| Leading Companies Online Magazine
The Law of Unintended Results
By Anthony I. Mathews, Beyster Institute Staff
 
In the last column, I started a brief exploration of some of the lessons learned during my 30 or so years working in employee ownership. As we all know, lessons as to how we ought to act in a given situation are most often learned by experiencing the negative results of acting otherwise. Like somebody once said, “My most valuable experience is really just a lot of big mistakes I don’t make anymore.”
Which leads us to one of the most reliable lessons I’ve learned on this path: perhaps 75 percent of all outcomes are unintended. And, more important, an unintended result is far more likely to be negative than positive. And, even more important, that the negative effect of an unintended result will be greater by a significant factor than the positive effect of a planned one.
Let me illustrate with a “not quite hypothetical” example. Let’s join the founding shareholder of a small company who has just sold his remaining 68 percent interest in the company to an ESOP. At the party celebrating the deal, there are lots of people from all sections of the company, and (at that moment) they are really excited about the new plan. The founding shareholder is ready to retire, and the ESOP is his answer. The intended result – that company ownership will transfer to the employees through an ESOP – will be achieved, and all should be happy ever after. Except for that pesky law of unintended consequences, that is.
During the course of the party and over subsequent months, it becomes clear that while the intended result has been achieved, there are many unforeseen outcomes that were not planned and not pleasant.
Take, for example, a long-term employee who was within five to ten years of retirement. Under the old defined benefit pension plan that was terminated and frozen in conjunction with the adoption of the ESOP, he would have been entitled to a benefit based on his average salary during his five highest-paid years. He came to realize that the decrease in his final benefit under the frozen old plan would not be offset by his new benefit accrual under the ESOP because the ESOP transaction was going to take 15 years to amortize and there were limits on how much of his compensation could be taken into account for ESOP purposes. The achievement of the intended result has cost him plenty and there’s no really good way to make it up – not anyone’s intention, but a natural outcome of the transaction as it was implemented.
An equally unpleasant example could be the young General Manager who owned 28 percent of the company before the transaction. He’d been told that he wasn’t going to be able to be in the ESOP after the transaction (because of the founder’s election to defer tax on the sale), but he was also assured, quite correctly, that as Trustee of the ESOP and CEO of the company, he would be in a position to control the company, and that was good enough for him, he thought.
What he hadn’t thought all the way through was the effect of the ESOP sale on his own net worth. As a result of the new debt on the company, his net worth was going to drop by more than half. The value of his 28 percent interest in the company fell from about $2 million to something less than $800,000 overnight with some difficult impacts on his life in other ways. Another unintended result and a lesson to be learned: almost no good result comes without at least a few unpleasant side effects. If you want to be in the game, you have to learn to roll with them.
To add an ironic twist, the selling shareholder himself could also suffer unintended consequences. As part of facilitating the transaction, let’s say he agreed to post his qualified replacement securities as collateral on the loan. He was planning to use the margin capabilities on the replacement securities to get some cash to make a major addition to his vacation home, but he soon realized that he would not be able to do that until the ESOP debt had been paid down sufficiently to release his pledge on sufficient shares.
He thought he could be patient, but just about the time he got used to that idea, the qualified replacement securities he elected to use as collateral declined in rating which lowered their margin potential. In the end he was barely keeping up with his collateral guarantee. It could have been worse. If the decline in rating had been more severe, it could have caused the call of his collateral altogether and triggered a taxable event at the same time. As it is, the vacation home will have to carry on with a single bathroom, and his love of the ESOP concept will decline accordingly. Nobody’s safe from the law of unintended consequences.
In the end, ESOPs in deals like this either gain traction in spite of these sorts of negatives, and take up the mantle of “ownership culture” and all the positives that brings with it; or, in some cases, they have a very hard time getting over the negative attitude that comes along with all the surprises (usually among key people). That sometimes even leads to the plan being terminated and unwound as a result.
For the most part, the unintended results here could have been anticipated (although they probably couldn’t have been changed very much). The experience has been that if you plan very carefully, and you get advice from the most experienced people possible, you might be able to lower the percentage of unintended outcomes to about 40 percent, but you can never get rid of them altogether. It’s important to understand that from the outset.
All you can really do is plan as carefully and intelligently as possible, anticipate the effects of what you are doing on as many of the stakeholders as you can identify in advance and, in the end, be creative about dealing with the surprise results when they come up.
Next time maybe we’ll talk about Mathews' 3rd Law of Social Dynamics:
“No matter what your actual intent, 8 to 15 percent of any population you serve will assume you are trying to cheat them and operate accordingly.”
©2007 The Beyster Institute and its authors and their entities. All rights reserved.
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