E. Han Kim and Paige Ouimet
Broad-Based Employee Stock Ownership: Motives and Outcomes
Journal of Finance | Volume 69, Issue 3 (Jun 2014), 1273-1320

Firms initiating broad-based employee stock ownership plans often claim ESOPs increase worker productivity by improving employees' personal incentives and team work. But skeptics are hesitant to buy into this reasoning. For one, free-riding may negate incentive effects; in other words, non-executive level employees may feel they have little impact on the stock price and therefore be unwilling to alter their behavior in tasks requiring additional effort or sacrifice. For another, the real motive might be to conserve cash by issuing stocks to employees in return for lower wages, or to thwart hostile takeover bids. ESOPs established for such purposes are unlikely to improve worker productivity. These concerns call for sorting out different motives, which we do by separating ESOPs into small and large ESOPs. Small ESOPs are defined as those never controlling more than 5% of the firm's outstanding shares. Firms would not implement these small ESOPs to conserve cash or prevent hostile takeover threats; to achieve those goals requires much larger scale ESOPs. We also separate ESOPs by the likely intensity of the free rider problem. Free riding is likely to be less severe when there are fewer employees, so we separate firms into not-so-numerous- versus numerous-employee firms.

With these stratifications, we begin our investigation by asking: If an ESOP is established for the sole purpose of improving employee incentives, and if the free rider problem is not severe, does it increase worker productivity? How are employees affected financially? How about stockholders?

Small ESOPS, not many employees

We answer these questions by examining small ESOPs adopted by public firms with not-so-numerous-employees, which are most likely to be motivated by the incentive purpose and less likely to suffer from free riding. Specifically, we estimate how adopting these ESOPs affect employee compensation, shareholder value, and worker productivity. We also investigate how productivity gains, if any, are shared by employees and shareholders. Wage and employment analyses are conducted with the U.S. Census Bureau database, which provides micro data on employee payroll at the establishment level. An establishment is a workplace, such as a factory, an office, a research lab, a restaurant, and so on. We find that small ESOP adoptions by not-so-numerous-employee firms do increase employee compensation. On average, cash wages—all forms of taxable ordinary income, such as regular paychecks, bonuses, and commissions—increase by 20% following these ESOP adoptions, relative to a control group of non-ESOP establishments. These cash wages do not include the value of ESOP shares granted; hence, our estimates underestimate real increases in total employee compensation. Shareholder value also increases, on average, by 21% relative to industry peers without ESOPs. Since employees and shareholders are the two main claimants to firm surplus, these estimates clearly imply substantial productivity gains. This inference is corroborated by direct estimates of changes in total factor productivity (TFP) for manufacturing firms that adopt small ESOPs with not-so-numerous employees; their TFP increases significantly. In addition, these ESOP adoptions are followed by increases in both employment and the number of establishments, indicating more hiring and more investment.

Gains depend on bargaining power

How are the productivity gains shared by employees and shareholders? It depends on the employees' bargaining power relative to the employers. We measure employee bargaining power by employer concentration within the industry and geographic location of each workplace, a measure akin to estimating alternative employment opportunities in the same industry and location. (This measure assumes switching to a different industry and relocating to a different region are costly to workers.). We find that when employee bargaining power is weaker, wage gains are smaller and shareholder value gains are greater, and vice versa. These results are not driven by pre-ESOP growth opportunities and firm performance, nor are they driven by anticipated changes in worker bargaining power at the time of ESOP adoption.

Large ESOPs have small gains in production

Our investigation also includes large ESOPs controlling more than 5% of the firm's outstanding shares at any point in time. When not-so-numerous-employee firms adopt them, there are no noticeable effects on cash wages, shareholder value, or employment. However, cash wages do not include the value of ESOP shares granted to employees. The average market value of shares granted through these large ESOPs in our sample is $26,796 (in 2006 dollars) per employee, equal to 5.06% of annual wages if the shares were allocated equally over 10 years. When this value is taken into account, large ESOPs seem to increase total employee compensation. Our estimates of total factor productivity for manufacturing firms also indicate an increase in productivity. However, the overall evidence suggests that large ESOPs at not-so-numerous-employee firms are associated with considerably smaller productivity gains than a small ESOP. The smaller gains are due to the different motives behind the adoption of large ESOPs.

Sell shares in the open markets to raise cash

Some large ESOPs are implemented by cash-constrained firms to conserve cash by substituting cash wages with ESOP shares. Employees cannot sell these shares until they leave the company or are close to retirement age. Because of the sales restrictions, employees are exposed to risk that can be diversified by other investors. Risk-averse employees will therefore value ESOP shares below market price. Thus, if the purpose is to raise cash, it would be better to issue shares in the open market than issuing shares to employees through ESOPs. However, cash-constrained firms often have limited access to external financing, and some of them resort to issuing shares to employees through large ESOPs.

ESOPs as an antitakeover device hurt shareholders

Another motive unrelated to improving employee incentives is for management to form an alliance with workers to garner their support in thwarting hostile takeover threats. A number of states have business combination statutes (BCSs) that impose a temporary moratorium on takeover bids if a sufficiently large block of shareholders unaffiliated with management, such as a large ESOP, vote against the takeover bids. If a firm's state of incorporation has such a BCS, the firm can adopt a large ESOP as an antitakeover device. This scheme requires employee support, which the management may buy with higher wages. Cash wages indeed increase following the adoption of such ESOPs. Thus, when management uses ESOPs for the entrenchment purpose, it costs shareholders in two ways: unearned wage increases and the foregone takeover premium.

With few employees, small ESOPs enhance incentives

When firms with numerous employees adopt ESOPs, the effect on cash wages and shareholder value is more or less neutral, which is attributable to the free rider problem. There are, however, a few large ESOPs increasing both cash wages and worker productivity, indicating some large firms are able to overcome free-rider effects by giving employees bigger shares of the firm.

To summarize, employee capitalism works when the true intent is to enhance incentives for a moderate number of employees. These ESOPs can improve team work and encourage co-monitoring among workers, leading to significant increases in productivity. The productivity gains are shared by employees and shareholders according to their relative bargaining power. Average wages, shareholder value, and the level of employment all increase. These ESOPs are win-win plans. The same cannot be said when the number of employees is numerous and/or the size of the ESOP is large. The free rider problem and/or non-incentive purposes such as cash conservation and management entrenchment negate much of incentive effects that could arise with employee share ownership.