dilution and risk

[Michael Harrington <mharrington@milken-inst.org>]

Dear Ownership Group,

This discussion is becoming more productive (at least from my perspective).
I would agree with Charles Upton's points below as they are consistent with
my perspective on capital ownership:
Points 1 & 2 seem to illustrate the trade-off for employees; this is exactly
why I focus on risk-return decision behavior; 

Point 3 seems plausible that ownership structures should vary, but I'm not
sure anyone knows how yet;

Point 5 begs the question: so, what explains all the inaction? It has been
claimed that it is largely insufficient credit. If one wants to understand
why lending is not forthcoming, I don't see how you can ignore the risks
associated with ESOP transactions. Bankers and former owners don't want to
assume these risks and therefore refuse to lend without a kicker. Finance
theory is as important as economic theory here.

Ellerman identifies the main problem as the diverging interests of employee
and non-employee shareholders in ESOP firms.  
That seems quite plausible for mixed ESOPs (and not being an ESOP expert I
hadn't considered it, but that's why I belong to this group) and his
analysis make sense to me, but in general I ask myself why I'm so willing to
support stock option dilution in the companies in which I am a shareholder?
Even without tax benefits.
Is it because as a shareholder I am willing to concede the productivity
benefits of employee ownership incentives and what's good for them is good
for me as an owner? 
Perhaps then it is necessary to make a strong empirical case for ESOP firms
on the productivity side to address this potential conflict in mixed ESOPs.
I don't believe Kelso's only contribution is that he finagled a way to pull
the wool over non-employee shareholders with a ESOP contrivance - I just
don't believe shareholders are or ever were that clueless. 

However, on an important related issue, I'm convinced that CAPM theory is
fundamental to understanding the differences between employment and
ownership and all the various stakeholders in between--in effect the entire
ownership/capital structure. It is residual claimancy and subordination that
determines how the risks and returns to the business are distributed. Thus,
it's not some special productivity distinction between capital vs. labor
that counts - it's the ex post distribution of returns that matter. The fact
that this distribution is largely determined by the ex-ante risk preferences
and loss aversion of agents is exactly the point. The success of the firm,
either through increased actual or expected cash flow accrues to residual
claimants (the owners) and perhaps trickles down to other stakeholders.
Considering Ed Wolff's research into the determinants of wealth and income
inequalities, the maldistribution of productive financial assets is exactly
the problem I am hoping to address here.

As an aside to Keith Wilde's summary, I don't view this as a debate between
economists and non-economists - I can't really make that distinction...


Regards,
Michael Harrington


-----Original Message-----
From: Charles W. Upton [mailto:cupton@kent.edu]
Sent: Tuesday, October 19, 1999 7:40 AM
To: ownership@cog.kent.edu
Subject: Re: Yes, the Earth is Round


Actually the earth is pear shaped. 

 Ellerman makes several good points, the key one being that economic theory
is being ignored and mischaracterized in this debate.  Several points are
worth making:

1.  Optimal portfolio theory requires diversification.  An individual
thinking of how to hold his or her accumulated financial wealth would
generally be well advised to avoid holding shares in his own company.  The
covariance between his or her human capital, both firm specific and non
firm specific is just too high.  

2.  The reason to hold capital in the firm for which you work must
therefore be found in incentives and minimizing monitoring costs.  When you
own the firm, you may be underdiversified, but at least you are playing
with your own money, which certainly focuses the mind.

3.  At the same time, monitoring costs will lead to different structures
for different employees in a firm and for different industries.  It may
make sense for a dentist to own the practice, rather than work for a dental
conglomerate, say, but does it make sense to cut the hygenists in for a
piece of the action?  And, why is the structure which is right for one
industry right for all industries?  Clearly it isn't.

4.  Remember, the Soviet system was, in theory, 100% ESOP'ed (with
apologies for killing the English Language).  And we know what a paradygm
of economic efficiency that was.  

5.  Finally, Ellerman is quite right.  Taxes drive a lot of activity, and
the tax subsidy to ESOP's explains a lot of the action.


Charles W. Upton
2324 Exline Circle
Hudson OH 44236

Department of Economics
Kent State University
http://www.personal.kent.edu/~cupton