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Transcript of Employee capitalism or corporate socialism? Broad ... 1 Employee capitalism or corporate socialism?...

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    Employee capitalism or corporate socialism?

    Broad-based employee stock ownership

    E. Han Kim 1

    and Paige Ouimet 23


    Employee share ownership plans (ESOPs) increase employee compensation. The gains

    are concentrated in small ESOPs, defined as those controlling less than 5% of outstanding

    shares. However, we also find evidence that some large ESOPs appear to act as

    management-worker alliances ala Pagano and Volpin (2005), wherein management

    bribes workers to garner worker support in thwarting hostile takeover threats. Worker

    compensation increases following the adoption of large ESOPs by firms in non-

    competitive industries when implemented during takeover battles and/or when the

    implementation takes place after the state of incorporation enacts Business Combination

    Statutes, which makes large ESOPs an especially effective anti-takeover device. The

    effects on firm valuation also depend on the competitive pressure from the product

    market: When the pressure is strong, ESOPs exhibit no relation to firm valuation,

    consistent with the contracting view that ESOPs are a part of equilibrium incentive

    contracts. When the pressure is weak, by contrast, firm value is related to the size of

    employee share ownership in a hump shaped fashion. The absence of strong external

    pressure for good governance seems to allow management and workers to capture

    incentive contracts. The deviation from equilibrium contracts allows the identification of

    how employee ownership affects firm value.

    October 29, 2009

    JEL classification: G32, M52, J54, J33

    Keywords: ESOPs, Employee Incentives, Worker Wages and Compensation

    1 Ross School of Business, University of Michigan, Ann Arbor, Michigan 48109; email: ehkim@umich.edu.

    2 Kenan-Flagler Business School, University of North Carolina, Chapel Hill, NC 27599; email:

    Paige_Ouimet@unc.edu. 3 We are grateful for helpful comments/suggestions by Sreedhar Bharath, Amy Dittmar, Charles Hadlock,

    Francine Lafontaine, Margaret Levenstein, Randall Morck, Clemens Sialm, Jagadeesh Sivadasan, seminar

    participants at INSEAD, University of Hawaii, University of Michigan, University of Oxford, and

    participants of Madrid conference on Understanding Corporate Governance, the US Bureau of Census

    Conference, the Census Research Data Center Annual Conference, and the International Conference on

    Human Resource Management in Banking Industry. We acknowledge financial support from Mitsui Life

    Financial Research Center. The research was conducted while the authors were Special Sworn Status

    researchers of the U.S. Census Bureau at the Michigan Census Research Data Center. Research results and

    conclusions expressed are those of the authors and do not necessarily reflect the views of the Census

    Bureau. This paper has been screened to insure that no confidential data are revealed.


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    Broad-based employee share ownership (ESO) is an important economic phenomenon.

    The two most common types of plans which encourage ESO are Employee Stock

    Ownership Plans (ESOPs) and 401-K plans with employer stocks. According to the

    National Center for Employee Ownership, in 2007, ten and one-half million employees

    participated in 9,650 ESOPs, with combined assets over $675 billion at public and private

    firms. The corresponding numbers for ESO through 401-K are four million participants

    in 2,200 plans with $75 billion in assets. Both of these plans show an increasing long-

    term trend; the NCEO estimates the number of participants in ESOPs was one-quarter

    million in 1975, five million in 1990, and over ten million in 2007. ESO through 401-Ks

    has also become increasingly popular since the 1990s.

    Previous studies have documented worker productivity increases following

    adoption of ESO plans (Jones and Kato, 1995; FitzRoy and Kraft, 1987; and Beatty,

    1995). The finance literature also shows positive stock price reactions to the

    announcement of ESOP adoptions that are not implemented under takeover pressure

    (Gordon and Pound, 1990; Chang and Mayers, 1992; Chaplinsky and Niehaus, 1994; and

    Beatty, 1995). However, there is little evidence on how ESO plans affect employee


    The effect on employee compensation is an important issue. It has an obvious

    employee welfare implication. Moreover, any change in employee compensation has

    implications for firm valuation and shareholder value. A typical ESO bestows not only

    cash flow rights, but also voting or other forms of control rights to employees. As the size

    of ESO increases, greater cash flow rights may lead to greater productivity gains through

    improved team effects and collective employee behavior, while greater control rights may

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    help employees obtain higher compensation. (Kruse, Freeman and Blasi 2009). It is not

    clear how greater cash flow and control rights jointly affect the shareholder value. This

    paper conducts an empirical investigation of how ESOPs affect employee compensation

    and shareholder value, and by implication, the size of economic pie.

    The data on employee compensation is obtained from a unique establishment-

    level database maintained by the Center for Economic Studies at the U.S. Bureau of

    Census. The regression estimates on wages control for establishment fixed effects, year

    fixed effects, state-year mean wages, industry-year mean wages, establishment age, and

    other firm-level variables. Panel regressions are estimated using all treatment firms and a

    matched control group.

    We find that the adoption of an ESOP is followed by both higher wages per

    employee and higher firm valuation. These positive effects are driven by small ESOPs.

    These findings, however, mask important heterogeneity across ESOPs and across

    sponsoring companies.

    To investigate how employee control rights bestowed by ESOPs are related to the

    differential impacts of small and large employee ownership, we divide the sample

    according to the degree of product market competition. Strong competition limits

    managerial slack and complacency, thereby reducing agency problems between managers

    and shareholders (Alchian, 1950; Friedman, 1953; Hart, 1983). More recently, Guadalupe

    and Wulf (2007) provide evidence that competition improves governance, and Giroud

    and Mueller (2009) demonstrate that product market competition serves as an effective

    external governance mechanism. Thus, we use product market competition as a proxy for

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    the strength of external corporate governance. This allows us to relate the differential

    ESOPs impacts to governance.

    We hypothesize that the standard principal-agent framework is applicable to

    incentive contracts when strong external pressure for good governance helps shareholders

    to act as principals. However, when the external pressure is weak, management and

    employees may capture the contracting process, making incentive contracts deviate from

    the equilibrium contracts. Bertrand and Mullainathan (2000 and 2001); Bebchuk and

    Fried (2004); Morse, Nanda, and Seru (2009); and Kim and Lu (2009) provide evidence

    of management’s capture of incentive contracts.

    ESOPs may be viewed as incentive contracts susceptible to capture. When ESOPs

    reflect equilibrium incentive contracts with shareholders acting as principals, they should

    exhibit no relation to firm valuation when contracting environments are properly

    accounted for (Demsetz and Lehn, 1985 and Himmelberg, Hubbard, and Palia, 1999).

    That is, the researcher may be able to identify a relation between ESOPs and firm value

    only if either the ESOP or the pre-existing incentive contracts deviate from the optimum.

    Our results suggest that for firms subject to strong product market competition,

    ESOPs have no impact on valuation as proxied by Tobin’s Q. However, when the

    competition is relatively weak, the relation between the size of ESOPs and Q is hump

    shaped: Small ESOPs increase firm values, but large ESOPs have no effects. These

    results support the notion that weak product market pressure for good governance allows

    management and employees to capture the contract process. Specifically, weak external

    pressure for good governance leaves more slack for ownership to cure or exacerbate,

    making the effects of ownership more pronounced. At a low level of share ownership, our

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    results suggest that the cash flow right effect enhances value creation by aligning

    employee self interest with the shareholder value. However, at a higher level of

    ownership, the greater employee control right seem to negate the alignment effect by

    leading to management-employee entrenchment. 4

    This capturing hypothesis is consistent with the Pagano and Volpin (PV) model,

    in which managers concerned with hostile takeover threats bribe workers with above-

    market wages in return for their cooperation in fending off takeover bids. It is also