other cases, ESOP contributions might be motivated by non-economic
motivations on the part of the original shareholders. The owners of
closely-held firms might see the ESOP shares as a reward to their loyal
employees. In anticipation of eventually selling the company to the employees,
an owner might set up an ESOP to give the workers a foretaste of ownership.
It is one of the great discoveries of Louis Kelso and the ESOP movement that
there can be significant ownership redistribution to corporate employees in both
public and private companies if it is spurred by a tax break, if the immediate
cost to the existing owners is in the relatively painless form of dilution (and
is well covered by a rhetorical fog), and if it holds out the promise of mutual
benefits for both the current employees and shareholders.
References
Blasi, Joseph R. 1988. Employee Ownership: Revolution or Ripoff? Cambridge:
Ballinger.
Hartman, Bart, David Laxton and Bill Walvoord 1977. ESOPs: Sources of funds and
their effect on the cost of capital. Financial Executive. July: 42-8.
Kelso, Louis 1967. How to Turn Eighty Million Workers Into Capitalists on
Borrowed Money. New York: Random House.
Kelso, Louis 1988a. ESOPs Readings in Binary Economics: The Foundation of the
ESOP. San Francisco: Kelso & Company.
Kelso, Louis 1988b. Preface. In Fair Shares for All the Workers. By I. Taylor.
1-5. London: Adam Smith Institute.
Kelso, Louis and Adler, Mortimer 1958. The Capitalist Manifesto. New York:
Random House.
Kelso, Louis and Hetter, Patricia 1967. Two-Factor Theory: The Economics of
Reality. New York: Vintage Books.
Kelso, Louis and Kelso, Patricia Hetter 1986. Democracy and Economic Power.
Cambridge: Ballinger.
Quarrey, M., Blasi, J. and Rosen, C. 1986. Taking Stock: Employee Ownership at
Work. Cambridge: Ballinger.
Reum, Robert and Sherry Reum 1976. Employee stock ownership plans: pluses and
minuses. Harvard Business Review. July-August: 133-43.
Samuelson, Paul A. 1977. Thoughts on Profit-sharing. Zeitschrift für die gesamte
Staatswissenschaft. (Special issue on Profit-Sharing) Vol. 133, 9-18.
Speiser, Stuart M. 1985. Broadened capital ownership-the solution to major
domestic and international problems. Journal of Post Keynesian Economics.
Vol. 7, No. 3 (Spring 1985), 426-34.
Taylor, Ian 1988. Fair Shares for All the Workers. London: Adam Smith Institute.
_______________________________
David Ellerman
Economic Advisor to the Chief Economist
World Bank, Room MC4-335
1818 H St., NW
Washington, DC 20433
Ph: 202-473-6368
Fx: 202-522-1158
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