Which of the following is an employee ownership plan that provides employees with the opportunity to buy company shares at previously established prices?

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  • How Do ESOPs Work?
  • How Do We Judge Performance?
  • ESOP Companies Grow Faster
  • Added Value of Participation
  • Having a Stake
  • What does ESOP stand for?
  • What does employee stock option plan mean?
  • How does an ESOP work for employees?
  • When an ESOP buys shares of a company how should the value of those shares be determined?

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Ever since 1974, when Congress enacted the first of a series of tax measures designed to encourage employee stock ownership plans (ESOPs), the number of employee-owned (or partially owned) companies has grown from about 1,600 to 8,100, and the number of employees owning stock has jumped from 250,000 to more than eight million.1 Employee-owners publish the Milwaukee Journal, bag groceries at Publix Supermarkets, roll tin plate at Weirton Steel, and create high-tech products at W.L. Gore Associates. How well are these companies doing?

Underlying worker ownership is a radically democratic, Jeffersonian ideal—one we strongly endorse. Every American wants to own some property, to have a stake. We all want to know that we are working “for ourselves.”

Still, the ultimate test of employee ownership is how well ESOPs affect corporate performance. If the only way to keep a company competitive is to distance employees from the managerial prerogatives of ownership, so be it. When a ship sinks, it is no consolation to the surviving hands that they own a piece of the wreck.

We have recently completed a major study of ESOP companies that should put an end to talk about wrecks. Not only have workers gained financially, but we can prove that ESOP companies have grown much faster than they would have without their ownership plans. We have found, moreover, that ESOP companies grow fastest when ownership is combined with a program for worker participation. A synergy emerges between the two: ownership provides a strong incentive for employees to work productively, and opportunities for participation enhance productivity by providing channels for workers’ ideas and talents.

How Do ESOPs Work?

The tax incentives have proven so attractive to companies, it’s little wonder that the number of ESOPs has grown. The 1986 tax reform act has only made ESOPs more agreeable. Businesses can still deduct contributions to ESOPs from corporate income taxes. If an ESOP buys stock in a closely held firm, the owner can defer taxation on the sale. Other laws—there have been 17 in all—allow an ESOP to borrow money and use the loan to buy company stock; the company can make tax-deductible contributions to the ESOP to pay off the loan. The 1986 act permits banks to continue to deduct 50% of the interest income they receive from ESOP debt. Estates of owners of closely held companies can exclude 50% of their taxable income from a sale to the company’s ESOP, up to a maximum benefit of $750,000.

Nor is it particularly difficult for a company to set up an ESOP. You begin with a trust fund. You then contribute new shares of company stock to the plan or contribute cash—again, this is tax deductible—for the ESOP to buy existing stock. You can help the ESOP borrow to purchase either kind of share.

Employees, meanwhile, acquire a gradually increasing right to company shares through vesting. For example, if an employee is qualified to receive 100 shares after seven years, he or she will receive, say, 20 shares after three years, 70 shares after five years, and so on. They are entitled to receive the entire cash value of their stock at separation or retirement.

While it is true that some ESOPs have been used as a last-ditch effort to save failing businesses, prevent hostile takeovers, or even induce employees to make wage concessions, the U.S. General Accounting Office reports that such cases account for only about 3% of all company plans. Only about 8% terminated pension plans to create their ESOPs, and about 40% of all ESOP companies have at least one other kind of retirement plan. Of the more than 100 ESOP companies we have studied, only one had required wage concessions; managers at the rest said their wage and benefit packages were competitive quite apart from the ESOPs.

By and large, then, ESOPs are started for the purposes Congress intended—such as allowing employees to become owners of profitable, closely held companies when a principal owner retires (such cases account for about half of all plans) or as an additional employee benefit. The typical ESOP owns a 10% to 40% interest in the company, with 10% to 15% of the plans owning a majority. At least one-third of all plans will eventually afford workers the chance to acquire a controlling interest. And companies, public and private, have instituted ESOPs for other positive reasons—to borrow capital, to divest subsidiaries, or simply to buttress a corporate commitment to having workers share in managerial decisions.

How Do We Judge Performance?

Nearly all previous studies of employee ownership have found that ESOP companies do respectably well.2 Unfortunately, all these studies look at ESOP companies only after the plans have been set up. As a result, it has been impossible to say whether employee ownership is the cause of better corporate performance or simply that the more successful companies were the ones to set up plans in the first place.

We determined to avoid this ambiguity in our research. In 1986, we studied 45 ESOP companies, looking at data for each during the five years before it instituted the plan and the five years after. We might well have simply compared pre-ESOP figures with post-ESOP figures for each company. But this could prove misleading. Suppose the business climate had brightened—which it did for many industries—during the latter five years? Could the gains be credited to ESOPs? You can’t tell how the Yankees are doing merely by comparing this year’s stats with last year’s. You have to consider the team’s standing among other American League teams. (Weirton Steel, perhaps the most familiar ESOP company—which we excluded from our study because it could not meet our ten-year requirement—registered impressive gains after adopting its plan in 1984. Were the gains due to an industrywide recovery or to changes within the company?)

We decided to compare the performance of ESOP companies with the performance of other similar companies. The pivotal year remained the one in which the companies’ ESOPs took effect. But we were careful to consider company performance in the context of industry trends. Of the ESOP companies we studied, 20 were from an earlier survey for which we had sufficient data; we excluded companies that had had ESOPs from the start. To provide an adequate sample, we looked at an additional 25 companies. We then chose at least five comparison companies for every ESOP company from Dun & Bradstreet, for a total of 238. These were comparable to the ESOP companies in terms of business line, size, and, where possible, location. We excluded from our ESOP sample companies with business line combinations for which there were no comparison companies.

ESOP Companies Grow Faster

Once we had our two samples, we collected data on sales and employment growth. We then compared the growth rates of each ESOP company with its five or more comparison companies, calculating the differences in performance before and after the ESOP was established.

If an ESOP company’s growth was consistent and significantly higher than its comparison companies’ growth, we ascribed this to the “ESOP effect.” An ESOP company might well have outperformed the comparison companies before it set up its ESOP. We registered an ESOP effect only if the company’s performance was even more impressive after it set up its plan.

The results of this analysis proved striking. During the five years before instituting their ESOPs, the 45 companies had, on average, grown moderately faster than the 238 comparison companies: annual employment growth was 1.21% faster, and sales growth, 1.89% faster. During the five years after these companies instituted ESOPs, however, their annual employment growth outstripped that of the comparison companies by 5.05%, while sales growth was 5.4% faster. Moreover, 73% of the ESOP companies in our sample significantly improved their performance after they set up their plans.

Incidentally, it would obviously have been preferable to judge the performance of ESOP companies by profit, not growth. Failing companies can grow—at least for a while. But most of the companies in our sample have remained closely held, and we knew in advance that unvarnished profit statements would not be available to us. The next best thing, we reckoned, was to look at growth over a sustained period. Again, we looked at only stable companies whose performance we could track for a minimum of ten years.

Finally, we wondered if there might be other factors involved in setting up an ESOP that might account for improved performance—a change in management, perhaps, or an extraordinary use of ESOP tax breaks. We tested for these and other factors and found no relationship.

Added Value of Participation

The data show that ESOPs exert a positive influence on corporate performance. But the question remains whether any one aspect of employee ownership can be thought the key to higher productivity.

When we looked at the ESOP companies alone, our most interesting finding was the impact of worker participation. Regardless of company size, or the size of employee contributions, or even the percentage of the company owned by the ESOP, the most salient correlation was between corporate performance and workers’ perceptions of their managers’ attitudes toward worker participation. ESOP companies that instituted participation plans grew at a rate three to four times faster than ESOP companies that did not. Also impressive was the correlation between performance and the actual routines of participation—for example, the number of meetings held in which workers and management could develop corporate plans and resolve difficulties.

One virtue of these data is that they are intuitively satisfying. Most people work better when they enjoy what they’re doing. Our data suggest that employees enjoy their work most when they feel they have some say about the conditions of their work day. At Cost Cutter Stores, a grocery chain based in Bellingham, Washington, the mere establishment of an ownership plan raised employee expectations about their role in the company, forcing management to get employees more involved. After a series of meetings between management and employees, managers began interviewing employees one-on-one. The productivity of Cost Cutter has gone up so much that Associated Grocers, which measures such things for its members, reported that the company was “off its charts.” Cost Cutter executives are the first to say that the transition to a different and more participative management style was difficult and would not have been made without the impetus provided by employee ownership.

Or consider, once more, Weirton Steel. In 1984, Weirton’s 7,000 employees bought the company to keep it from closing. As 100% owners of a steel mill (which could be worth $1 billion in good times), Weirton’s workers suffered from no lack of entrepreneurial spirit. Weirton set up intensive three-day training programs to teach employees to run employee involvement teams on their own; it installed television monitors throughout the plant to keep employees informed of developments, and it shares detailed financial and production data, good and bad, with employee-owners. After 3½ years, Weirton now employs 8,500 people and has made a profit for 14 straight quarters, a record unmatched among integrated steelmakers.3

Given these findings, companies might well decide they should implement participation programs without necessarily ceding ownership to workers. That conclusion would be unwarranted. Data on participation’s impact on non-ESOP companies is at best mixed, while ownership alone has a modest but important effect. Ownership and participation together have considerable impact. There is no escaping the conclusion that American workers sense a difference between working for their own benefit and merely being employed for the company’s benefit; a difference between participation by right and participation at the sufferance of managers.

Having a Stake

Clearly, feeling like a participant is critical to a worker’s greater contribution to a company after it establishes an ESOP. But it is important not to define participation too narrowly. For a worker to feel like a participant-owner, there must be a tangible financial benefit and a process of consultation, not just abstract prestige.

In 1985, we conducted a study of 108 randomly selected ESOPs, looking at how much workers had profited from them during the previous four years. The average contribution was the equivalent of 10.1% of workers’ pay, and the average annual gain in stockholders’ equity was 11.5% (compared, incidentally, with about 6% for the Dow Jones industrial average during that time).

Using these figures and applying conservative assumptions about how quickly workers’ shares are vested, we calculated that an employee making the 1983 median wage of $18,000 would accumulate $31,000 over the next 10 years and $120,000 over 20 years.

This may not sound like a great deal of money. Yet in 1983, the median net financial assets of a family at retirement, aside from home equity, amounted to only $11,000. Americans are clearly not in the habit of saving. Of course, by putting aside 10% to 15% of their yearly pay into other retirement or forced savings plans, workers could accumulate a sum equal to the value of ESOP shares. But would they elect to put this much aside?

And if ESOPs are a hedge against feeling strapped at retirement, they matter as much to workers for the way they can improve life before retirement. We surveyed 2,800 employees in 37 representative ESOP companies across the country. While our data show clearly that employees react to ownership primarily in financial terms—the larger the annual company contribution to their accounts, the more motivated they claim to be—workers nevertheless say they cherish the demonstrated commitment of management to worker ownership and participation.

In fact, such basics as company size, lines of business, and work-force characteristics do not affect employee attitudes much. Not even employee voting rights correlated with higher morale, though in about 15% of private ESOP companies employees can vote their shares on all issues. (By law, employees in private ESOP companies must be able to vote on issues involving sale, liquidation, relocation, or merger. In public companies, workers have the right to vote on all issues.)

Again, employees are enthusiastic about companies that engage their ideas and talents, whether in an informal open-door meeting with the president or at a random meeting with a supervisor. The best companies, they say, regularly hold sessions in which managers and workers can thrash out problems. But employees attached little importance to the formal trappings of corporate control, such as having representation on the board.

Workers may well appreciate the money they get by owning company stock. But their enthusiasm won’t do much for corporate performance unless it can be channeled into creative enterprise. Employees ought to feel that they can share new ideas, devise new ways to work together more efficiently, take on responsibility for customer satisfaction.

The lessons for management are clear. Give employees an opportunity to acquire a significant share of the company and develop opportunities for them to participate as owners. This course is remarkably effective, remarkably exciting, and remarkably different from the one the vast majority of American companies travel.

2. See, for example, Michael Conte and Arnold Tannenbaum, Employee Ownership (Ann Arbor: University of Michigan Survey Research Center, 1980); Thomas Marsh and Dale McAlister, “ESOP’s Tables,” Journal of Corporation Law, Spring 1981, p. 612; Matthew Trachman and Corey Rosen, “Report to the National Venture Capital Association of the Relationship of Employee Ownership and Corporate Growth in High-Tech Firms,” unpublished paper, 1985.

3. For an earlier look at Weirton Steel, see William E. Fruhan, Jr., “Management, Labor, and the Golden Goose,” HBR September–October 1985, p. 131.

A version of this article appeared in the September 1987 issue of Harvard Business Review.

What does ESOP stand for?

What does employee stock option plan mean?

How does an ESOP work for employees?

When an ESOP buys shares of a company how should the value of those shares be determined?