1998 saw the continued rapid growth of broad-based employee ownership plans. The National Center for Employee Ownership (NCEO) estimates that at least 18 million employees in the U.S. now participate in employee stock ownership plans (ESOPs), broad-based stock option plans, or other plans designed to deliver equity to employees. NCEO reports that as the concept of broad-based plans has grown, so has the research on the phenomenon. 1998 was a landmark year for new studies, the most important of which are highlighted here.

Employee Ownership and Employee Well-Being

According to the NCEO, the most important new research of 1998 was a study by Peter Kardas, Jim Keogh, and Adria Scharf of the impact of employee stock ownership plans (ESOPs) on employee pay and benefits. Using compensation data from the state of Washington, the researchers found that compared to employees in non-ESOP companies, participants in ESOPs received 5% to 12% higher wages and had three times the assets in their retirement plans. Given that prior studies of employee ownership companies also showed these businesses are more successful than their peers, the results indicate that employee owners generate an additional surplus for their companies, part of which they share, and part of which adds to the success of the company.

Companies with broad-based stock option plans and ESOPs, topped the "Best 100 Companies in America to Work For," in 1998.

Employee Ownership and Corporate Performance

Another significant study was completed by the Kellogg School of Business at Northwestern University. The study looked at 382 publicly traded companies with ESOPs. They were compared to their competitors for two years before setting up a plan and two years after. The research found that after indexing out market effects, the ESOP companies had a return on assets 2.7% per year better in their post-ESOP period than in their pre-ESOP period.

A study by Joseph Blasi and Douglas Kruse at Rutgers University and Margaret Blair at the Brookings Institute showed that companies that were at least 20% owned by employees were 16% more likely to continue as independent businesses than were comparable non-employee ownership companies.

A continuing tracking of public companies with at least 10% employee ownership found that investments in employee ownership companies had grown 214% since 1992, while an investment in the S & P 500 index over the same period grew only 181%. The tracking is conducted by American Capital Strategies.

Industry makes little difference, except for agriculture, forestry, fishing and mining, although the differences are small, in setting up broad-based ownership programs. Companies with high fluctuations in output are more likely to have equity ownership plans.

In 1993, Libby Perszyk Kathman (LPK) found itself at a corporate turning point. The privately held firm had grown and prospered over the years. But it now faced important issues regarding retirement plans of the original shareholders and preparing a future ownership succession plan.

Selling the company meant that the remaining employees would face an uncertain future and the sellers would face the certainty of taxes. At the same time, the company was trying to find ways to retain its employees who were, after all, its only real asset. When a tax advisor suggested an ESOP, it looked like a solution had been found to both problems.

Background

LPK is a brand-identity development and management firm on Cincinnati, Ohio. The company has been through several incarnations since its founding in 1919 and is now considered to be the nation's largest employee-owned design firm.

LPK had the financial strength to make an ESOP purchase practical. The CEO had seen the company grow from a small firm to an international player with 40 employees. He liked the idea of being able to sell gradually while remaining active in the business. So, in 1994, a leveraged ESOP bought just over 30% of the company and, in 1998, the ESOP acquired another 19%. The plan is for the ESOP to eventually own 100% of the company. A defined benefit pension plan was frozen with its assets put into a 401(k) plan which operates alongside the ESOP. In addition to contributions to the ESOP to repay the loan, LPK makes additional cash contributions based on profitability.

Creating an Ownership Culture

LPK had always shared some financial information, but now they decided to move towards open-book management, sharing sales, expense, profit, and key task reports at quarterly meetings. These basic numbers constitute their "score card," measurements that can be easily tracked from quarter to quarter. The "key tasks" part of the score card is developed by asking employees to identify the most important things they will work on for the year in terms of people, profits, growth, and development. In addition to the all-employee quarterly meetings, there are monthly departmental meetings and other exchanges as needed. The CFO doesn't see sharing financials as a risk. In fact, they think it's a good thing. LPK wants the business community to be aware of its financial strength and it believes it adds an additional enticement to qualified candidates who are seeking employment.

Celebrations are also part of the process. During ESOP month, there are fun events and the company is decorated with ESOP stickers and signs. Questions about the company's history, the ESOP, and financials are sent daily by e-mail to inform and involve employees in the ESOP culture.

Results

LPK's CFO says that employees are just now beginning to understand the potential of the ESOP. Turnover has been nearly zero. The numbers bear out the tale of growth. Sales stood at $7 million in 1994, rose to $14 million in 1998 and probably will grow to $18 million in 1999.

Employment has grown from 40 employees to 150, with new hires being added almost weekly.

The share price of ESOP stock has doubled in four years.

This case study is based on remarks by Dennis Geiger, LPK's Chief Financial Officer, at a recent NCEO ESOP workshop.

At its April 6, 1999 meeting, the Competition Council authorized the distribution to executive branch agencies of its new "Employee Stock Ownership Plan (ESOP) Information and Process Guide." The purpose of this guide is to introduce to agencies the ESOP concept and how an ESOP can benefit the Commonwealth, the citizen/customer, the ESOP company, and its employee owners. This column will introduce to readers the "Father of ESOPs," Dr. Louis O. Kelso, and his ideas on wealth redistribution.

Who is Louis Kelso?

The ESOP concept is based on the theories of capital ownership developed by Dr. Louis O. Kelso, a lawyer-economist-investment banker. Kelso reasoned that only through widespread capital ownership could modern economies provide for more equitable distribution of wealth. Kelso is justly recognized as the visionary who developed the first ESOPs, and who worked with U.S. Senator Russell Long (retired) to get them written into Federal law in 1974.

Historical Background

According to Kelso, the concentration of wealth in the U.S. economy results from the fact that capital producing assets are owned by a small minority of individuals. (Studies conducted by the Joint Economic Committee of Congress, the Federal Reserve, and the General Accounting Office have confirmed that nearly 50% of the privately owned stock in the U.S. is owned by 1% of the population). In an economy in which capital is inexorably replacing labor as the means by which wealth is produced, Kelso emphasized the importance of providing the majority who do not own capital with a means to achieve substantial stock ownership.

What was Kelso Attempting to Accomplish through the Creation of ESOPs?

Since the average worker does not have the financial capability to buy capital, Kelso conceived of the ESOP as a means of providing employees with access to capital. By giving employees a stake in corporate financial transactions, by making them employee owners, their capital ownership could be paid for out of the future earnings produced by the corporation.

Widespread application of the ESOP concept would thus promote broadened ownership of wealth through free enterprise initiatives, rather than resorting to government redistribution through taxation.

Federal Legislation

In 1973, Kelso convinced U.S. Senator Russell Long, the then Chairman of the Senate Finance Committee, that tax benefits for ESOPs should be permitted and encouraged under employee benefit law. The Employee Retirement Income Security Act of 1974 (ERISA) established the statutory framework for ESOPs. Due primarily to vigorous legislative promotion by the U.S. Congress, the number of ESOPs nationwide has increased from several hundred in 1974 to well over 10,000, with continued growth expected.

Promoted as a means of broadening the ownership of capital and improving the productivity of the American workforce, ESOPs have been at the forefront of a movement for employee ownership that is having profound effects on employee compensation and efforts to increase corporate performance and competitiveness.

What is the Ohio Employee Ownership Center?

The Ohio Employee Ownership Center (OEOC) is a university-based program which provides information, financial and technical assistance, to retiring owners, buyout committees, labor unions, managers, and community-development organizations interested in exploring employee ownership. Center staff can help locate competent and appropriate legal and financial advisors, and perform initial assessments to determine whether employee ownership is a viable option. The OEOC sponsors workshops and conferences for the general public, develops training programs for employee owners, coordinates a comprehensive succession planning program, and assists international efforts to privatize businesses through employee ownership. The Center also supports Ohio's employee-owned network.

The OEOC is funded by grants from the Ohio Department of Developments's Office of Labor/Management Cooperation, the Ohio Bureau of Employment Services, private foundations, and contributions from Kent State University.

What is the Mission of the Employee-Owned Network?

The network provides a forum for those working at all levels in employee-owned companies to learn from each other how to make employee ownership work more effectively.

Kraft Fluid Systems Joins the Network

Kraft Fluid Systems in Strongsville, Ohio is one of Ohio's newest ESOPs. Founded by Bob and Marie Kraft in 1972, they hired their first employee in 1975. The company value statement pledges that "our employees are our greatest resource and we value their suggestions for improvement." With this commitment, the Krafts began selling the company to its employees. Today, Kraft is 45% owned by its 40 employees.

Kraft joined the Ohio network before it put its ESOP in place. After forming the ESOP, Kraft sent its entire ESOP committee to the network's employee owner leadership development retreat. Committee members stated that "we soon learned that now whatever decisions we make are not going to affect 'their' profits, but instead 'our' profits. Our focus, as employee owners, should be to make this company run as smooth and as efficient as possible."

Other New Ohio Network ESOP Companies

Falcon Foundry, ACRT, Brainard Rivet, Community Electric, Cornwell Quality Tools, Decorative Surfaces, and Gutknecht Contractors.

Accomplishments of the OEOC

The OEOC has assisted about 250 employee and/or management groups of companies that have considered employee ownership as a strategy to secure prosperous businesses in Ohio. Thirty-nine (39) of these firms, employing nearly 10,000 employees, have adopted employee stock ownership plans.

A recent report to the Legislature concluded that its program is achieving its economic development ends through averting shutdown of otherwise viable firms and, more importantly, retaining jobs through providing an ownership succession strategy for small businesses.

The report states that as an economic development strategy, employee ownership yields long-term benefits in three additional areas: (1) employee-owned firms reinvest in capital improvements in existing facilities at a higher rate than other firms, (2) employee-owned firms also reinvest in their human capital at a higher rate, and (3) there is growing evidence that employee-owned firms have a higher economic multiplier effect in their communities.

Virginia ESOPs

In Virginia, there are only approximately 240 ESOP companies.

Increasingly, government agencies and private developers are negotiating and structuring public-private partnerships to develop public facilities and commercial development projects. The annual value of developments financed, developed and constructed using this approach ranges from $18 billion to $25 billion.

Government Officials Should be in a Position of Strength in Public-Private Partnerships

Based on increasing government use of public-private finance and development partnerships, governors, city managers, mayors, development directors and special project directors are realizing that they can negotiate from strength in structuring these partnerships. Much is at stake:

• Significant non-tax income to the sponsoring governments;
• Substantial new tax revenues;
• Reduction in government ownership, development and construction risks;
• Reduction in government capital investment;
• Acceleration of the pre-development process.

Gaining Confidence in Public-PrivatePartnerships

Officials are increasingly confident in the use of public-private partnerships as well as "public-public" partnerships or intergovernmental agreements to complete important projects such as:

• Convention hotels;
• Stadiums and arenas;
• Parking garages;
• Administrative office buildings;
• Mixed-use developments;
• Transportation projects;
• Airports;
• Correctional facilities.

Many government officials conceptualize a building project and prematurely issue a RFP to determine the development community's interest. They are reacting rather than taking the initiative by not determining local market demand for the project nor its financial feasibility. They have not explored creative public-private finance plans or the public partners's most advantageous ownership and investment role.

If, prior to issuing an RFP, or entering into negotiations with a developer, government officials have not completed several types of analyses and explored alternative ownership and investment scenarios, they are going into the process blindly, totally dependent on the developer.

Officials must realize that developers generally do not enter into any project without completing the appropriate analyses. Thus, the developer knows if the project is "doable" but the government does not.

In order to be proactive and complete the pre-development process from a position of strength, government officials first need to do the necessary research before they initiate a project.

The Public-Private Finance and Development Process to Place Government Officials in a Position of Strength

The following overview will provide government officials with the basic framework to deal from strengthin structuring and negotiating public-private development partnerships.

• Conceptualize the proposed project;
• Establish a process to obtain project approvals and gain a consensus for the project to proceed;
• Complete a market-demand analysis for the building uses included in the preliminary project concept;
• Develop a land, building, and infrastructure program;
• Complete a conceptual master plan for the site;
• Complete a "total development budget" for the proposed project;
• Complete a preliminary project schedule to structure and implement the project;
• Complete a cash flow analysis and other financial analyses;
• Develop alternative public-private finance and development plans;
• Develop an implementation phasing plan;
• Develop alternative ownership, investment, and development and facility management scenarios for the public and private partners;
• Prepare a preferred public-private financing structure;
• Manage the developer RFQ/RFP process;
• Negotiate the Development and Facility Management Agreements.

These steps, at a minimum, must be completed prior to issuing a developer RFP.

The Four Essential Steps:

Market Analysis

Without an analysis of the demand and supply of the proposed building uses, most lenders will not finance a project. The results of the market analysis drives the remaining steps in the public -private finance and development process.

Total Development Budget

The next step is to develop a building program that provides an architect a solid basis for creating a design. This budget is essential because it describes all of the major "hard" and "soft" costs required to finance, design, develop and construct the proposed project. There will be few, if any, surprises in project financing and construction, and the cash flow analysis will be based on a credible development cost.

The total development budget is also the basis to accurately allocate the split of equity and debt financing.This, in turn, is essential to the cash flow analysis and the determination of the return on investment for the public and private partners.

Financial Analysis

Financial analyses include cash flow analysis, financial sensitivity analysis, and analysis of the various types of returns on investment. The results of the financial analyses provide officials with initial insights into the financial feasibility of the proposed project under selected scenarios such as private equity and conventional debt, a public-private sharing of financing, or solely financed with public funds. Financial sensitivity analysis is very important because it allows government officials to determine the impact on net cash flow of changing selected key assumptions or project variables such as the cost of financing, occupancy rates, etc. This, in turn, allows officials to assess the level of risk for the public and private partner investors.

Alternative Public-Private Finance Plans

Like many projects, the cash flow analysis will reveal that if financed and developed under a traditional private investment scenario, the project is not financially feasible. That is why completing alternative public-private finance plans is considered to be essential prior to issuing a developer RFQ or RFP. By developing alternative public-private finance plans, officials and their consultants can become creative, using a multitude of methods and finance techniques to reduce development costs and enhance cash flow. One of the most advantageous features of the public-private finance and development process is the fact that there are so many ways to transform projects from financially infeasible to those that are acceptable to the capital markets.

Summary

By following a proven public-private finance and development process, government officials can deal from strength in structuring and negotiating projects with private developers. The process not only allows officials to negotiate a fair and reasonable sharing of costs, risks, responsibilities and economic return, but also could reduce the government's capital investment; maximize its non-tax income and revenue base; reduce its risk; and accelerate the pre-development process.

This column was generated from an article written by John Stainback in "Council Insights", a newsletter of The National Council for Public-Private Partnerships.

Mr. John Stainback is the National Director of Public-Private Development for the E & Y Kenneth Leventhal Real Estate Group of Ernst & Young LLP. He is based in Los Angeles and heads the National Public-Private Development Practice which includes eight offices in the U.S. The Real Estate Group provides financial, building development, real estate asset management and privatization advisory services to all levels of government, universities and school districts. For more information on public-private partnerships and alternative financing, Mr. Stainback can be reached at (310) 785-4066.

Editorial Note: The Council's 1998 Annual Report revealed approximately 90 major capital projects with an estimated construction cost of over $700 million that were identified as potential candidates for public-private partnerships and other methods of alternative financing.

Outsourcing in State Government: A Comptroller's Perspective

Taking a lesson from the private sector, more and more government managers are asking a simple question about some of the things they do: Should we be in this business? That is, should we be running our own print shop, our own mail operations, our own computer center? Often, the answer is yes. At other times, it may make more sense to outsource the operation to a business (or to another agency).

In Texas, the Comptroller of Public Accounts has been a leading advocate of reasoned approach to outsourcing. The Comptroller's office has completed four comprehensive performance reviews of state government since 1991, with savings recommendations totaling more than $8 billion (on an annual budget of just under $45 billion).

Outsourcing has been a significant part of this program. At the Comptroller's recommendation, the legislature in 1993 created a Council on Competitive Government which includes the Governor, Lieutenant Governor, Speaker of the House, Comptroller, and Executive Director of the General Services Commission. Recently, the Council has approved proposals to consolidate state printing and mail operations, renegotiate state long-distance telecommunications services, and outsource one state data center.

The Comptroller's Key Issues in Texas Outsourcing

• Can someone else really do a better job?
• What is it costing us to do it internally? One of the most difficult challenges in government efforts at competition has been getting realistic internal costing of a service for comparison. Indirect costs (legal services, data support, etc.) are frequently overlooked.

• Do everything possible to avoid changes in scope.
• Bid the services widely.
• Negotiate like you mean it.
• Monitor implementation and performance.

Report Card on American Education by the American Legislative Exchange Council (ALEC)

In ALEC's recent Policy Forum publication, it reports "that there is no evident correlation between teacher-student ratios, spending on school construction, and teacher salaries on the one hand, and educational achievement as measured by various standardized test scores, on the other hand. In other words, the keys to educational excellence must lie outside of conventional measures of investment in American schools."

In ALEC's 1998 state by state ranking by academic performance/per-capita spending rank, it found that Minnesota was first in academic performance and 27^th in per capita spending, whereas New Jersey was first in per capita spending and 29^th in academic performance. Virginia ranked 27^th in academic performance and 19^th in per capita spending.

Is There Room for Competition in Public Schools?

Thirty-three states and the District of Columbia have passed charter school legislation since 1991. There are 1,129 charter schools operating in these states and the District of Columbia. During the 1996-1997 school year, the 433 charter schools in operation were educating just over

110,000 students. The growth in charter schools has grown from only 2 in 1992-93 to 1129 in 1998-99.

"PRIVATIZATION IS A TOOL THAT CAN HELP PUBLIC OFFICIALS PROVIDE ESSENTIAL SERVICES IN A COST-EFFECTIVE MANNER. INTRODUCING COMPETITION AND PRIVATIZATION TO GOVERNMENT SERVICES REQUIRES REAL COST INFORMATION. PRIVATIZATION INCREASES COMPETITION AND COMPETITION INCREASES PRODUCTIVITY."