Privatization Through Employee Ownership: Learned From The International Experience

by David Binns

Current efforts directed at reinventing, downsizing and privatizing Foundationeral government programs include a focus on the possibility of utilizing employee ownership plans to privatize selected government programs. Such an approach to privatization builds upon the substantial growth of employee stock ownership in the private sector over the past two decades as well as prior privatization initiatives of the Foundationeral government. However, despite the fact that the United States has clearly been the world leader in the promotion of individual stock ownership among employees of private corporations, foreign governments have led the way in the use of employee ownership as a technique of privatization. Countries as diverse as Great Britain, France, Chile, Argentina, Hungary, Poland, Slovenia, Russia, China, Sri Lanka, Pakistan, Nigeria and Egypt and others have made employee ownership a key element of their privatization programs. Specific techniques for utilizing employee ownership vary widely from country to country and the use of employee ownership in international privatization efforts is subject to different social, legal and economic conditions than those driving current efforts to restructure U.S. government agencies. Many of these programs have nevertheless been influenced by the U.S. model of employee ownership and, as  such, their experience is pertinent to current efforts to utilize employee ownership in privatization initiatives in the United States. This paper  provides a general overview of the international experience with employee ownership in privatization programs, explains why employee ownership has become a central element of the privatization strategy of growing numbers of foreign governments, and offers several key principles for the effective use of employee ownership based on the international experience.

THE CASE FOR EMPLOYEE OWNERSHIP IN PRIVATIZATION

Though several countries have had long traditions of employee ownership, for the most part it has been limited to worker cooperatives or stock option programs limited to top executives. With the advent of broad-based employee ownership plans in traditional market-based corporate structure, coupled with the failure of socialist economies, employee ownership has come to the fore as a mean of facilitating the transition from state to private ownership. Literally dozens of countries have utilized employee ownership as a technique of privatization and scores more are actively considering such a strategy. Indeed, employee ownership is rapidly becoming a non-negotiable component of the privatization process, with the emphasis shifting from whether workers should own a stake to just how large a stake they should own and how that ownership should be achieved. As a means of understanding why employee ownership has attracted such international attention it is helpful to understand some of the practical and strategic advantages that employee ownership offers in the context of privatization.

Policy makers implement employee ownership strategies for a variety of reasons. Objectives for utilizing employee ownership range from distributing private ownership broadly throughout the economy, enhancing enterprise performance by giving workers an economic stake in its financial success, improving labor-management relations and advancing notions of economic and social justice. Indeed, the flexibility of the concept is one of the key attributes of employee ownership. One of the main attractions of employee ownership is its broad appeal in terms of both macroeconomic policy and industrial organization. Employee ownership is considered to be an effective means of promoting economic efficiency through free enterprise while also promising fairness of economic opportunity through a widespread distribution of the wealth being transferred from government to private control. This is particularly important in formerly socialist countries undertaking the transition to a market economy. Whereas Marx observed that conflict between owners and workers is built into the capitalist system, the emergence of employee ownership in both western economies and transitioning socialist economies represents a new dynamic of free enterprise which emphasizes widespread participation in the ownership of productive property. Establishing widespread capital ownership is therefore seen as a means of strengthening the constituency for free enterprise by giving large numbers of employees a direct financial stake in the performance of private corporations.

Employee ownership also offers a practical means of jump-starting the privatization process by organizing a clearly defined, knowledgeable shareholder group that has a vested interest in working for the success of the privatized enterprise. Employees are typically the largest and most vocal interest group in the privatization process and they are often the natural candidate to consider in fostering the privatization process. Where employees' interests allow, and where privatization is feasible, transaction utilizing employee ownership can help to jumpstart the privatization process. In most cases, the greatest resistance to privatization comes from employee groups themselves, but allowing employees to obtain a significant stake in the capital ownership of their enterprises can potentially overcome their legitimate fears over losing the protection of government jobs, while also providing a financial incentive to support private enterprise at the grass roots level. Such an approach can save on political, economic and administrative costs associated with privatization strategies that do not address the legitimate economic concerns of the workforce. Providing workers with a shared financial interest in the success of the enterprise, particularly when ownership is combined with participatory management techniques, can also help to accelerate the transition to a private sector environment and provide an incentive to improve productivity.

Employee ownership also offers a practical means of organizing enterprises and of facilitating the privatization process through creative uses of finance. Since most employees lack the financial resources to purchase stock, the use of leveraged ESOPs (employee stock ownership plans) as a technique of corporate finance has in many cases allowed employees of privatizing enterprises to obtain a substantial ownership stake. Whereas a straight sale of government assets to the highest bidder may be the simplest and most direct strategy of privatizing government-owned enterprises, such an approach typically results in sales to either well-connected insiders in the state companies who trade their political power for economic power, or to black marketeers who have built fortunes in the "informal" economy. Such a strategy runs the risk of perpetuating old economic structures and further increasing skepticism about privatization among the general population. Similarly, sales to foreign companies provide much-needed capital and expertise and are welcomed as part of the privatization process -- but to what extent and for how long? Without assuring legitimate opportunities for its citizens to obtain ownership in the newly privatized economy, governments expose themselves to charges of selling off the national patrimony.

Some privatization strategies have relied on the issuance of vouchers to citizens at large that can be exchanged for shares in privatized companies. While this method helps ensure a wide distribution of shares initially, it is typically limited to only the largest companies and the government receives no revenue from the distributed vouchers. In addition, broadly distributed shares among absentee owners is not likely exert any influence on improving the operation of the newly privatized company as is the case with key investors and, of course, the employees themselves who are often in the best position to ensure the viability of the enterprise as a private company. Furthermore, employees are more likely to invest their own money in the one company they know something about and where their own efforts can have the greatest impact. In many cases employees may actually be the only significant constituency interested in purchasing a particular company. Having the mechanisms in place to facilitate employee purchases can help speed the process of employee buyouts in cases where other investors are unavailable. For these marginal companies with uncertain prospects for success and/or an inability to attract outside interest, employees may be in the best position to determine the viability of the enterprise as an independent entity. Because they represent a readily identifiable buyer, sales to employees can be conducted more expeditiously.

Common Misperceptions of Employee Ownership

It is important to emphasize that employee ownership does not necessarily mean ownership exclusively by employees. Particularly in the context of privatization of state-owned enterprises, "mixed" privatizations involving outside investors (both individual and institutional), foreign companies and employees are likely to predominate. The experience with employee ownership in the United States indicates that the majority of companies with significant levels of employee ownership typically have employee stakes of 10-45%. Employees own a majority of the stock in only 10-15% of these firms. Coincident with the confusion over the definition of employee ownership are common misperceptions of what employee ownership represents and how employee ownership might affect the privatization process and the operation of privately owned corporations in a free market economy. For example, emphasizing employee ownership in the privatization process does not necessarily mean giving away state assets to employees without compensation. Quite to the contrary, employee ownership rarely involves a give-away of government assets. Employees are often encouraged to purchase stock (often at discounted prices with deferred repayment terms at subsidized interest rates), but since employees have limited or non-existent investment capital, employee buyouts of state assets are more typically structured with the use of credit, either from the state itself or from third party lenders. Under this approach, part of the future profits of the newly privatized companies are used to repay the debt. As the debt is repaid out of corporate profits, the stock ownership transfers to employees.

Employee ownership does not mean day-to-day control or management of companies by workers, nor does it mean that all important business decisions will be made collectively by a large group of workers. Just as in traditional corporations, boards of directors and management will continue to be responsible for developing long range business planning in employee owned companies, subject to oversight and ultimate control by the company's shareholders. The majority of the shareholders in any particular company may or may not be employees, but employee-owned companies are no less inclined to control the allocation of labor costs nor less capable of responding to market forces than are companies with outside ownership. Nor does employee ownership necessarily mean that employees will emphasize consumption over investment. Privatized companies soon realize that they can no longer depend on the state for Investment support, and that they must improve corporate productivity to succeed in a market economy. Employee owned companies are no different in that respect. Indeed, if given a financial stake in the long-term success of the firm, employees are more likely to support investment in new technology and capital improvements if they understand that such investments will improve the value of their own individual shareholdings.

Applying The International Experience With Employee Ownership To U.S. Privatization Initiatives

Given the extensive role of employee ownership in the U.S. economy, the broad legislative framework of employee ownership laws, the tax advantages  available to companies implementing equity compensation plans, and the  ability to use ESOPs as a technique of corporate finance, there is certainly  good potential for employee ownership to play a major role in U.S. privatization initiatives. More than 12,000 U.S. firms now share significant equity ownership with their employees and the total value of employee stock ownership holdings is in excess of $300 billion. Employee ownership can be found in virtually every sector of the American economy from large manufacturing companies to small service firms. An infrastructure of legal, financial, administrative and human resource management experts are available to help structure employee ownership transactions and provide ongoing services in relation to employee ownership issues. This expertise could easily be brought to bear in a program for using employee ownership to facilitate privatization. In fact, most of the growth of employee ownership in the U.S. has taken place since the early 1970s, a period marked by extensive restructuring and downsizing among American companies.

Many employee owned companies in the U.S. have been created as divestitures from larger corporations undergoing extensive downsizing, a dynamic similar to that now facing the Foundationeral government in the context of privatization. Employee ownership has actually been an element of U.S. privatization strategy dating back to 1974 when the privatization of Conrail resulted in a 15% equity stake for the Conrail employees through an ESOP. In 1986 the Office of Personnel Management developed a Foundationeral Employee Direct Corporate Ownership Opportunity Plan, or Foundation CO-OP, which sought to privatize government functions through a modified A-76 approach to contracting out services. Though the Foundation CO-OP proposal attracted a good deal of attention and several agencies were prepared to proceed with Foundation CO-OP privatization efforts, legislation was introduced in Congress which effectively blocked the use of Foundation CO-OP and no transactions were ever completed. In terms of assessing the viability of utilizing employee ownership to facilitate U.S. privatizations, the specific legal and structural issues associated with other privatization programs are less important than certain key principles that should be included for a program to be effective. Privatization initiatives in the U.S. will of necessity conform to U.S. law which differs in important respects from that of other countries that have utilized employee ownership in privatization. The lessons learned from the international privatization experience and prior U.S. efforts to include employee ownership as a technique of privatization can best be summarized in the following key principles that should be included to ensure the viability of privatization transactions involving  employee ownership:  

Ensure Fairness Of Opportunity

All employees should have an equal opportunity to acquire some stock ownership, though overly restrictive stock distribution rules should be avoided. Lenders to private employee buyout transactions often require that key employees be given greater performance incentives and/or larger investments on the part of key employees, so some flexibility should be allowed in structuring specific transactions.

Maintain Transparency Of The Process

Ensure widespread distribution of information on employee ownership options for privatization to Foundationeral employees and to outside firms who may be interested in bidding on certain government services. In some instances employees may be the only bidder whereas other units subject to privatization may require a competitive bidding process.

Be Prepared For Differing Expectations

Some will advocate employee ownership as a means to enhance corporate performance. Others will emphasize the benefits of making ownership available to a broad cross-section of employees. Employees may see employee ownership as a job preservation strategy. While these perspectives are not necessarily incompatible, different interest groups will approach employee ownership with different priorities.

Allow For Flexibility

One of the problems with the Foundation CO-OP proposal was the fact that it proposed a standardized approach to contracting out procedures contemplated under the proposal. Functions that could be targeted for privatization with employee ownership will vary greatly in terms of the work performed. The program should therefore allow for transactions to be structured in a variety of ways to accommodate the needs of a particular program.

Involve Employee Groups From The Beginning Of The Process

Employee groups, in particular labor unions, are typically the biggest roadblock to privatization initiatives. Giving them a financial stake in the privatization can help counter potential opposition, but employees need to feel that they have an opportunity to affect the outcome and not have their fate determined by dynamics entirely beyond their control and which prevents their active participation in the process.

Empower Employees To Participate in Structuring Privatization Transaction

Foundationeral conflict of interest law prohibits Foundationeral government employees from negotiating terms of their employment. This restriction can be alleviated by allowing employee groups to retain the services of an independent trustee (as typically occurs in private sector transactions) to negotiate for them. Employee groups could act in a consultative capacity to the trustee to help the trustee determine a feasible approach to the employee buyout.

Facilitate The Use Of Credit To Help Finance Employee Ownership Transactions

Employees will not be in a position to bid directly on contracting out proposals without assistance in the form of financing. Leveraged ESOP transactions are feasible if the government provides the winning bidder a contract term long enough to convince lenders of the ability of the newly privatized enterprise to meet debt payments. Alternatively, the government could allow for discounts on employee purchase of shares in privatized enterprise and/or allow deferred payment terms for purchases of stock.

Do Not Dictate The Permissible Level of Employee Ownership

In some instances employee groups may be able to structure a complete employee buyout of a privatizing agency. In other cases they may be require to partner with other investors. The government should allow employee groups to determine the best feasible deal without establishing arbitrary limits as to the amount of equity available to the employee group in a given transaction. Employee groups should be encouraged to negotiate for the best economic deal, not necessarily the largest ownership percentage.

Policy Reforms Should Facilitate Legal Environment

A good example of a policy reform to support the legal environment for employee ownership would be to clarify that independent trustees could be retained to negotiate privatization transactions on behalf of employee groups.

Emphasize Privatization, Not Revenue Enhancement

The immediate goal should be primarily to privatize government operations and only secondarily to reduce government expenditures. Studies indicate that contracting out government services results in net cost savings and subjecting government  functions to competitive markets will undoubtedly drive down costs over the long term. The government should therefore be prepared to underwrite the transaction costs of structuring effective employee buyouts to achieve the short-term goal of privatization in order to achieve long-term reductions in the cost of government operations. This would include the costs of legal and financial representation that employee groups will need to determine whether an employee ownership privatization is feasible and to structure the transaction itself.

Education and Training

Many Foundationeral employees have little or no experience in working in the private sector. Privatization promises to be a difficult transition, but programs focused on training employees participatory management techniques can help prepare them for a new competitive environment. The most successful employee ownership firms combine the incentive of stock ownership with the motivation of employee participation in working to improve the operations of the enterprise. A privatization program will ultimately be judged in large measure not just by the total value of assets and services transferred to the private sector, but by the successful transition of Foundationeral employees to the private sector. An investment in training and education can go a long way towards supporting that goal. Privatization is a political process. It requires political will to get started and political savvy to ensure that it will be a continuous process that is perceived as fair by diverse interest groups. Properly designed and implemented, employee ownership offers a viable means of facilitating a privatization program by providing a key interest group -- Foundationeral employees subject to downsizing pressures -- with an opportunity to transition to the private sector with a job and with a financial stake in the future success of their privatized company. That's no panacea, but it does represent a viable means of accomplishing a needed public policy objective in circumstances where government operations can be effectively performed by the private sector.