Commonwealth Competition Council - Senate Document No.12

Report of the Secretary of Administration and the Commonwealth Competition Council on Methods to Privatize Appropriate State Government Functions Through the Development and Promotion of Employee-owned Companies (ESOPs)

To the Governor and the General Assembly of Virginia

Senate Document No. 12

Commonwealth of Virginia, Richmond 1997

PRIVATIZATION STUDY
METHODS TO PRIVATIZE APPROPRIATE STATE GOVERNMENT FUNCTIONS THROUGH THE DEVELOPMENT AND PROMOTION OF EMPLOYEE STOCK OWNERSHIP PLANS (ESOPs)

EXECUTIVE SUMMARY

Employee ownership is having a significant impact on employee motivation and corporate productivity in the United States economy. Whether through employee stock ownership plans (ESOPs), broadly granted stock options, or 401(k) plans with the option to purchase employer stock, American employers are more and more interested in making their workers owners. Just as important, however, are potential productivity gains. Studies consistently show that when broad employee ownership is combined with a highly participative management style, companies perform much better than they otherwise would be expected to do. As a result of this, the number of employers sharing ownership broadly with employees has grown substantially. The employee ownership experience in the private sector and in other countries can be applicable to developing the ESOP concept in Virginia government.

There are approximately 12,000 ESOPs in the United States covering about 15 million participants and controlling over $300 billion in company stock. Of these companies, 15 percent are publicly traded and 85 percent are privately held. The median percentage ownership for private companies is about 35 percent with approximately 2,500 companies now majority employee-owned. Included in this report is "The Employee Ownership 100," listing the largest ESOP companies in the country.

An ESOP is a federally qualified employee benefit plan regulated by the Department of Labor and the Internal Revenue Service according to the guidelines of the Employee Retirement Income Security Act (ERISA), as amended, of 1974. ERISA is the enabling legislation which gave ESOPs their specific statutory framework. Since 1974, federal legislation has provided ESOPs with additional tax benefits.

The ESOP gives the employees of a company sponsoring the ESOP a beneficial ownership in the company, which is why the employees are referred to as "employee-owners" and the ESOP is referred to as the "employee ownership" plan.

There are several unique features about employee ownership in an ESOP. First, the assets in an ESOP, which are primarily the stock of the company, are held in trust. As the company increases in value, the stock in the ESOP, including the value of employees' shares, increases in value. The reverse can also happen and the stock can go down in value. With an ESOP, gains such as productivity, profits, revenues, and efficiencies increase the value of all the employee accounts in the ESOP. Second, unlike other employee benefit plans, an ESOP may borrow money. There are significant tax savings to the ESOP company as it repays the ESOP loan. As the company makes contributions to repay the ESOP loan, it receives a tax deduction for both principal and interest. An ESOP that borrows is referred to as a "leveraged" ESOP.

Leveraged or unleveraged, the ESOP is unique from other employee benefit plans in transferring ownership of company stock to employees. Other plans can transfer ownership, but the ESOP is specifically designed to transfer shares to employees, and its ability to borrow money to acquire the shares makes the leveraged ESOP unique from other employee benefit plans. The ESOP creates a direct link between company interests and employee interests. This report shows an example of the flow of funds and the accounting treatment of a leveraged ESOP, facets of which would apply to a government ESOP privatization.

The increasing interest in combining employee ownership and privatization in other countries suggests that employee buy-outs of government enterprises and service functions is an idea whose time has come. The use of employee ownership and ESOPs as a means of privatizing government services and enterprises is much further along in the United Kingdom, parts of Europe, Russia, Latin America, and Canada, than in the United States. More than 50 countries have included employee ownership as part of their privatization initiatives.

In the United States, the first ESOP privatization of a government function occurred in 1996 when the federal Office of Personnel Management assisted over 700 federal employees in creating a new ESOP company called US Investigations Services, Inc. This national ESOP company, based in Annandale, Pennsylvania, now conducts all the personnel background investigations for the federal government, which were formerly performed by the Office of Personnel Management. There are a number of other federal and local government functions that are currently being analyzed for potential ESOP privatizations.

It is clear from the research conducted during this privatization study that ESOPs have become a "cottage" industry and that federal legislation continues to strongly support employee-owned companies. This strong support has continued in the 1997 Tax Act, which contains a provision expanding ESOPs to Subchapter S corporations beginning in 1998. Also, a number of state governments have enacted "Employee Stock Ownership Assistance Acts" as part of their economic development and retention programs to assist current and potential companies in developing and converting to an ESOP. From national trade and research organizations devoted to employee ownership, to quality expert consultants, law firms, and specialists, there is an abundance of expertise available to implement ESOPs.

This report details the process the experts use to implement an ESOP: conduct feasibility studies; provide and arrange financing; incorporate a new company; establish and administer the ESOP; develop marketing and business plans; recruit senior management; and develop and train management and employees in open book communications and participative management.

The research has determined that the Commonwealth of Virginia is the only state government entity in the United States that has undertaken an effort to study the privatization of state government functions through the development and promotion of employee-owned companies, and that the ESOP community supports the purpose of this study. This support was confirmed through meetings with major Virginia-based ESOP companies and surveys of ESOP companies in the Mid-Atlantic region of the country. Some of these companies have indicated a willingness to become financial and strategic partners with a state "government" ESOP company to ensure its success in the private sector.

With many governments undergoing the process of "reengineering", "retooling", or "reinvention", a perennial concern is the employee factor in these movements. An ESOP can be the solution to this human element. There is strong evidence in the United States that ESOP companies tend to be more efficient than their competitors. The economic benefits of employee ownership are numerous. Public agencies via ESOPs can achieve cost savings above and beyond other methods of privatization and studies have shown that employee-owners are very motivated. The more shares employees own, the more committed they are with their jobs. Since an initial contract of an ESOP company with Virginia government would presumably be a sole source procurement, the former government employees who are now employee owners of the ESOP company, would not be displaced.

This report discusses in depth the analysis of the three groups that were assigned to this study. Also included is comprehensive information on the features and unique tax-favored advantages of ESOPs; motivation/corporate performance of employee ownership; ESOP survey results; ESOP examples; ESOPs in other countries; an ESOP process; federal and state laws pertaining to ESOPs; and key organizations supporting ESOPs.

Summary

This study did not reveal any current Commonwealth of Virginia rules, procedures, policies or limitations that would preclude an ESOP privatization of a government unit or service. Moreover, there is no current recognition or implementing regulations in the Code of Virginia pertaining to ESOPs.

At the federal and local government level, there presently exists, or are underway, innovative ESOPs generated from former government functions. It will be necessary for the Commonwealth to make an initial investment in funding a pre-assessment analysis and feasibility study in promoting ESOPs. The original investment is recoverable through cost savings or a favorable repayment contract provision with the newly created ESOP company/s performing the government service.

Conclusion

An ESOP is an excellent privatization method for performing government services. It gives employees a direct stake in the equity growth of the privatized company and more control over their own future. Employees will have an incentive to support the privatization process since job displacement concerns will be reduced.

The employees can achieve greater financial rewards when the ESOP is combined with other retirement plans, such as a 401(k) plan, which can provide substantially higher retirement benefits than under the state system. The rewards are predicated upon the success of the new privatized company. Experience in the private sector has demonstrated that once employees understand the potential for financial accumulation in the ESOP, many will become enthusiastic supporters of the privatization process.

In the ESOP privatization process, the opportunities for everyone to gain is present. The state can realize a fair selling price from the privatized entity to perform the service, taxpayers can look forward to a reduced cost of providing the service, and the privatized entity can offer the potential of significant financial rewards to the former government employees that have become employee owners. Lastly, the reduction in the capital gains tax in the 1997 Tax Act will provide a strong motivation for substantial growth in ESOP formation.

An ESOP privatization of a government function can produce multiple results: more cost-effective and efficient services; reduced government payroll with little or no job displacement; employee support for the privatization process; private sector job creation; increased tax revenues; and promotion of economic development.

Recommendations

Consideration should be given by the Governor and the General Assembly to enact legislation for funding to support and assist current ESOP companies and to promote the creation of new ESOP companies in both the private and public sectors. This ownership transition service function should be assigned to an appropriate state agency.
The mission of this service and state agency should be to promote employee participation and stock ownership by providing information, education, and technical services to employee groups and business owners and to generate awareness of the concept with the general public.

By providing practical information and assistance to help organizations implement equity-based compensation and broad-based participation programs, the designated agency providing this service will enhance economic and social development through broader ownership and involvement in the free enterprise system.

It is further recommended that funding be provided in the 1998-2000 budget to conduct a pre-assessment analysis and feasibility study on selected state functions that may be candidates for an ESOP privatization.

Taskforce on Commercial Activities of Charitable Organizations

Competition@dpb.virginia.gov