ESOP Education Series
The History of ESOPs
Employee ownership is not a new idea. The earliest reference to employee ownership in the U.S. came from William Meredith, Zachary Taylor’s secretary of the treasury. In 1849, he noted that workers were owners in many enterprises, and thought the idea would be a great way to create a common interest between labor and capital. In the late 1800s, the Knights of Labor, one of the United States’ first unions, created several worker-owned businesses. In the 1920s, leading industrialists called for a “new capitalism” based on employee ownership. Employees were encouraged to buy shares in their own companies, and more than one million did. Unfortunately, none of these efforts endured, and the idea faded away until the 1950s.
It was then that a San Francisco-based investment banker and lawyer, Louis Kelso (pictured above), created the modern ESOP. In The Capitalist Manifesto, a best-selling book written with the philosopher Mortimer Adler (a household name at the time), Kelso and Adler argued that capital investment in new machinery and technology would drive workers into lower-paying jobs, or even out of work completely. Historically, when investments in machinery and technology went up, workers became more productive and were paid more. But Kelso and Adler believed the pace of change in the next generation would be so fast that it would replace a lot of well-paying jobs permanently. People who owned capital would do very well indeed; people who worked for them would struggle to stay in place. So the solution, they argued, had to be for more employees to be owners.
Kelso’s predictions have proven true. Real wages (wages adjusted for inflation) since the 1970s, when ESOPs became law, have hardly budged, but an investment in the stock market has grown by about 500% in real dollars. So the problem, Kelso and Adler said, was that not enough people owned capital. They couldn’t afford to just go out and buy it, so there needed to be a way for them to become owners because of the work they do. But how?
ESOPs to the Rescue
Kelso envisioned a solution. He proposed laws that would give everyone a chance to own capital that could produce income. He called this plan an employee stock ownership plan (ESOP).
Rich people and wealthy companies are able to acquire companies by borrowing money. Already having money, these groups could persuade lenders that they would make enough money from the profits of the company they bought to pay off the loan.
How, then, could normal employees buy ownership in their own company? With wages stagnant and consumption costs rising, setting aside money to buy stock was not practical for all but a few. If they approached a bank as a group and asked for a loan to buy all or part of the company, bankers would politely laugh. Kelso’s solution was to have the company borrow money on behalf of the employees. The company, not the employees, would take the risk if the loan could not be repaid. The ownership of the capital acquired by the loan would be contributed to employees in the form of company stock. In return, companies could get a tax deduction for buying the shares for employees, paying for part of the cost. The remaining cost, the argument went, could be made up by workers being more productive because they were now owners.
Kelso spent almost two decades trying to persuade companies to use this idea, arguing that ESOPs would help improve productivity while simultaneously offering tax benefits. A few adopted Kelso’s idea, but most companies remained concerned that courts would find ESOPs improper and void the tax benefits that Kelso was proclaiming. Kelso needed a law.
Russell and Huey Long
It turned out that there was just a man to do this. Back in the 1920s, a populist politician from Louisiana named Huey Long was making quite a reputation for himself as state governor, U.S. senator, and presidential candidate. He argued strongly for redistribution of wealth from the rich to everyone else. His career was cut short when he was assassinated by the son-in-law of a judge Long had maneuvered out of office. His son, Russell Long, became a U.S. senator during the 1940s. By the 1960s, he had become the chair of the Senate Finance Committee, the group that writes the nation’s tax laws. That made him one of the most powerful senators.
Russell Long and Kelso met in 1974. Long was interested in Kelso’s plan, claiming that Kelso’s ESOP idea was “Huey Long without the Robin Hood”—in other words, ESOPs would make the distribution of wealth fairer without “robbing from the rich.” ESOPs, they believed, were a way to use the capitalist system itself to create a more equitable distribution of wealth within the economy. Instead of allowing rich people to get richer and then taxing them at higher rates (which, Long believed, discouraged investment and could in turn hurt the economy), ESOP legislation aimed to change the way future wealth became owned. Long, inspired by this idea, began a crusade to provide ESOPs with tax incentives and shepherded 17 pieces of legislation through Congress in 12 years. More bills were added after that, the latest having passed in mid-2018.
As a result, the government now provides substantial tax incentives to encourage companies to use ESOPs. In most cases, companies borrow money with an ESOP loan and use the money to buy stock from an owner. Instead of borrowing, the ESOP can also buy stock with periodic cash contributions from the company, or the company can just contribute stock to the ESOP.
ESOPs are one of the rare ideas to restructure the economy that have support from the right, left, and center, from Ronald Reagan to Ted Kennedy; from the current Republican Party platform to Bernie Sanders and Hillary Clinton. As one poll found, it is as popular as apple pie.
Has It Worked?
More than 14 million employees are currently owners through ESOPs and similar plans. Research shows that employee-owned companies that promote employee involvement outperform their competitors by a substantial margin and that employees in these plans do substantially better in terms of retirement and other conditions of work. The idea has started to spread to other countries, in large part because of how successful it has been here in the U.S. The idea has a long, long way to go—the vast majority of employees are still not in these plans—but it has come a very long way.