In this enlightened age, why is it so many companies do not embrace employee ownership when employees are openly craving it? Research tells us it is a combination of tradition, fear, and sometimes ignorance. However, research also tells us that employee ownership substantially improves corporate performance with just one caveat — the ownership compensation must be at least 5% of pay per year.
If you are considering employee ownership as an option, One of the most popular vehicles is through an ESOP. An ESOP can provide excellent tax advantages to an owner if at least 30% of company shares are held in the ESOP. Consider these facts about ESOPs:
1) If employees want to invest in your company, it’s easy for them to purchase shares through the plan.
2) If you want to finance growth, an ESOP can borrow money to buy newly issued shares. The company can then use this money to buy other companies, buy new equipment or sites, etc. The company can repay the loan in pre-tax dollars by making contributions to the ESOP.
3) An ESOP will cost at least $25,000 to set up and $15,000 per year to run. These costs are frequently a fraction of the tax benefits derived, but not always. The complexity of ESOP administration normally requires outside professionals.
Another choice for employee ownership is Stock Options. Stock Options allow employees to purchase shares in their company at a price fixed when the option is granted for a defined number of years into the future. Options rights are usually subject to vesting.
For instance, a company may give an employee the right to buy 100 shares at the current price of $10 per share. This employee vests this right over four years at 25% per year, meaning after the first year, option on 25 shares could be exercised. There is a time limit on the exercise, typically 10 years from the date of grant.
There are two main kinds of options, Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). In an ISO, if certain rules are met, the employee does not have to pay tax on the “spread” between the grant and exercise price until the shares are sold. Capital gains would then be due. The company, however, cannot take a tax deduction for the spread. In an NSO, the employee pays taxes on the spread just as if it were wages, and the company can take the corresponding tax deduction.
Consider these facts about Stock Options:
1) Stock options do not work to sell some of an owner’s existing shares to employees. Employees are buying either new shares issued by the company or existing shares at a bargain price which would likely be unacceptable to the current owner.
2) As a financing mechanism, stock options are less effective than ESOPs since the cash comes in very slowly.
3) Options are much more effective than ESOPs in attracting and retaining good employees. In an ESOP, all employees are treated as equals. With stock options, you can specify who gets how many options.
4) Stock option plans are relatively simple and inexpensive to install. The largest challenge is that the company must be valued annually to determine a per share price.
Are ESOPs or Stock Options a miracle cure? Absolutely not! The impact of any plan depends a great deal upon the company and the goals for the plan. The largest factors of success include the company’s commitment to ownership culture, the amount of training and education it puts into explaining the plan, and the cash goals of the individual employees (do they want more cash now or later?). In companies who make a commitment to employee ownership, stock plans can have a tremendous positive impact. One has only to look at companies like Starbucks, PepsiCo and Microsoft to see the effective these plans can be when coupled with a true commitment to treating employees as owners.
Before you jump into Employee Ownership, consider carefully whether your company is ready to treat your employees like owners. Are you ready to open your books? Are you ready to train in financial statement analysis and understanding? Are you willing to accept their ideas and criticisms?
If you decide employee ownership is for you, consider carefully the amount of stock (i.e. number of shares) you want to make available, who should have that stock, and how employment may grow in the future. A common error, particularly with option plans, is to grant too much stock too soon and run out of shares for future employees.
Employee ownership plans should never be added at the sacrifice of other benefit programs. Instead, use them as a supplement to other compensation programs to link pay to performance. Stock ownership can be linked to pay grade, salary, or strictly merit. If the program is based on merit, make sure merit-criteria is succinctly defined. In a recent survey of ISO companies, 75% reported using merit-based rewards.
If you would like to learn more about employee ownership, there are two good resources:
- The Foundation for Enterprise Development – This nonprofit agency has excellent materials including a kit called “The Owner’s Toolbox on Equity Incentives.” Visit their web site www.fed.org or call 858-822-6000 if you’re on the West Coast and 202-833-4617 if you’re on the East Coast.
- National Center for Employee Ownership – This is also a nonprofit group dedicated to employee ownership education and materials. Call them at 510-208-1300 or visit their web site at www.nceo.org.