UK: ESOP's fable becomes a reality.

UK: ESOP's fable becomes a reality. - Employee share ownership schemes can make a difference to performance - if they are combined with participatory management.

by Anita van de Vliet.
Last Updated: 31 Aug 2010

Employee share ownership schemes can make a difference to performance - if they are combined with participatory management.

Recent months have seen a resurgence of interest in employee share ownership. One reason is the election of the Labour government, which explicitly backed employee share ownership plans, or ESOPs, in its election manifesto, and which is expected to encourage them, through tax provision, possibly in the next Budget. Another is the launch of the UK Employee Ownership Index. Devised by Capital Strategies, a corporate finance house, the index measures the performance of 30 companies with more than 10% of issued capital held by or for employees (other than board directors). In April, it showed an 89% outperformance against the FTSE All-Share Index over the period from January 1992.

Nigel Mason, managing director of Capital Strategies, is quick to warn that it would be 'unwise to claim any direct relationship of cause and effect between employee ownership and share price growth'. The UK index, in particular, contains a number of biases - for example, towards the support services and transport sectors, where labour costs represent a high proportion of total costs, and improvements in motivation and productivity often feed through directly to the bottom line.

Nevertheless, the index is in line with research in the US, where the population of employee-owned companies is large enough - covering 10,000 companies and 11 million employees - to draw more reliable conclusions.

Several US studies have shown that employee-owned companies outperform their competitors in terms of sales and employment growth. In one well-known piece of research (cited by Charles Leadbetter in A Piece of the Action, published this year by Demos), the US National Center for Employee Ownership found that in companies using participatory management techniques, such as self-directed team-working, performance improved by between 8% and 11% after the ESOP was introduced.

But what exactly is an ESOP? Essentially, it consists of a trust which acquires shares in a company for the benefit of its employees. The confusion arises because there are two types in the UK index - those based on case law, and statutory ESOPs. Case law ESOPs are ratified on a case-by-case basis by the Inland Revenue. They are totally flexible and can be used for whatever purpose the company may choose, whether to benefit all employees, from the humblest to the highest, or to fatten up further only the chosen few. Indeed, the case law variety is not obliged by law to distribute its shares to anyone at all. It does not bring with it any express tax benefits, although the company may get tax relief for payments to the trust established through contract.

The statutory ESOP, or Qualifying Employee Share Trust (QUEST), is quite different. There are several legal requirements: at least 50% of the trustees must be elected by the workforce; shares have to be distributed to all employees on a 'fair and similar' basis; and all the equity must be distributed within 20 years. In return, there are several tax advantages, including capital gains tax relief for company owners (with at least 10% holdings) who sell their shares to the trust, and tax relief to the company for payments into the trust. Despite this legislative support, ESOPs are still relatively rare in the UK - between 100 and 200, according to the Employee Share Ownership Centre, benefiting around 150,000 employees. Some estimates put the number even lower, at 50, with fewer than 10 QUESTs. Individualised share schemes are another way of extending share ownership. These have so far proved more popular than ESOPs. Indeed, almost every quoted company has some form of share scheme; and about 10% of the workforce own shares in the company they work for. The real point, however, is whether this changes the way the company is run.

There are three main approved schemes - profit sharing, savings-related share options, and all-employee share options - all attracting tax relief.

Each has its own advantages and disadvantages. To over-simplify: with profit-sharing share schemes, everybody gets a stake in the company, and the link to company profits focuses minds on financial performance, but they are complicated and costly to administer. Savings-related share option schemes introduce an element of commitment to the company from the individual, but not everyone can save from their salary. While all-employee option schemes are simple to set up and easy to administer, there is no savings element, no discount for the employee, and tax relief only once every three years.

The choice of scheme will depend on the nature of the company and what it is trying to achieve. You must be clear why you are introducing a scheme, who it is for, and what sort of behaviour you want to encourage, advises Mason. Thus, for example, the retail industry normally suffers from a high staff turnover. So Asda in 1995 replaced its profit-sharing share scheme with an all-employee share option scheme. Anyone with one year's service and working 15 hours a week is offered options worth 25% of their annual salary: the profit on half the option (in terms of share price) is paid out in shares after three years, and the remainder after six.

'Under profit-sharing, which we operated from '86 to '89, everybody benefited, whether they still worked for Asda or not,' explains Mike Hazelgrove, share schemes manager. 'But now, if you leave too soon, you lose out.'

Or consider the more complex objectives of the FI Group, the software services group. An employee buy-out in 1991, when the workforce held 54% of the equity, FI Group floated in 1996 in order to raise additional capital for its rapid expansion. Foreseeing the potential dilution of the employee shareholding, FI progressively put in place a set of share schemes before the flotation (see box). The aim has been to keep as many employee shareholders as possible rather than losing them to the temptations of cash, and to integrate newcomers at a time of great change. The package also helps attract new recruits in the highly IT competitive market. Remarkably, the percentage of FI Group equity held by the employees is still 46%.

Just as remarkably, pre-tax profits have grown by 40% or more four years in a row.

So is there, one wonders, an optimum percentage of the equity which determines the success of employee ownership? Not really, answers Mason, since that will vary according to how capital-intensive the company is. What matters, he says, is the monetary value per head: 25% of the annual salary is really worth something. It also matters how widely ownership is spread. The vast majority of companies restrict share options to the top 30 or 40 executives, which is not exactly the way to engender a sense of commitment to the company: if anything, it reinforces cynicism and 'them and us' divisions.

Crucially, for employee share ownership to make a difference to company performance, it must be combined with open-book, participatory management. Then, believes David Erdal, former chairman of the Tullis Russell Group, the Scottish paper manufacturer, it is an unbeatable formula. Tullis Russell had been an independent family company since 1809. But when Erdal became chairman in 1985, he 'realised that the family nature of the company was not benefiting either family or employees as much as might be thought', and decided on eventual employee ownership as a solution to succession. Accordingly, between 1985 and 1994, Tullis Russell ran a profit-sharing share scheme, which transferred around 7% from the family to employees, set up an internal market, and went through the process of changing the management style from 'very directive to participative'.

In 1995, a QUEST, financed by the company, bought the 55% of shares then in family hands. Eventually, explains Erdal, employees will hold 30% of the equity directly, the remaining 70% being held in one or more trusts.

At Tullis Russell, participative management has involved introducing teams and groups to run projects or control machines (the company runs a five-shift system over 50 weeks in the year). It has also meant intensive communication: monthly briefings and face-to-face meetings whenever necessary; meetings between the board and the share council at least twice a year, with a completely open agenda; and the publication of every letter from every employee, 'however scurrilous'.

And the results? Well, in performance terms, Erdal points to the company's major switch in shift patterns, for example: 'We were advised by the Paper Manufacturers' Federation that it would take us two years to introduce (the new shift system). We did it in six months, because of the trust and co-operation of our employees.' And in financial terms, he can cite the 34% growth in pre-tax profits from £5.3 million to £7 million in the last financial year.

Certainly, it seems clear that employee share ownership combined with participative management can make a significant difference to company performance. But the process needs to be thought through very carefully.

Companies need to consider just how much of the equity employees should hold directly; and they need constantly to create new ways of making it attractive for them to hold on to the shares. Otherwise, employees might find the temptation to sell out irresistible.

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