Driving performance through ESOPs

August 2012  |  10QUESTIONS  |  PRIVATE EQUITY

financierworldwide.com

 

J. Michael Keeling, President and Chief Staff Officer of The ESOP Association, speaks with Alexander P. Moss, a principal at Praxis Consulting Group, Inc., about driving performance through ESOPs.

Keeling: Based on your experience, what are the overall benefits of employee ownership under an ESOP structure?

Moss: It is inevitable that every firm will be sold; eventually, the owners today will not own the firm forever. The central questions are: to whom will they sell, when, and for whose benefit? The ESOP provides a critical and simple answer for selling shareholders, particularly in private – not publicly traded – firms: the ability to liquidate their ownership interest, while preserving the health and independence of the organisation, and while sharing the future opportunity with those who will contribute to creating that value. This is very attractive to certain sellers, and without this combination of benefits, far few sellers would be attracted to employee ownership. From the perspective of the company itself, and its employee owners – the beneficial buyers – ESOPs provide a separate and quite powerful opportunity. It is clear from both published academic research and anecdotal reporting by ESOP-owned firms that these firms are generally able to outperform marketplace competitors. However, the performance benefits of employee ownership are not solely associated with the simple fact of sharing stock ownership. Rather, it is the combination of stock ownership along with meaningful opportunities for employee-owners to drive operational performance that leads to the most dramatic performance gains. That people who are properly incentivised should perform better should not surprise us. The ESOP provides a long-term equity structure to accomplish this, embedded within the formal US retirement scheme under ERISA.

Keeling: In what ways does the financial structure of an ESOP corporation help to drive operational performance?

Moss: The ESOP provides a highly structured mechanism for distributing increased equity value to employees who participate in the plan, over an extended period of time. For all of their complexity and imperfections, the retirement regulations under which ESOPs operate are extremely well tuned to ensure that all participants benefit fairly. This has two primary and specific consequences. First, all participants receive shares of stock in their employer firm, as part of their retirement compensation benefits. The ESOP therefore provides a broad-based sharing mechanism that gives employees as a whole an opportunity to share the financial benefits of ownership. And opportunity is the key – the ESOP in no way guarantees the future value of those benefits. Second, the value of benefits that participants receive is dependent on the growth in the equity value of the firm. When properly communicated and executed, this provides a powerful incentive and reward for employee-owners to engage in behaviours that actually drive increased long-term share value. When the dust settles, ESOPs provide a compelling combination of fairness and accountability, for employee-owners, above and beyond the liquidity and financial planning benefits that ESOPs provide to selling shareholders.

Keeling: How important is it to set expectations and align shared visions among the company’s employees? What strategies are most effective in this respect?

Moss: Is it absolutely essential. Virtually every employee-owned firm wrestles with misperceptions at all levels regarding the meaning of shared ownership. Is the ESOP ‘only a retirement plan’? It can be used that way, but only at the expense of leaving the performance opportunity unclaimed. Is the ESOP a 1-person/1-vote democracy? Almost never – though there are a small number of highly successful ‘democratic ESOPs’. What is this ‘retirement plan plus ownership structure’, and what does it mean for our company? This is a messy question with answers that vary dramatically from firm to firm. For most, the challenge is to define ‘shared ownership’ in a way that is meaningful and inspiring to employee-owners, that provides real opportunities for increased engagement in daily decision-making, and that clarifies and reinforces the appropriate authority boundaries that any organisation requires to operate successfully. Of course, where those boundaries lie also varies widely from firm to firm, so the essential question is: ‘What forms of engagement in which kinds of decisions will work best in our own company context?’ Firms engage in a range of strategies to clarify these issues, from organisational assessments to senior leadership retreats to whole-company visioning and planning processes, among others. What is most essential is to build an authentic and commonly shared set of expectations regarding ‘what contributions are expected of me (‘what do I give’), and what I can expect to receive (‘what do I get’), now that I am a co-owner of the firm’.

Keeling: In your view, do employees in ESOP corporations often feel more engaged in executing the business strategy than employees in a more traditional business model?

Moss: On a good day, in a well-managed ESOP, certainly. And it is also the case that not all days are good, nor are all ESOPs routinely well-managed. Shared ownership through the ESOP is an opportunity, not a guarantee or entitlement. Employee-owners want the opportunity to understand core business strategy – where the organisation is headed and why – as well as how their work ties to the greater success of the organisation, how the firm makes money, reinvests, and builds share value. And they want to act on that knowledge: to improve their core business processes, to feel that they are making a difference. These are powerful motivators, and innumerable stories of successful employee-owned firms in action illustrate the point better than we can possibly summarise in a few words here. Yes, employees in ESOPs often feel deeply engaged in executing business strategy. Turning the question around, most of us intuitively understand that most employees are not actually freeriders, in spite of the dire warning of economists. Sure, there are a few out there. But if we build our systems primarily to prevent the freerider problem, rather than primarily to enable and inspire people to perform, then we will get what we have designed, and shame on us for aiming low.

Keeling: Could you outline some of the processes that ESOPs may adopt to educate and communicate employees about how individual actions contribute to company performance and yield individual rewards?

Moss: Here are two examples, working from opposite ends of the organisation. Many firms initiate ‘top-down’ educational programs to teach employee-owners about their basic financial models and systems. One particularly effective way to do this is to start not with a financial statement, nor simply with a dollar bill, but rather with an actual product or service that employee-owners provide. By humanising the unit – that is, working with something that people already understand – we can then introduce financial concepts – revenue, material, direct labour, indirect costs, overhead – in a way that is obvious and tangible… and sometimes dare we say even fun. We may discuss the impact on profitability of issues ranging from scrap to throughput, on-time performance, various quality metrics (taking care of our customers), asset protection (taking care of our equipment), and of course, workplace safety (taking care of ourselves). And we tie everything back to its impact on share price, now and in the long-term. A different approach is more ‘bottom up’, to solicit ideas from employee-owners about what does not seem to make sense to them, where they believe that money is being spent, and possibly wasted. The principle is similar to the top-down method – engagement via concrete examples. But the entry point is quite different. One example of this approach is to ask employee-owners to guess the top 20 expenses – of the organisation, if small, or of their unit, if the organisation is larger – and then to target improvements that will drive the most meaningful cost savings while supporting ongoing revenue growth.

Keeling: In terms of increasing productivity, could you explain the difference between informal and formal participation systems?

Moss: Both are critical, and both rely on the same set of expectations and values. But they look different in practice. Formal participation systems involve work teams or other structured mechanisms through which employee-owners work together on shared objectives. These teams have clear charters, assigned leaders, tasks, and decision processes, and they have specific accountability for delivering products and services to internal or external customers. Walking the floor of an organisation with these mechanisms in place, one would observe employees working together in groups for various purposes at various points in the value chain. Informal participation is a broad term we use to connote leadership practices that actively encourage employee-owners to contribute ideas that will enhance work processes. One may or may not observe these practices from a distance. Rather, on closer observation, one would see employee-owners actively seeking to share and vet ideas with one another and with their supervisors, and one would see leaders at all levels actively and constantly encouraging employee-owners to offer input, test their ideas, and learn from their accumulating experience. We rarely recommend a simplistic ‘formal vs. informal’ choice. We generally recommend a combination that is best suited to each individual firm’s environment.

Keeling: Why are some of the challenges that arise when managing decision-making boundaries in an ESOP corporation?

Moss: Managers often worry that non-management employees will want to participate in decisions that they do not fully understand, and that they will make selfish decisions from a narrow employee-benefit perspective. Employee-owners often worry that they will be asked to shoulder risks that they are not fully prepared for, or that their input will not be sincerely considered. Senior leaders often worry that decision-making will get bogged down, and that employee-owners will act either too rashly, or be too risk-averse – that is, be unable to make coherent risk-based judgments on the fly. There is merit in all of these concerns, and the goal is not to simplistically wish them away. Rather, the goal is to build organisations that are capable of taking full advantage of what employee-owners at all levels bring to the workplace. Certain kinds of decisions lend themselves particularly well to group input, while others do not. The ESOP gives everyone a vested interest in decision processes that lead to effective input and success in the marketplace, but it does not mandate a specific decision-making structure other than in a very small number of exceptional circumstances. Our experience is that most ESOP companies, once they are ready to focus on these issues, are able to find a balance that works effectively for them.

Keeling: Leadership development is a vital part of the process. How does the ESOP model help companies to develop from within, integrate from outside, and retain talent?

Moss: ESOP firms require much in their leaders that is comparable to non-ESOP firms, particularly with respect to the technical knowledge, skills, and experience that are specific to a company’s industry environment. However, ESOP firms also require leadership skills that are often associated with high-engagement workplaces generally – self awareness, active listening, giving supportive but clear feedback, accountability, and so on. And effective ESOPs demand leaders who have and can communicate a baseline understanding of shared ownership through the ESOP vehicle itself, as well as personal values that are in alignment with all of the forgoing. These competencies do not simply appear, leaders learn them. This occurs both informally through practical experience and self study, and formally through external professional development and internal leadership development activities. Leadership development in the broad sense is the process of first defining the competencies that an ESOP firm’s leaders require, now and looking to the future, and then teaching those competencies in a systematic and reliable manner. ESOP companies are often initially inclined to hire from within, so as to provide maximum growth opportunities for their employee-owners. As they mature, however, they often become increasingly focused on finding, growing and retaining leaders with the right mix of competencies and aligned values, and this may or may not result in hiring from within vs. from outside. Once again, the ESOP narrowly defined as an ERISA retirement plan does not offer or require much support for any of this: strictly speaking the ESOP is simply a shareholder. However, as a way of doing business, employee-owned firms require these attributes and competencies in their leaders, in order to capture the performance opportunity of the shared ownership model. And of course the ESOP is a form of golden parachute, in the positive sense that it rewards not only longevity, but also deep and sustained focus on driving performance.

Keeling: What general advice would you give to ESOP corporations on succession planning?

Moss: The broader subject of succession planning is really the extension of the leadership develop conversation above. We address here the more general issue of leadership succession, rather than the narrow question of ‘disaster planning’ – that is, whatever will we do if the CEO or other key player passes away suddenly. Every leader needs a plan to develop the person who will eventually step into her or his role, not strictly to perform their job as it stands today, but rather to perform the job that person will be required to handle as the firm grows and executes its strategic plan. Along with that growth comes organisational complexity, and this requires that leadership consistently monitor whether managers at all levels have and are using the necessary competencies. Accordingly, succession planning is not a task for the C-suite alone. It is a mandate to which all leaders should be held accountable. In effect, succession planning is both the inspiration for and the ultimate outcome of effective leadership development.

Keeling: What are the primary factors behind a sustainable ESOP structure that delivers long term value?

Moss: Several inter-dependent factors drive the sustainability of ESOP firms. From a narrow ESOP perspective, we require an actively supportive legislative and regulatory environment, so that the ESOP form continues to thrive as a broadly-shared equity ownership vehicle. We also require an evolving approach to managing the ESOP repurchase obligation, that is, the requirement that ESOP firms liquidate the shares of their ESOP participants at an appropriate time following termination of employment. Within any individual ESOP firm, we need sufficient sustained profitability to generate adequate investment returns, which in turn we use to fund strategic growth and remain competitive as the market evolves. Pretty simple stuff, on paper. What ESOP companies need, on the ground, day in and day out, is a culture that actively supports appropriate levels of workforce engagement, so that the firm can actually execute its strategy. And to do this, consistently and effectively, ESOP firms need leaders, today and in the future, who understand the marginal performance opportunity that the ESOP provides and who are ready, willing, and able to bring out the best in themselves and their employee-owners.

 

J. Michael Keeling, CAE, is President and Chief Staff Officer of The ESOP Association, a national trade association promoting the growth of employee ownership in America through Employee Stock Ownership Plans, or ESOPs. He is also President of the Association’s affiliated 501(c)(3) educational and research foundation, the Employee Ownership Foundation. He is a graduate of Yale University and the University of Texas Law School. He can be contacted on +1 (202) 293 2971 or by email: michael@esopassociation.org.

Alexander P. Moss, MPPM, is a founder and principal of Praxis Consulting Group, Inc., where he advises employee owned, non-profit, and mission-driven corporate clients in fully engaging employees to drive organisational performance. He currently serves as a Trustee of the Employee Ownership Foundation, is a past Board Member of both The ESOP Association and the National Center for Employee Ownership, and is past Chair of the ESOP Association’s Professional Advisory Committee on Ownership Culture. He can be contacted on +1 (215) 753 0304 or by email: alex@praxisCG.com.

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THE RESPONDENT

 

Alexander P. Moss

Praxis Consulting Group, Inc.


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