David Ellerman

Dellerman@worldbank.org

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 is 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 capitalist 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, to this day, he refers to his theories as "Binary Economics" (see Kelso, 1988a).

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:

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.

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 capital-less 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.

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.

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).

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.

Kelso paints a similar picture using "in effect" metaphors.

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.

The original question of "Who pays for ESOP shares?" can be answered with some precision 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 extreme-case 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.

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.