Based on this week's Learning Team assignment, create a spreadsheet where you analyze the costs and returns using ROI, Payback, IRR, and NPV and include it in your presentation.
1243753 - SAGE Publications © Equity Benefits 11 Introduction In the late 1980s in the United States, Avis Rental Car Company aired a television advertisement touting that Avis employees try harder because they are number two behind Hertz and because “they own the company.”1 The ad referred to Avis employees’ participation in a stock ownership plan that gave them a significant stake in the company. The inference to be drawn from the ad was that employee ownership can be the ultimate link between employees and shareholders. By owning stock, employees would be more committed to “total shareholder return” (TSR), a combination of stock price appreciation and dividends. More important, they would be focused on the drivers of TSR —increased sales, profits, better customer service, consistent quality, reduced costs, and improved productivity. The advantages for employee ownership, however, proved to require more than just passing out stock to employees. It required a whole new attitude of ownership within the company. And employers understood that even with substantial employee equity they still had to maintain a substantial block of public ownership in the capital markets in order to ensure stock price growth.2 Thus, their operating policies had to appeal to both constituent groups even though, ultimately, the interests of both were aligned. Motivated by the implications of the agency theory, a labor economics principle endorsing reward practices that link the interests of owners and managers, employers surveyed the landscape of benefits that might have the same impact on large segments of the total workforce. With Avis, broad-based stock ownership became a critical marketing program. For others, stock ownership offered a new approach to business success and they searched for benefit plans that would put more stock in employees’ hands.3 Retirement Plans and Stock4 There are direct and indirect ways that serve the purpose of increasing employee stock ownership. Employer sponsors of profit sharing retirement plans often fund employee accounts with company stock. Employees’ shares grow each year as the plan sponsor deposits annual allocations of company stock. The employee participants maintain all the privileges of stock ownership—they receive dividends and have voting rights. Counting on stock price growth to increase their own retirements, employees are perceived to share 1243753 - SAGE Publications © common interests among executives and other shareholders. They have every incentive to productively apply themselves on the shop floor just “as if they were the owners of the company.” Profit sharing plans are a key part of the overall strategy of successful companies like The Procter & Gamble Company (P&G) where all employees accumulate employee stock in their retirement accounts and are focused on stock price growth and the factors that drive it.5 The introduction of 401(k) plans in the mid-1980s offered employers another opportunity to increase employee stock ownership. In the early years of these plans, company stock was one of only a few investment options available to employees.6 Additionally, employer matches were made in company stock and, in some cases, additional stock matches were paid if the employee chose company stock as his sole investment option. While today’s 401(k) plans offer many other investment opportunities, company stock remains a frequent choice among employee participants,7 and company matches are still paid in company stock. It is estimated the introduction of 401(k), profit sharing plans, and ESOPs increased employee stock ownership to about 35 percent of U.S. employees who work for companies that have stock.8 Employee stock ownership plans (ESOPs) became popular in the 1980s and 1990s. In these plans, which were frequently leveraged,9 the employer periodically funds the plan by making contributions of company stock to employee accounts.10 If the ESOP is leveraged, the employer funds the retirement accounts with company stock as the loan is repaid. Like some profit sharing plans, the integrity of the employee’s retirement income is based on the continued growth of the company stock. Fearing this might create significant investment risks to the participants, the Internal Revenue Code provides employee participants over age 55 with ten years of service the opportunity to gradually divest their company stock and reallocate their ESOP accounts with other securities.11 Stock Purchase Plans Employers also can take a more direct approach to increasing employee stock ownership by simply facilitating the purchase without a brokerage commission, or offering employees a discount when they buy company stock. Further, employers can include dividend reinvestment plans (DRIPs) where the dividends on the company stock are automatically reinvested to purchase additional stock, thus increasing employee ownership. Stock purchase plans continue to be offered as benefits and in many instances are regarded highly by employees.12 Employers see these plans as low-cost efforts to increase employee ownership. American companies are somewhat unique in the world market because of their interest in, and in many instances commitment to, the idea of employee ownership.13 In the 1970s they started to develop more direct benefit plans that rewarded certain segments of the workforce, particularly executives, with specialized stock ownership plans that included unique features and new incentives. They were called stock options. Stock Option Plans 1243753 - SAGE Publications © A stock option is an offer made by the employer to an employee giving the latter the opportunity to purchase a specified number of shares of company stock at its average market price on the date of the grant. The market price is often referred to as the “strike price.” The term of the grant is typically ten years,14 with a vesting requirement of three to five years. Thus, once the employee-grantee has a vested interest in the options, he has the right to purchase the stock at the strike price for the period of the grant. The stock option plan also can stipulate graduated vesting. For example, with a five- year graduated vesting requirement, the grantee can exercise 20 percent of the option shares granted after the first year, 40 percent after the second, and so on. Or, the options can be subject to cliff vesting, where the grantee earns the nonforfeitable right to the options after the total vesting period has elapsed. Options are called long-term incentive plans (LTIPs) because their value usually accrues over a period of several years. The employer’s strategy is to provide employees with the opportunity to acquire the same appreciation in stock value as a shareholder except, in the case of the option grantee, there is no requirement at the outset to buy the stock. Unlike the shareholder, the employee has little downside investment risk.15 Nevertheless, the same agency theory principles designed to create a mutuality of purpose among shareholders, executives, managers, and possibly other employees are apparent with stock options.16 In offering options, the company mantra is “if we do well, so will you.” Figure 11.1 The Balanced Approach to Total Rewards NOTE: The proportional allocation is meant for illustrative purposes only. It varies by firm, industry, and level of employees. The point is to create a reward plan that causes the firm and its workers to focus on short, medium, and long-term business perspectives. Designing rewards with this strategy in mind can fulfill all the elements of the pay and benefit models. 1243753 - SAGE Publications © So, the employee is paid a fixed wage or salary and, when performance targets are met and bonus potentials realized, he can earn more. If he owns stock or has options, when the stock price increases, the employee’s total compensation could rise significantly above market levels.17 The employee who receives options is sometimes paying for them through lower, fixed compensation.18 As commentators debate whether options enhance company performance, it is clear the lower, fixed labor expense associated with option grants does generate higher productivity to the employer. Example of Stock Option and Wealth Accumulation: An employee receives 2,000 option shares each year for 20 years. The options include a three-year cliff vesting and a ten- year term. The employee exercises each tranche of options as they near their ten-year term. The stock price increases an average 10 percent per year for 20 years. The first year, the strike price was $20 per share. At the end of 24 years, the stock price has risen to $122.32 and the employee will have accumulated $1.3 million in value. This represents the cumulative differences between the strike price and the market price. It does not include deductions for income taxes. This potential for creating wealth can be optimized by the employer in his effort to recruit, retain, and motivate his workforce. Studies show that between the years 1992 and 2000, just prior to the stock market’s dramatic drop, the cumulative value of options granted by 200 Fortune 500 companies equaled nearly $25 billion. During this period, up to 20 percent of the options were granted to nonmanagement employees.19 The mechanics of the exercise process involve several steps. If options are vested, the employee can notify the company that he wishes to exercise. He advances the cash for the shares to the employer, multiplying the strike price times the number of shares to be exercised. The employer then awards the actual shares to the employee. The difference between the strike price and the current market price is called the “option spread.” Example of Stock Option Exercise: 1,000 options shares are awarded to an employee. The strike price is $20 per share, they have a ten-year term, and five-year graduated vesting. The second year after the grant, the employee can exercise 40 percent of his options or 400 shares. The market price of the stock at the end of the second year is $30 per share. The employee exercises by paying his employer $20 times 400, or $8,000. He is granted the 400 shares that have a value of $12,000. The spread for the exercise is $4,000 and it is taxed as ordinary income. His 400 shares have a base of $30 per share and, if he holds the stock for one year or more and sells it at a higher price than $30, the gain on his stock sale will be taxed at the long-term capital gains rate. In some cases, the employee may not want to expend the cash to exercise the shares. Instead, he can “swap” shares for the options and pay no cash. For example, let’s say the employee wants to exercise 1,000 shares with a strike price of $10 per share. The current stock price is $20 per share. The employee can agree to use the value of a certain percentage of exercised shares to pay for the exercise, thereby swapping some shares for the transaction. In this example, to exercise the employee must advance $10 multiplied by 1,000 shares, or $10,000. Or, the employee could agree to exercise without advancing any 1243753 - SAGE Publications © money, but would have to swap or trade 500 shares with a current price of $20 per share in order to receive the