STRATEGY EMPLOYEE STOCK OWNERSHIP PLANS: THE ROLE OF EMPLOYEE PERCEPTIONS AS MOTIVATION Greg Filbeck University of Toledo greg/ilbeckA~a'uno. coni Raymond Gorman Miami University gomnaiuf(Qantuohio.ed» Sandra Fink The Andersons, Inc. .sandie JinkPoandersonsi nc. rom ABSTRACT Studies indicate that the primary reason for implementing employee siock ownership plans (ESOPs) is to increase employee motivation. However, few studies have assessed the relationship between participation in ESOPs and employees perceiving that their efforis affect their company's value. Our interest in this study is to determine whether the assumptions of management about the effectiveness of ESOPs on employee motivation prove correct. By comparing survey responses io questions concerning employee perceptions, we can deierniine thc importance of the differences thai exist between employees of small and large corporations. We find that ihe responses of small corporation employees are usually indistinguishable from those of large corporation employees. This result is consistent with our claim that prospect theory may help in explaim'ng why company managers should consider adding ESOPs to their benefits packages. INTRODUCTION Through surveys of company managers, Rosen (1989) finds that "increased employee motivation" tends to be among the primary management objectives when implementing and maintaining employee stock ownership plans (ESOPs). Pendleton, Wilson and Wright (1998) find that higher levels of commitment and satisfaction by employees are related feelings of ownership, including opportunities for decision-making. Managers believe that participating employees may feel that their individual performance will atTect the value of their company's stock. These conclusions have been reached by surveying literature regarding managerial attitudes such as Rosen and Klein (1983) and Marsh and McAllister (1981). However, little work has been done which directly surveys employee perceptions of their how their etTorts affect their company's value. In this paper, we investigate the impact that ESOPs have on employee attitudes and performance by questioning employees how much they believe that their actions affect the value of the company's stock. 68 Journo/ ofSmall Business Strateg)t Vol. /0, No.2 Eall/Winter /999 MOTIVATION FOR ESOPs Employee stock ownership plans (ESOPs) have dramatically increased in popularity since they were first authorized by the Employee Retirement Income Security Act (ERISA)of 1974. Approximately 10,000 firms have ESOPs and more than 12 million employees receive part of their compensation through ESOPs (National Center for Employee Ownership, 1997). ESOPs have grown in popularity for a variety of reasons, both from financial and motivational perspectives. An overview of previous research on the subject appears in Figure l. Figure I Results of Previous Studies on ESOPs Study Finding Managers of firms with ESOPs ranked the performance of their employees Rosen and Klein higher than did managers of non-ESOP firms. However, these studies (1983) could not determine whether the ESOPs caused the change in performance or whether superior companies set up such programs in the first place. General Survey of managers indicated that providing a benefit to employees (91%) Accounting was the most common reason for starting an ESOP. Taking advantage of Otyice (1986) tax benefits (74%) and improving productivity (70%) were ranked second and third in the survey. The adoption of an ESOP alone could not explain the improved Rosen and performance in a firm. In those firms in which employees were given any Quarrey (1987) opportunity for participating in job-level decision making, growth figures indicate a relationship seems to exist between productivity gains and a participation/ownership system. Bruner and Managerial control and altruism may be motivating factors in the Brownlee (1990) establishment of an ESOP (case study of Polaroid). Chang (1990) Announcement of ESOP formation results in enhanced market performance of stock when used as wage concession or leveraged buyout. Rosen Continued growth in ESOPs is tied to the belief that ESOPs improve (1990) company performance. Kumbhakar and Employee participation in an ESOP is positively associated with 13unbar(1993) productivity measures. The productivity effect increase with the age of the ESOP at the rate of 1.8 to 2.7 percent per annum. Park and Song Firms that adopted ESOPs show significant improvement in their year-end (1995) performance. ESOPs tend to work best as employee incentive when the ownership structure of the firm serves as an etTicient monitoring device. Pendleton, Stock ownership through ESOP programs is associated with higher levels Wilson, and of commitment and satisfaction for employees based on a study of British Wright (1998) firms. In addition to these studies of ESOPs that focus on traditional arguments, Brickley and Hevert's (1991) investigation of the composition and distribution of direct employee stock ownership plans presents alternative speculation on the determinants of employee stock ownership. They argue that incentive benefits must exist for such programs since they continue to increase in popularity despite their cost and the impact of unresolved questions about productivity, tax benefits, and takeover likelihood. A summary of their discussions on the rationale for ESOP formation appears in Figure 2. They separate their arguments into two categories, traditional (concrete, economically based) and nontraditional (abstract, psychologically based). Our study focuses on one of these non-traditional arguments —that of prospect theory. 69 Journal oISmall Business Strategy Vol./0, No.2 Fallltyinter /999 AN INTRODUCTION TO PROSPECT THEORY Imagine yourself at a carnival entering a particularly inviting looking tent. As you enter the tent, you are handed $ 1,000 and told you may leave the tent by one of two doors. If you leave by door number I, you will receive an additional $500 for certain. If you exit by door number 2, you will either receive an additional $ 1,000 or receive no additional money. There is a 50% chance for either outcome when leaving out of door number 2. Which door would you choose to leave from? Figure 2 Summary of Rationales for ESOP Formation Brickley and Hevert (1991) TRADITIONAL ARGUMENTS Increased conscientiousness Fewer security leaks Higher respect for property Increased suggestive participation Higher awareness of shirking NON-TRADITIONAL ARGUMENTS Group identification Prospect theory implications Better informed employees Now suppose you go back to the carnival the following year and see this tent again and decide to enter. This time you are given $2,000 upon entering. You are then told that it will cost you $500 to exit from door number l. If you leave by door number 2, there a 50% chance that it will cost you nothing to leave and a 50% chance it will cost you $ 1,000 to leave. Which door would you leave from? If you are like most people, you chose door number I in the first case and door number 2 in the second case. But as reported by Kahneman and Tversky (1979), the choice between which door to exit from is the same in both tents. In each case, you are faced with a certain $ 1,500 by going through door I or a 50-50 chance of a total of either $ 1,000 or $2,000 by going through door 2. What seems to fool most people is that the first scenario was presented in terms of an extra gain al)er receiving $ 1,000, while the second scenario was presented in terms of losses alter receiving $2,000. Experiments such as these have led some researchers to conclude that people treat gains much differently from losses and people make different choices in what are essentially identical opportunities, simply because of the way the problem is presented. In prospect theory, this is called the "framing effect." 70 Journal ofSmall Business Strategy Vol./0, No.2 Fall/Winter l999 Prospect theory is part of a burgeoning literature in behavioral economics (see e.g. Thaler, l992). Whereas traditional economic theory assumes that people are super rational and selfish decision makers, prospect theory observes that people do not always make choices that are consistent and predictable. Prospect theory, as explained by Kahneman and Tversky (1979), was recently summarized in a Wall Street Journal article on November 28, 1995. Figure 3 presents some of the highlights of prospect theory. Figure 3 Prospect Theory: Observations of Human Behavior Summary of Wall Street Journal article (November 28, 1995) ~ Ipe hate ta lose. People are more risk averse than most economic models assume. There is o(ten more pain from losing than pleasure from gain. There is evidence that people tend to sell their winning stocks too early and hold onto their losers for too long to avoid the recognition that they have lost money in the market. This also explains why some people never invest in stocks at all in spite of their superior long-term returns. ~ We (ach self-control. Anyone observing the annual rite of making New Year' resolutions sees evidence of our lack of self-controL Signing up for automatic reinvestment plans so we won't be tempted to squander this money made from our investments is seen by some as a recognition by investors of their lack of self- control. ~ Ipe often misread the past. Many investors allen overweight recent performance as they make financial decisions. The billions of dollars currently being invested in mutual funds while the market is at an all time high with a historically high price to earnings may be evidence of this phenomenon. ~ We don't see the big picture. Investors tend to divide their money into different mental accounts. They may keep large balances on their credit card accounts while maintaining a savings account earning a minuscule return. ~ Ipe overweight law probability events. The popularity of lottery tickets and the purchase of accident insurance are both consistent with this assertion. MOTIVATIONAL ASPECTS OF PROSPECT THEORY Applying these ideas to ESOPs, Brickley and Hevert suggest "that employees might systematically overweight the likelihood that their actions will affect firm value." In other words, ESOP participants will be less likely to take self-serving actions that increase their personal wealth because of the possible expense such an action could have on firm value. For example, careless or inattentive work on an assembly line that might make the day pass more pleasantly for employees could result in shoddy products that eventually decrease the value of the firm. Since ESOP participants have a direct stake in the value of the firm, they may be less likely to take such actions. However, would this assumption apply across all companies in all situations? This question may be answered by an application of prospect theory. It seems reasonable to assume that the ESOP is likely to be an effective motivational tool only to the extent that employees of large corporations feel that their actions affect firm performance as significantly as the actions of employees in small corporations. While the organizational behavior 71 Journal ofSmall Business Strategy Vol./0, ttto.2 Fall/Winter /999 literature remains relatively silent as to the relationship between company size and employee motivation, the labor economics literature indicates that based on company size and empirical observations (Brown, 1990), incentive structures of companies differ, and, therefore, affect employee attitudes. Brown points out that one of the critical size-related variables affecting incentive structure is monitoring costs. Employees of larger firms can "hide" more easily than those in a smaller firm, so it is more diAicult to monitor them. Conversely, a hard-working employee in a larger firm has a more diAicult time demonstrating superior effort and feeling rewarded for that extra effort. Thus, we contend that employees of smaller corporations would be expected to perceive that they have a greater influence than employees of larger corporations on the success of the firm, and hence firm value. With the inclusion of the ESOP, the perceptions of the employees of larger corporation might more resemble that of the smaller corporations because they now have their personal wealth at stake. If there are no significant diITerences in the survey responses based on firm size, then this should constitute evidence that prospect theory may be part of the explanation for the success of ESOPs as a motivational tool in a large corporation. SURVEY CHARACTERISTICS To study the impact of prospect theory on incentive implications of stock ownership, we used a survey similar to that of Marsh and McAllister (1981) to question the rank-and-file employees and top management concerning their attitudes toward ESOPs. Our survey sample significantly dilTers from that of Marsh and McAllister, since we are including rank-and-file employees. Marsh and McAllister's survey was restricted only to top management perceptions of employees'nitudes toward ESOPs, rather than directly surveying employee attitudes. Specific information about the survey and methodology appears in Figure 4. Figure 4- Survey and Methodology Characteristics ~ 150 companies with ESOPs were randomly selected from the National Center for Employee Ownership data base. For each company, six survey forms were mailed: one to be completed by a company contact person, usually the CEO or owner, and five to be completed by employees designated by the contact person. Pre-stamped, addressed response envelopes distributed to assure confidentiality. ~ Thirty-three surveys were returned because the contact person had left the company, company had been dissolved, or company bad been purchased by another company. 14 companies returned the surveys indicating unwillingness to participate in study. ~ As a result, 103 valid mailings of type I surveys (contact person) and 515 type 2 surveys (employees) remain. A total of 16$ valid responses were received for a 27,2% response rate. ~ Firms were divided by size into three categories: small, I —100 employees; medium, 101 —500 employees; and large, greater than 500 employees. 47 responses were from small Iirms, 53 responses were from medium firms, and 68 responses were from large firms. Participants responded on a five-point scale with "5" representing "strong agreement" with a question to "I"indicating "strong disagreement" with a question. A chi-square (X ) test of independence (e.g., Winkler and Hays, 1981) was used to test for differences between the firm size and level of agreement among questions. 72 Journal ofSmall Business Strategy Vok/0, No.2 Fall/Winter 1999 RESULTS The survey is divided into two parts. The first portion reports on issues related to the perceived reasons for implementing the ESOP, while the second portion reports issues about the effects of the ESOP on attitudes. In each case, these responses are subdivided into three categories based on firm size (small, medium, and large) for the employers (i.e., CEO or owner), employees, and the total sample. Nationally, 86% of afl businesses have fewer than 20 employees, 11% have between 20 and 100 employees, 2% have between 100 and 500, while only fewer than 1% have more than 500 (U.S. Bureau of the Census, 1993). Table I denotes those questions where statistical dilTerences in the chi-square tests exist in the responses (by company size) to the survey related to perceived reasons for the ESOPs. Results are reported for both the employers and employees responses, as well as for the combined sample. Among the seven questions listed, there appears to be an overwhelming difference in how both employers and employees of firms of dilYerent size perceive the rationales for the ESOP. While this data is interesting, our focus is on the effects of the ESOP on attitudes within the firms. Table I - Statistical Differences in Chi-Square Tests for Survey Questions Section I —Perceived Reasons for the ESOP How important was each of the following motivation in your Emp- Emp- company's decision to have an ESOP: loyers 1oyees Total 1. to finance an employee purchase of the company? 2 to provide o private market for stock of existing shareholders? 3. to improve the productivity ofemployees? 4. to minimize the potena'al of unionization or strikes? 5. to provide a benefit for employees? 6. to finance the growth of the company? 7 io avoid a merger or shui-down? Section I - Total significant 6 6 7 Denotes significant difference exisis m responses by company size at the five percent level and that smaller Jirms responded more favorably than larger firms. '+ Denoies signi Jicant difference exisis in responses by company size at the five percent level and that larger firms responded more favorably than smaller firms. Denotes significant difference exists in responses by company size at the five percent level with no difference between larger Jirms responses and smaller firm responses. We tested the hypothesis that the attitudes of survey participants toward the ESOP is unrelated to the size of their firm. Accepting this hypothesis would be consistent with a prospect theory contention that individuals tend to overweight the importance of their actions since individual employees in large companies are likely to have less influence on the stock price. If the employee perception is unaffected by firm size, then employees of larger companies may be under the mistaken assumption that they have more influence than they really do. This similarity in response between large and small companies is consistent with prospect theory. Table 2 denotes those questions where statistical differences in the chi-square tests exist in the responses (by company size) to the survey related the effects of the ESOP on attitudes. Results are reported for both the employers and employees responses, as well as for the combined sample. Note the instances in which the employees provide different answers based on company size compared to employers. Figure 5 lists the areas of significant dilTerences. 73 Journal of Small Business Sfrafegy Vol. /0, N0.2 Fajllkyi uter l 999 Table 2 —Statistical Differences in Chi-Square Tests for Survey Questions Section ii —Effects of the ESOP on attitudes Questions Emp- Emp- loyers ioyees Total 9 Do you think that the ESOP hus resulted in reduced employee obsenieeism? 10. Do you think that the ESOP has resulted in reduced employee mrdi ness? I I. Do you think that the ESOP hos resulted in reduced employee turnover? 18. Because o the ESOP, how do you perceive higher employee morale? i'+ 19. What is your reaction to the ollowmg statement concerning the impact of your company's decision to have an ESOP —because of emplol ee ownersbip, my work is more saris/sing? 20. What is your reaction to the following statement concerning the impact of your company's 0 cci sion to have an ESOP —employee ownersbi p ai ibis company maRes my day-io-day work more enj oyable? 21. What is your reaction to the following statement concerning the impact of your company's decision to have an ESOP - owning siocR in ibis company makes me more interested in ihe company's Jlnanciel succets? 26. What is your reaction to the following statement concerning the impact of your company's decision to have an EsoP - Ifeel thai I havej ob securiyr? 27 What is your reaction to the ollowing statement conccming the impact of your company's decision to have on ESOP - ibe work I do on myj oh is meaningful to me? 28. What is your reaction to the oliowing statement concerning the impact of your company's decision to have an ESOP - 4 porrion of my pay should be ' v+ based on bow Iperform? 33. What is your reaction to thc ollowing statement concerning the impact of your company's decision to have an ESOP —coming io worR is a pleasure? 36. What is your reauion to the ollowing statement concerning the impact of your company's decision to have an ESOP -iJI could begin working over ogain in ibe same field as I am now, I would choose the same company as a place io work? 37. What ts your reaction to thc ollowing statement concerning the impact of your company's decision to have an ESOP -if another company oPered me v+ more money (wiib no ESOPI for Ibe same Rind oJwork, I would almost cenainiy accept? 38. What is your reaction to the ollowing statement concerning the impact of your company's decision to have an ESOP - on occasion, I Rave been angered by attempts made by ibis company io inJIueuce my anirudes and bell efs? 39. Please indicate the extent to which you agree with the following statement because your company has an ESOP - I am more careful noi io have accidenu? 40. Please indicate the extent to which you agree with the following statement hccuuse your company has an ESOP - I lend ro endorse our products more? 43. Please indicate the extent to which you agree with the following statement because your company hes an ESOP-itis more lmpononi Jar mero Reep upon v+ news about my company? 47. Please indicate the extent to which you agree with thc following statement because your company hus on ESOP - I am more liRely io volunteer for otviviriess onsoredb m co an? Denotes signi Jicani difference exisis in responses by company size ui ilie five percent level ond iboi smaller Jirms responded more favorably shan larger Jirms. '+ Denotes signijicanl difference exists in responses by company size at the five percent level ond that larger firms responded more favorably Ihan smaller Jirms. Denotes significant difference exists in responses by company size at ibe five percent level with no difference benveen larger firms responses and smaller firm responses 74 Journal ofSmal/ Business Strategy Vo/. /0, No.2 Fa//IIV/nter /999 Figure 5- Differences in Employer and Employee Responses on Perceived Reasons for the ESOP Based on Firm Size ~ Employee absenteeism (question 9) ~ Morale (question 18) ~ Pay based on performance (question 28) ~ Pleasure of working (question 33) ~ Volunteer activities (question 47) Of these questions, question 28 probably relates most strongly to the concept of an ESOP as a motivational device. However, we can see from Table 2 that, for question 28, the employees from the largest firms were more in agreement with the notion that pay should be based on performance compared to employees from the smallest firms, a complete reversal from what we should expect. In fact, on 22 of the 40 questions relating to employee motivation, employees from the largest firms were more in agreement with the statements than employees from the smallest firms. This constitutes further evidence for the idea that employees tend to overweight the value of their actions. Overall, 94 out of 120 statements (78%) do not have statistically significant chi-square statistics (i.e. there is no statistically significant difference between groups). For the employee surveys, 35 out of the 40 (88%) "attitude" questions do not have significant statistics. This general lack of a significant difference provides further support for a prospect theory explanation for ESOPs. For the employer surveys, 24 out of 40 (60%) of these same questions do not have significant statistics; in the combined sample, 34 out of 40 (85%) are also not significant. Perhaps surprisingly, employers may actually underestimate the degree to which employees feel that their performance affects firm value. CONCLUSION The results from this survey have a potentially far-reaching implications for compensation managers when recommending the implementation or maintenance of an ESOP. It appears that companies that establish an ESOP as a motivational device will find it works equally well in large and small companies. Figure 6 highlights some of the areas of agreement and disagreement in attitudes of employees in large and small companies. The areas of agreement far outweigh those of disagreement. However, it is interesting to note that employees of smaller firms are more agreeable to the effects of ESOPs as a motivational tool than employees of larger firms on a number of points. In particular, employees of smaller firms believe that ESOPs serve as a motivational tool in such direct areas of job satisfaction and performance-based pay. Benefits are also observed in indirect ways. Employees of smaller firms tend to find work more pleasurable and are more likely to engage in volunteer work as a result of an ESOP. Smaller firms seeking an edge over larger firms in employee motivation might well consider the impact that an ESOPs has in these areas. This by no means "proves" that the existence of ESOPs can be explained entirely by prospect theory or that prospect theory is the only perspective to consider when implementing an ESOP. However, we do feel that prospect theory adds an important piece to the puzzle that explains ESOPs. This research also helps to clarify and illustrate the incentive impact oi'SOPs. Employee stock ownership plans are costly, yet firms continue to use them as a part of the employee benefits/retirement package. Tax-based, takeover-based, and traditional incentive arguments 75 Journal of Small Business Strategy Vol.10, iuo.2 Fall/IVinter 1999 Figure 6 - Implications for Managers Effects of ESOPs on Attitudes Employees of smaller firms with ESOPs have indistinguishable views from that of larger firms with ESOPs with respect to the following points: e Reduced employee grievances Improved quality of work Enhanced cooperation among employees Improved communication between workers and management More satisfying and enjoyable work Greater willingness for elfort beyond expectation Recognition ofhard work well done Loyalty and confidentiality e Likelihood of endorsement and purchase of company products e More interested in company affairs ply f If*If * I I II ~bl* 9 d * plyfn f larger firms regarding the effects of ESOPs as a motivational tool. e Job security Performance-based pay Work viewed as pleasurable Increased likelihood for volunteer work may be incomplete explanations. They do not individually or collectively explain the motives for and the consequences of ESOPs (although they certainly help to explain the popularity of ESOPs). Brickley and Hevert (1991) state that "employees who are basically indifferent between alternative behaviors will tend to choose value-enhancing activity when they own stock in the firm." Our research shows that whether employees actually affect stock performance or not may not be as initially essential as their perception of their inliuence on the company's success. As a non-traditional incentive explanation, prospect theory helps us to understand why these employee perceptions prove valuable to the inclusion of ESOPs in company packages, and why they, in turn, may provide positive performance motivation across all sizes of companies. REFERENCES Behavior specialists put investors on the couch (1995).Wall Street Journal November 28. Brickley, J., & Hevert, K. (1991). 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Harvard Business Review 65 (5), 126-132. Thaler, R.H. (1992). The winner's curse. Princeton: Princeton University Press. U.S. Government Accounting Office, (1986), Em lo ee Stock Ownershi Plans, (GAO- EMD-86-4BR), February. Winkler, R. & Hayes, W. (1975) Statistics robabili inference and decision. New York: Holt, Rinehardt and Winston. Greg Filbeck is an Associate Professor of Finance in the College of Business at the University of Toledo where he also serves as Associate Director for the University of Toledo Center for Family Business. His teaching and research interests include investments, corporate finance, behavioral finance, and learning styles. He earned his D.B.A. from the University of Kentucky, and his B.S.Pom Murray State University. Raymond F. Gorman is the Associate Dean for Curriculum and a Professor of Finance in the Richard T. Farmer School of Business at Miami University where he is also the Director of the Cenier for Sustainable Systems Studies. His teaching and research interests lie in the broad area of corporate fmance and intersections offinance with public utilities, sustainable development, and human behavior. He earned a D.B.A, from Indiana University, an M.B.A. Pom Duke University, and a B.A.Pom Brown University. Sandra Fink is Benefits Manager for The Andersons, managing the health and welfare plans, retirement programs, and other benefits for its 3,000 employees. JVith l5 years of experience in Human Resource Managemeni, she specializes in the benefits and compensation area. She earned her M.B.A. from the University of Toledo, and her B.S. Pom George Mason University 77