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Economic Value Theory and ESOPs

David Johanson

June 1996

It is very interesting to note that one of the primary concepts underlying employee stock ownership plans (ESOPs) (i.e., rewarding employee-participants by allowing them to share in the long-term success of the companies for which they work through beneficial stock ownership in such companies) is gaining great influence and acceptance in the area of executive compensation. Executive compensation plans traditionally used salary incentive plans based on performance as measured by earnings per share (EPS). However, EPS oftentimes fails to accurately gauge the financial performance of a particular corporation and ignores aspects more indicative of long-term financial success. To remedy this problem, many companies are turning to Economic Value Theory (EVT) to evaluate and reward executives.

Under EVT, economic value is determined through an evaluation of the spread between a company's return on capital and its cost of capital, the amount of capital invested in the business, and the company's ability to sustain a favorable spread on its capital investments. In the past, this theory was used to assess investment and business strategies. Recently, however, executive compensation plans have linked compensation and bonuses to performance measures though EVT principles. Specifically, such plans have been based on the performance and value of the stock of such companies.

The application of EVT principles for evaluating and rewarding executives appears to be more successful in motivating managers than plans based on calculations of EPS. There are several reasons for this success. First, because EVT implementation is based on shareholder activism, which is the shareholders' interest in corporate governance and executive compensation plans, the executives have a greater sense of ownership and responsibility in the companies for which they work.

Using EVT principles, managers are also evaluated on measures that are not linked to pure economic considerations (i.e., customer service indicators, employee safety, productivity, and quality). These considerations may not convert to profits immediately, but will ultimately decide the financial well-being of the company and of its employees. The sense of ownership that develops in managers under this type of executive compensation plan by focusing on these factors has resulted in rather quick improvement in behavior and thinking. These results can be achieved without having to mount an exhaustive training program.

In addition, because there is a limit on the options for promotions and step wage increases which are the conventional methods of rewarding employees, incentive compensation based on EVT which is not tied to such limitations can be very useful. It is especially advantageous for a company that does not have enough cash resources to continue to make salary increases because executive compensation based upon EVT principles allows employees to share in company profits when stock value increases.

Such plans will require substantial planning to establish and will require patience, but the rewards can be substantial. (Most plans based upon EVT principles require five-year commitments because it takes that long to evaluate whether they work, and at least six months to implement.)

More and more companies are working on compensation theories based on EVT not only for executives but also for all types of employees. This is because for EVT-based executive compensation plans to work most effectively, a sense of ownership has to be developed at all levels of employment. If EVT-based compensation programs are developed for employees of all compensation levels, this also could be an alternative to an ESOP when it is not feasible for a company to adopt an ESOP, but where the company wants to reap the benefits of the philosophy underlying ESOPs.

Ayako Onoda assisted Mr. Johanson in preparing this article.

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