THE EMPLOYEE SHARE OWNERSHIP PLAN (ESOP):
- GENERAL EXPLANATION, TOGETHER WITH SPECIAL APPLICATION TO SRI LANKA.
- by Dr. Itil E. Asmon, International Consultant
NOTE: THIS ARTICLE WAS WRITTEN FOR A SRI LANKA CONFERENCE.
HOWEVER, ITS PRINCIPLES CAN BE EQUALLY WELL APPLIED TO ISRAEL.
II. THE ESOP PRINCIPLES
III. THE "CLASSICAL" ESOP MECHANISM
IV. ESOP ACHIEVEMENTS IN INDUSTRIALISED COUNTRIES
V. ESOP ACHIEVEMENTS IN DEVELOPING COUNTRIES
VI. CASE STUDY: PEOPLE'S PROVINCIAL BUS COMPANY, U.K.
VII. CASE STUDY: THE ALEXANDRIA TYRE CO., EGYPT
VIII. POSSIBLE APPLICATION OF THE ESOP IN SRI LANKA
APPENDIX: Issues Related to the Implementation of ESOPs in Sri Lanka
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Employee Share Ownership Plans (ESOPs) are a new financing
technique which is experiencing phenomenal growth in the U.S.
Since 1974, over 11 millions of U.S. employees have become
through ESOPs part owners of over 11,000 corporations, including
some of the largest in the U.S. The innovation of ESOPs is that
employees acquire individual shares on credit, without any cash
payment or salary deduction on their part. The credit is repaid
over a number of years through the increased revenue of the
company - the employees pay for their shares through increased
productivity. The employees receive their shares upon
retirement, but from the first year obtain dividends on their
shares if the company shows a profit. The U.S. Congress has
passed over 20 acts containing provisions which encourage
employee ownership. Some 300 ESOPs have likewise been
established in the U.K. ESOPs are advantageous to and are
supported by employees, management, present owners, the banks,
the government, and the major political parties. Research has
shown that companies with significant employee ownership have
much better labor relations and productivity increases than
comparable companies without employee ownership.
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ESOPs are fast becoming a topic of actuality in developing
countries. A pilot ESOP has been successfully installed in Egypt
(the $150 million Alexandria Tire Company, with 30% employee
ownership). Argentina has recently legislated many ESOP
provisions. ESOPs are being actively studied in Mexico,
Guatemala, Costa Rica, the Philippines, Poland, Czechoslovakia,
and even the Soviet Union. Many developing countries look to
employee ownership as a politically acceptable way to end or
reduce government involvement in ailing public-sector
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THE ESOP PRINCIPLES:
The ESOP is merely the best-known application of an economic
system called "ownership economics" (sometimes known as "binary
economics" or "economic democracy"). Ownership economics focuses
on the questions of who owns the productive assets of society,
and how can ownership be better distributed. It is a third
economic system which transcends both conventional capitalism
(ownership of most productive assets by a wealthy minority) and
socialism (ownership of most productive assets by the state). It
advocates economic policies which lead to ownership of productive
assets, in the form of significant individual holdings of
corporate shares, by a broad base of employees and other
The inventor of the ESOP is Louis Kelso, a San Francisco
financier and corporate lawyer, who established the principles of
ownership economics in his 1967 book entitled "Two-Factor
Economics: How to Turn 80 Million Workers into Owners on
Borrowed Capital". The basic principle of ownership economics is
to create new owners at the same time that new capital is being
created, through the use of production credit. The ESOP and
similar financial mechanisms create access to productive credit
for employees and other citizens who normally do not have such
access due to lack of collateral. The ESOP allows employee share
purchase with no money down, no salary deduction, no commitment
of the employees' pension funds and no personal liability. The
shares are acquired through credit which is organised for a group
of employees and repaid out of its own profits and company
contributions. Technically, the ESOP is a 100% leveraged buyout
in favor of the employees (and Louis Kelso is indeed the inventor
of the leveraged buyout).
It is also important to note what the ESOP is not. The ESOP
is not any kind of collective ownership, cooperativism,
syndicalism (ownership by trade unions), nor the German "co-
determination" model (union representation on the company board)
or the Yugoslav "worker management" model (politically-driven
management by committee). The ESOP results in private-sector,
profit-maximising corporations, in which a large number of their
own employees and other citizens have individual share ownership.
The ESOP makes employees feel like owners and behave with the
care typical of an owner, while leaving management to
professional managers under the authority of a board of
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THE "CLASSICAL" ESOP MECHANISM
The basic mechanism of a U.S. "leveraged ESOP" (i.e. an ESOP
financed through bank credit) functions as follows:
- 1. The company establishes an ESOP trust, which is a legal
entity distinct from the company and legally considered to be an
employee provident fund.
- 2. The ESOP borrows funds from a lender. Since the ESOP has no
collateral, the loan is usually guaranteed by the company.
- 3. The ESOP uses the loan proceeds to buy company shares
(newly- issued shares if the company uses the loan to acquire
productive assets, or old shares if the ESOP buys from an
- 4. The ESOP shares may be pledged to the lender as additional
- 5. Every year the company deposits enough money into the ESOP
trust to service the loan. Since the ESOP is regarded as a
provident fund, through an ESOP the company can repay the loan
with pre-tax dollars.
- 6. Whenever a part of the loan principal is repaid, a
correspon-ding number of shares is released from pledge and
deposited in employees' individual accounts in the ESOP trust.
The number of shares allocated to each employee is usually
proportional to salary; seniority and other factors may also be
- 7. Of any dividends distributed on the shares in the ESOP
trust, a part is retained to help service the loan and another
part is paid out to employees in proportion to the number of
shares in each employee's account.
- 8. Employees normally receive their shares only at retirement.
Depending on the trust provisions, retiring employees may receive
either the shares themselves or their fair market value in cash.
- 9. If an employee terminates service before retirement age, and
has been in service less than 5-7 years, he receives only a part
of the value of his account, according to a "vesting schedule"
included in the articles of the trust.
- 10. The ESOP trust is voted by its trustees, who may include
company and bank officers, professional trustees, and/or employee
representatives. For major decisions (e.g. merger, liquidation)
the vote is passed through the trust to the employees.
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ESOP ACHIEVEMENTS IN INDUSTRIALISED COUNTRIES
ESOPs became a significant movement in the U.S. since 1974,
when the ERISA (Employee Retirement Income and Security Act) gave
the ESOP legal recognition and fiscal advantages. Since 1974,
over 11,000 ESOPs have been established in the U.S. This
includes most airlines, most petroleum companies, most major
money centre banks, and household names like Xerox and Polaroid.
The employees' share in ESOP companies typically ranges from 15%
to 100%, and the trend is towards majority ownership by the
employees. Avis, the world's second largest car rental company,
was 100% purchased for US$ 1.75 billion by its 20,000 employees.
After the employee buyout, Avis changed its motto from "we try
harder" to "owners try harder", and has become more successful
Over 20 acts promulgated by the U.S. Congress since 1974,
and many more acts passed by state legislatures, contain
provisions which promote ESOPs. The net effect of this
legislation is that at present in the U.S., the cheapest way for
a corporation to finance expansion is to borrow through an ESOP
trust by selling shares on credit to its employees, and the most
advantageous way for an owner who wants to sell for any reason,
is to sell his shares to his employees.
It has been shown by comparative studies that companies
which have introduced significant employee ownership perform
better than comparable companies which have not. In very general
terms, it can be said that the percentage of added profitability
is of the same order of magnitude as the percentage of employee
ownership: for example, if a company becomes 50% employee-owned,
it can expect to become 50% more profitable.
While headlines have been made by employee buyouts which
turned failing companies around and saved them from liquidation,
employee buyouts of troubled companies comprise only about 2% of
all U.S. ESOPs. Some 98% of ESOPs have been established in going
concerns, and usually helped to make them more successful than
before. Of particular significance to Sri Lanka is the fact that
ESOPs have been quite successful in factories with a large
immigrant labor force whose educational level was lower than the
average in Sri Lanka. Ownership is something which even
illiterate workers can understand.
These economic effects were parallelled by the beneficial
social effect of ESOPs. Where employee ownership was introduced
strikes stopped, petty theft disappeared, and labor-management
confrontations were replaced by mutual search for increased
ESOPs enjoy support by management (which usually initiates
the ESOP), present owners, organised labor, the government, and
naturally the employees. Politically, the ESOP concept cuts
across the traditional division between right and left and enjoys
support across the political spectrum - from both Democrats and
Republicans in the U.S., from both the Conservative and the Labor
Party in the U.K.
In the U.K., the ESOP movement has become significant since
1987. ESOP legislation was enacted in 1989 and again in 1990.
Some 300 ESOPs have been established so far, and the number is
rapidly growing. The U.K. ESOP closely resembles the U.S. model.
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ESOP ACHIEVEMENTS IN DEVELOPING COUNTRIES
Two countries, for their own social and political reasons,
have applied on a large scale the principles of ownership
economics, through mechanisms different from the U.S. ESOP model:
- - In Mexico, after the general failure of cooperatives and
collectives in the land reform sector, the farmers were
reorganised in "smallholder agricultural corporations". This is
a private-sector corporation in which each farmer has a double
role: as worker and as shareowner. His share holding corresponds
to the land area which he voluntarily puts at the disposal of the
corporation (while retaining the title). Over 10,000 such
smallholder corporations were established in Mexico (notably for
sugar, cotton and oilseeds), and they have been quite
- - In Malaysia, the government's "bumiputera" initiative aims
to give more economic power to the Malay majority. To this end,
state-owned estates have been divested to their (predominantly
Malay) labor force, with private-sector management. In this case
as well, the results are reported to be quite favorable.
The first developing country to apply the U.S. ESOP model
was Egypt, where a pilot enterprise - the Alexandria Tyre
Company, discussed below - was initiated in 1988. The ESOP
concept, adapted to Egyptian legal and social conditions, was
actively embraced by the Egyptian government. The government
regards ESOP as a way to divest itself of troubled state-owned
enterprises without the political liability attached to sale to
already wealthy persons or to foreign corporations. Three such
divestitures are now being studied, with USAID and IBRD support.
The ESOP receives wide coverage in the government press, and
favorable treatment in both right and left opposition newspapers.
At the same time, several Egyptian private-sector leaders started
installing ESOPs in their own enterprises.
Argentina passed in July 1989 an economic reform law
containing many expanded-ownership provisions. The national
carrier, Aerolineas Argentinas, is presently being privatised,
and one of the criteria for choice of purchaser is the percentage
of ownership he will provide to the employees. Guatemala, Costa
Rica, Mexico and South Africa are actively studying the
application of ESOP. In the Philippines, President Aquino sold
through an ESOP shares to all workers in her family estate,
Hacienda Luisita (a sugar plantation). In the former East Block,
ESOP-like setups are being promoted in Poland, Czechoslovakia,
Hungary and even in the Soviet Union.
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CASE STUDY: PEOPLE'S PROVINCIAL BUS COMPANY, U.K.
The current initiative for peoplisation of the Sri Lanka
Transport Board may draw an example from Provincial Bus Co. in
the U.K. Provincial Bus was 100% acquired in 1987 by its 200
employees from its parent company, the state-owned National Bus
Co., and renamed People's Provincial Bus Co. Through an ESOP
trust, the employees borrowed ú580,000 (from Barclays Bank and
Unity Trust) to finance 80% of the acquisition cost. The other
20% were financed by each of the employees purchasing preference
shares for ú700 (redeemable after 5 years) and ordinary shares
for ú50. (The purchase of preference shares by employees was a
condition of the lenders for agreeing to finance 80% of the
employee buyout; in some other ESOPs, 100% credit financing has
The ESOP trust is managed by seven trustees, of whom three
are employees elected by all employees, two represent the two
lenders (these two will step down after five years), one
represents the community and one is a professional financial
The London Financial Times discussed the experience in an
article entitled "Workers' drive helps company turn the corner".
The newspaper reported that "...the ESOP at People's Provincial
seems to have been remarkably successful. Absenteeism has
dropped significantly, and internal theft has stopped altogether.
Despite a passenger drop of 7% per year, revenues have remained
fairly steady. This has been achieved through major cost
trimming and some employment attrition. Most importantly... the
attitude at People's has changed dramatically. Drivers are now
very concerned about the business. The take an interest in
delivery schedules and marketing, and have expanded service".
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CASE STUDY: THE ALEXANDRIA TYRE CO., EGYPT
The first ESOP in a developing country is the Alexandria
Tyre Company (ATC) in Egypt. ATC will construct and operate a
manufacturing plant for all-steel radial truck tyres. ATC is a
$150 million joint venture between the Pirelli Tyre Company of
Italy, the Egyptian-owned tyre manufacturer TRENCO, ten Egyptian
banks and an insurance company, and the ATC Employee
Shareholders' Association (ESA). Through the ESA, the employees
acquired 30.5% of the founding shares of this new company and
thus became as a group the largest shareholder. The employees'
shares were 100% financed by a $18 million loan from the Ministry
of International Cooperation. The loan funds originated from
sale of U.S. commodities through the USAID. Until the ESA is
legally established, the National Investment Bank has assumed the
loan as a temporary borrower on behalf of the employees.
Through the ESA, the share holding of every ATC employee
will exceed eight times his annual salary. His dividend income
is projected to reach 50% of his salary once the factory reaches
full production, and exceed 100% of his salary after a several
- The adaptation of the ESOP model to Egyptian conditions
contains several modifications with respect to the U.S. model:
- -The Employee Shareholders' Association, which was invented
as a substitute for the U.S. ESOP trust (since trusts are
not recognised under Egyptian law), by its nature involves
the employees more closely and is expected to give them a
more tangible sense of ownership.
- -Employees are being consulted regarding design of the ESA
from the very beginning.
- -Through the ESA, full voting rights in the employees' shares
are passed to the employees.
- -Since the $18 million worth of shares financed for the
employees, if allocated only to ATC's 750 employees, would
have created a disproportionately large share holding per
employee, the government decided to allocate 40% of these
shares to employees of TRENCO, the Egyptian "mother company"
of ATC. (Where there is a problem of redundant employees,
shares could be similarly allocated to retrenched
- -To reconcile USAID's insistence on market-related interest
rates with the Egyptian Civil Code which prohibits a non-
banking institution such as the Ministry of International
Cooperation from charging an interest rate exceeding 7%, itwas agreed that in lieu of principal and interest payments,
the Ministry will receive during the first ten years of full
production 50% of the dividends distributed on the shares
purchased with the loan. This is projected to repay the
Ministry the actual purchasing power of its loan, plus a
certain administrative charge and risk premium, regardless
of the rate of inflation.
- The ATC transaction has other aspects of particular interest
for a developing country such as Sri Lanka:
- -A multinational company - in this case Pirelli - agreed to
provide state-of-the-art technology and to assure
performance through a ten-year technical management
contract, while possessing only 10% of the shares. The
remaining 90% are owned by Egyptians, including 30.5% owned
- -The Italian government provided a $59 million loan to the
company - and thus indirectly to the employee-owners - at a
nominal interest rate of 1%. Thus bilateral (and multi-
lateral) credits can be used to finance employee ownership.
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POSSIBLE APPLICATION OF THE ESOP IN SRI LANKA:
The ESOP, properly adapted to Sri Lanka realities, can be a
powerful means to accomplish the goal of Sri Lanka's peoplisation
programme: to transfer the share ownership of state-owned
enterprises to their employees and a broad base of other citizens
(including former employees). Through the ESOP, share purchase
for employees is accomplished without cash down payment, salary
deductions, personal liability by the employees, or use of their
pension funds. Nevertheless, there is no giveaway of national
assets: employees do pay the fair market price of their shares.
The innovation of ESOP is that employees do not pay for their
shares out of past savings, which they don't have, but out of
future earnings which they help to generate.
The ESOP can be equally useful in Sri lanka's existing
private sector, to expand the ownership base of companies while
increasing their profitability through greater employee
A Possible Scenario for ESOP Implementation in Sri Lanka.
In Sri Lanka, the ESOP could be implemented as follows:
- 1. In each enterprise to be peoplised, an ESOP trust to
purchase shares for employees is legally established. (ESOP
participants may include employees who must be retrenched since
in a restructured company there is no physical work for them, but
through the ESOP they may stay on as "capital workers").
- 2. The trust obtains credit to purchase shares on behalf of
employees. The source of credit may be from banks, from the
Government outside of the banking system, from international
agencies or from international corporate investors. The key
aspect of financing the ESOP is discussed in more detail below.
- 3. The loan is paid back over a number of years out of company
contributions to the ESOP - which constitutes a new employee
pension fund - and from a part of the dividends on employee
shares. (This implies that an ESOP can be established only in a
company which is profitable or which can be made profitable. But
if a company cannot be made profitable, it will not find a
private-sector buyer either).
- 4. Another part of the dividends on the employees' shares is
distributed to the employees in cash, so that they perceive an
immediate benefit from the ESOP and become motivated to increase
- 5. Whenever the ESOP makes a repayment of the loan principal, a
corresponding number of shares is allocated to the individual
account of each participant, according to a formula embodied in
the articles of the ESOP trust.
- 6. The trust holds the shares for each employee until his/her
retirement or other separation from the company. At that time,
depending on the articles of the ESOP, the employee either
receives the shares, or the fair market value of the shares in
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Issues Related to the Implementation of ESOPs in Sri Lanka.
Legal status: Sri Lanka, unlike most countries in the
world, is fortunate in that the legal mechanism for implementing
ESOPs is already in place. In Sri Lanka the employee pension
trust is a recognised legal entity. Furthermore, Section
55(1)(b) of the Companies Act No. 17 of 1982 specifically
provides an exemption from the general prohibition against a
company providing loans, guarantees or other financial assistance
to purchase company shares, in the case where the company
provides money for the purchase of company shares to be held by,
or for the benefit of, employees of the company.
Percentage of employee ownership: An a priori determination
of the percentage of company shares allocated to employees is not
likely to be optimal. The guiding principle should be that
employees must have a significant stake in the company in order
to feel and behave like owners. Research has shown that what
matters most to an employee is not the percentage of company
shares held by all employees, but the value of his/her individual
share account. To provide significant motivation, the employee's
share value should ideally equal 3-5 years' worth of salary or
more. Thus it is recommended that the value of company shares
allocated to the employees (including retrenched employees) in
the course of peoplisation should equal 3 to 5 times the payroll
or more. In different companies this would amount to different
percentage of the company shares, depending on the capital
intensity of each company.
Voting of shares by the employees: As long as the shares
are in the trust, they are voted by the trustees. These may be
company, lender or employee representatives, or professional
trustees. There is considerable latitude regarding the voting
rights to be passed through the trust to employees. The ESOP is
a very flexible instrument which can be designed to accommodate
any concerns of its founders. Proper checks and balances can be
built into the trust to safeguard against irresponsible employee
representatives as well as against unscrupulous managers or
Moreover, research has shown that what matters most to the
individual employees is not their voting rights in the general
assembly, but the control they have over their immediate working
environment. Systems such as "quality circles" which allow
employee groups to formulate and implement their own ideas about
how to improve their work, coupled with ESOP which motivates the
employees, have resulted in large increases in company
profitability as well as employee satisfaction.
Sources of financing for employee ownership: The entire
ESOP scheme hinges on credit. Four sources for financing the
ESOP may be envisaged:
- 1. Banks may provide loans to ESOP trusts to purchase company
shares. Such a loan may be backed by company guarantee, in
addition to pledging the purchased shares to the lender. If the
company to be peoplised is not credit-worthy, the loan may be
backed by a Government guarantee.
- 2. The Government is potentially the most important finance
source for peoplising state-owned enterprises, by selling its
shares to an ESOP trust against an obligation of the trust to pay
for the shares in installments out of future cash flow, without
recourse to bank credit. This is analogous to a car dealer
selling a taxi to an individual at no down payment, to be paid in
installments out of future income earned by use of the taxi. All
sales of existing assets to employees can be done in this way.
- 3. International finance organisations such as the World Bank
or the Asian Development Bank provide credit for acquiring
productive industrial assets. State-owned enterprises subject to
peoplisation will usually need fresh funds for rehabilitation.
Credits provided by multilateral or bilateral finance
organisations can be used to create employee ownership if they
are not channelled to the government as in the past, but to the
ESOP trust with Government guarantee. (A recent ADB report
recommended 100% employee acquisition of Sri Lanka's sugar
refineries through ESOPs). This is the most appropriate way to
create employee ownership of new assets.
- 4. International corporate investors may in certain cases have
to acquire a majority position in an ailing company in order to
insulate it from the factors which obstruct its performance and
to provide the financial, technical and managerial resources
necessary to put it back on its feet. In such a case, ownership
by the foreign investors need not be permanent. The objective of
a corporate investor is not to retain perpetual ownership, but to
recover its investment in a given period of time with an
acceptable return. Thus the sale of shares may contain "sunset
clauses" which provide that the foreign investor's rights in the
shares are gradually extinguished without additional payment in
favor of the employees and other citizens. Normally quite a
small discount from the present sale price, or favorable tax
treatment, will be sufficient inducement for the investor to cede
his shares 10 or 20 years hence. For example, if the original
divestiture is 60% to a foreign investor, 30% to the general
public and 10% to the employees, a "sunset clause" may provide
that from year 10 to 20, in each year the investor will cede 5%
of the total shares to the employees at no cost, or through a
call option at a nominal price. Thus final ownership will be 60%
by the employees, 30% by the public and 10% by the investor.Conclusion.
- Employee ownership through ESOP is a powerful means to
accomplish the Government's goal of peoplisation. The ESOP
offers both the economic efficiency of a private-sector, profit-
maximising firm, and wide distribution of the profits to
employees and other citizens. The ESOP has been successful
wherever it was tried, in both industrialised and developing
countries. The performance of ESOP companies is generally higher
than of conventionally-owned private-sector companies, because of
the added employee motivation. Beside its good economic results,
the ESOP has been shown to be beneficial socially (fostering
industrial peace, eliminating strikes) and politically (being
supported by both the traditional right and left).
In Sri Lanka there are no legal impediments to the
installation of ESOPs. Finance for peoplising companies through
ESOPs can be found in different cases from local banks,
international finance organisations, foreign investors, and most
importantly the Government itself by agreeing to be paid in
installments. The ESOP is a very flexible tool, which can be
designed to accommodate any particular concerns in a specific
situation. The ESOP road to peoplisation is wide open, and
success depends only on the will of government decision-makers to
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