Repurchase Obligation and Distribution Planning, Public ESOPs Increase Total Compensation, Repricing Options

November 17, 2008 Employee Ownership Update is online and discusses the following:

• New Study Shows ESOPs Increase Total Worker Compensation in Public Companies Significantly, But Not at Shareholder Expense
  
• Repricing Options Gaining Momentum
  
• New Resource on Employee Ownership Cases
  
• A Cautionary Tale About Planning for the Repurchase Obligation
  

The Update discusses how the Antioch Company ESOP (Yellow Springs, OH) has filed for Chapter 11 bankruptcy, and notes that the problems may have been prevented if the repurchase liability were properly reflected in the stock price and with proper repurchase obligation and distribution planning:

Antioch is one of the more remarkable ESOP stories. A small printing company with a long history of pro-employee policies, it set up an ESOP in 1979. In the late 1980s, it bought an album company (Creative Memories) and sales took off. In the next 25 years, employment grew from about 150 to over 1,100, and the share price went up over 2,000%. But then the album market peaked. Employees started to leave, taking advantage of the company's high price and immediate cash-out provisions. Over the next few years, about 800 employees resigned. The resulting cash drain led the company to seek a buyer, but when that fell through, Chapter 11 became the only course. The company will continue to operate, but its ESOP will be terminated. Employees, however, will receive a membership interest in a trust linked to a successor limited liability company (LLC). Antioch might have been able to deal with the problems more effectively had the repurchase obligation been more accurately reflected in stock value and if it had more flexibility in its ESOP payout schedule.

While Antioch's problems are deeply distressing to its employees and leadership, who have an unusually strong commitment to ownership ideals, it's worth remembering that it paid out tens of millions to dollars to employees over time, with account balances into six figures and even seven figures common for employees with significant tenure.

It also discusses how a new study found that ESOPs have a positive effect on total compensation in public companies:

In an new study, E. Han Kim of the University of Michigan and Page Ouiment of the University of North Carolina ("Employee Capitalism or Corporate Socialism: Broad-Based Employee Stock Ownership," October 28, 2008) find that ESOPs owning less than 5% of company shares have a small (0.8%), but positive effect on total compensation, while in companies where the ESOP owns more than 5%, total compensation is 5.2% higher. The more leverage associated with the ESOP, the lower the increase in employee compensation, perhaps because companies exercise restraint on total compensation in the face of greater debt. By contrast, the sub-sample of companies where the ESOP was established in conjunction with declining sales resulted in lower total compensation (2.8% for small ESOPs and 6.3% for large ESOPs).

The effect on value (measured by a standard measurement, Tobin's Q, a ratio of the company's stock value to its book equity value) followed a similar pattern. Overall, ESOPs led to an 8.12% increase in company valuation relative to the industry median. Companies with ESOPs with less than 5% ownership showed a valuation increase of 16% relative to the industry median; companies with larger ESOPs showed neither an increase nor a decrease.

Here is the abstract for the Employee Capitalism or Corporate Socialism? Broad-Based Employee Stock Ownership study:

Adopting employee share ownership (ESO) plans leads to a higher firm value when the plan is small, i.e., less than 5% of outstanding shares. When the plan is larger, however, we observe no changes in firm value. This inverse U-shaped relation between shareholder value and ESO size is robust to firm fixed effects and controls for possible endogenous selection biases in the timing of plan implementations. The value relation appears driven by changes in employee compensation: Large ESOP adoptions are followed by substantial increases in employee compensation, whereas small ESOPs show no such increases. These results imply that most of productivity gains generated by ESOPs accrue to employees (shareholders) when employees have substantial (small) control rights. In addition, compensation increases following large ESOPs are smaller when financial leverage is higher. This leverage effect on compensation, in turn, seems to have a favorable impact on firm valuation. The value negating impact of large ESOPs becomes weaker with higher leverage.

The Update also discusses the issues involved in repricing underwater stock options and references Technology Options Sink - Silicon Valley Considers Repricing but Risks Riling Investors:

Corporate governance specialists are leery of repricing plans. Kent Hughes, a managing director at Egan-Jones Proxy Services, said he generally recommends shareholders reject such repricing proposals because of dilution and concern they may be seen as rewarding poor management.

Some companies are trying to pre-empt shareholder opposition, designing "value-neutral" plans that allow employees to exchange existing options for a smaller number of new ones at lower exercise prices. That will help protect part of an employee's grant but avoid large-scale dilution or additional accounting charges, said compensation specialists.

"[Executives have] earned advanced degrees in compensation governance," said Brett Harsen, an analyst at compensation advisory firm Radford Surveys + Consulting, who added that half of the valley's companies are considering such plans. "Shareholders have been demanding greater balance between their interests and those of the management on all compensation-related matters."

RiskMetrics' Mr. McGurn said investors will be much more sympathetic to plans that don't include executives and directors, many of whom are seen as overpaid. Shareholders also may want to see vesting schedules, the length of time employees have to work at a company before getting their grants, extended in order to entice employees to stay longer.

"I would probably lean toward [repricing] if it would help keep employees," said Ryan Jacob, chief investment officer at Jacob Asset Management, which holds shares in many major technology companies, including Google, Apple and Yahoo.

It also discusses the Curriculum Library on Employee Ownership (CLEO)

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