Dynamics of Shared Capitalism Policies MidYear Beyster Fellow

Dynamics of Shared Capitalism Policies Mid-Year Beyster Fellow Conference Rutgers University February 24 -25, 2011 Joe Hsueh System Dynamics Group MIT Sloan School of Management

This Paper… p Answers: under what conditions do shared capitalism policies improve firm performance? p Describes: the causal mechanism of the high performance work system in a startup company p Uses: mixed survey data, case study and simulation methods p Proposes: a set of dynamic hypotheses on how salary, stock grants, stock options, profit sharing and employee participation influence employee behavior and firm performance p Contributes to: Strategic Human Resource Management, High Performance Work System, and Employee Ownership literature 2

Research Overview Research Question: System Dynamics Model of HPWS 1. What is the casual mechanism of HPWS? Empirical Puzzle: Why employee ownership (EO) improves firm performance in some but not others? 2. Under what conditions do shared capitalism policies improve firm performance? Literature Gap: To explicate the causal mechanism of High Performance Work Systems (HPWS) Objective NBER survey data Startup case study Model Insights Strategy ? Best MC, EW: Worse FW S+ 1. Employee ownership has mediating effect that closes firm performance-employee behavior reinforcing loop. G Best FW: Mediocre MC S+ G Win-Win: S+ G 2. Salary effect is sensitive to the non-linear relationship between compensation and job satisfaction. Stock Grants Lose-Lose: or S+0 G Salary 3. Stock grants have productivity gain, diminishing returns and dilution effects. 4. Tipping points of where EO out or underperforms depend 3 on the dynamic tradeoffs of these three effects.

Motivation Why Shared Capitalism? p Shared Capitalism is “a diverse set of compensation practices through which worker pay or wealth depends on the performance of the firm or work group (Kruse, Freeman and Blasi 2010). ” p Shared capitalism is prevalent – almost half of US employees participate in some form of shared capitalism, such as employee stock ownership, stock options or profit sharing. Why Startup Company? p Motivational tools in a cash constraint environment p Dynamic effect from the startup phase p Founder imprints, path dependency 4

Empirical Puzzle Does employee ownership (EO) improve firm performance? 30 -year review of EO literature found (Kaarsemaker 2006): p 2/3 of 129 studies found favorable effects Negative 10% p 1/10 found negative effects Empirical Puzzle: Why does EO improve firm performance in some cases but not others? Neutral 23% Positive 67% Literature Gap: “One of the reasons for the relative weakness of the results from empirical research … is that, as yet, theory behind many of the studies on the effects of employee ownership has been underdeveloped. In particular, no research has been done on comprehensive models of employee ownership and the broader HRM system”. (Kaarsemaker and Poutsma 2006)

Research Questions 1. Causal Mechanism: What is the causal mechanism between shared capitalism policies and firm performance? 2. Dynamic Theory: What are the dynamic effects of stock grants, stock options, profit sharing and employee participation on employee behavior and firm performance? 6

Method Startup Calibration NBER data SHRM, HPWS, EO Contribution 2: Directions for future empirical studies. Contribution 1: Dynamic theory building for SHRM and HPWS literature. 7

Model Boundary, Sector and Source Business Processes Customers - Customer chain - Product development - Product attractiveness - Pricing - Brand equity - Competition - Customer service - Sales effort - Marketing effort 5. Sterman (2000) 6. SHRM, HPWS and EO Literature 1. Miller (2007) 2. Case study: Calibrated to a clean tech startup Endogenous 7. Regression analysis using NBER dataset Exogenous Compensation Human Resource Finance - - Employee chain - Salary - Stock grants - Stock options - Profit sharing - Work experience - Employee quality - Employee participation - Job satisfaction - Productivity Balance sheet Income statement Cash flow Firm valuation Shares outstanding Ownership structure Venture capital 3. Oliva, Sterman and Giese (2003) 4. Finance and Accounting Literature Excluded Tax Regulation of Specific EO Plans Corporate Governance Disaggregated Policy Recipients Venture Capital Control Union Labor Market Multiple Startups Public Company Debt Financing 8

Causal Loop Diagram of High Performance Work Systems 9

Estimating Table Functions Using NBER Shared Capitalism Dataset p p p Largest dataset conducted in shared capitalist firms. 80 to 100 survey questions to 41, 206 employees in 14 firms and 323 work sites. Kruse, Douglas, Richard Freeman and Joseph Blasi 2010. "Shared Capitalism at Work: Employee Ownership, Profit and Gain Sharing, and Broad-based Stock Options, " National Bureau of Economic Research. Data Limitations p Self-selected nonrandom sample of US establishments p Self reported data as opposed to objective financial data 10

Regression Results for Job Satisfaction Variables Coef. Std. Err. [95% Conf. Interval] Constant 2. 4048*** . 1167 2. 1759 2. 6336 Compensation Greater Than Average . 0063*** . 0006 . 0051 . 0075 Compensation Greater Than Average Squared -. 000065*** 9. 6 e-06 -. 000084 -. 000046 Compensation Less Than Average -. 0158*** . 0008 -. 0175 -. 0143 Compensation Less Than Average Squared . 000167*** . 00002 . 000126 . 000211 Employee Ownership Dummy . 0117 . 0107 -. 0092 . 0328 Employee Ownership Stake Over Pay . 0217** . 0095 . 0031 . 0405 Employee Ownership Stake Over Pay Squared -. 0027 . 0018 -. 0063 . 0007 Profit Sharing Dummy -. 0052 . 0113 -. 0275 . 0171 Profit Sharing Over Pay . 2327*** . 0682 . 0990 . 3665 Profit Sharing Over Pay Squared -. 2180** . 0751 -. 3653 -. 0707 Stock Options Dummy . 0127 . 0219 -. 0301 . 0557 Stock Options 1. 1 e-06 9. 2 e-07 6. 1 e-07 3. 0 e-06 Stock Options Squared -5. 7 e-12 3. 8 e-12 -1. 3 e-11 1. 7 e-12 Training Dummy . 0964*** . 0078 . 0811 . 1117 . 0001 . 0008 . 0013 Training Hours . 0011*** Training Hours Squared -8. 8 e-07*** 1. 6 e-07 -1. 2 e-06 -5. 6 e-07 Job Security . 3871*** . 0180 . 3517 . 4225 Supervision . 0193* . 0109 -. 0021 . 0407 Participation . 3279*** . 0174 . 2937 . 3620 R 2 0. 3784 Adj. R 2 N 0. 3748 20, 206 *p <. 10, two-tailed test **p <. 05, two-tailed test ***p <. 01, two-tailed test 11

Effect of Financial Compensation on Job Satisfaction 12

Model Calibration p The model is built on Miller (2007)’s thesis on clean technology startups. p Calibrated to a startup company that develops an integrated energy efficiency system for commercial and industrial buildings. p Used company financial data, archival data, interviews. p Interviewed executives on decision rules regarding pricing, financing, human resource and compensation policies and projections of business performance. p Caveat – No meaningful time-series data from an early stage startup, data used to parameterize the initial conditions of the model. 13

POLICY ANALYSIS 14

Annual Stock Grant Value as % of Industry Compensation: Salary Only (Blue) Salary + 10% Stock Grants (Red) Salary + 20% Stock Grants (Green) More wealth is shared, more wealth is created due to productivity gain. Productivity gain diminishes as annual stock grant % increases. 15

Employee Ownership Loop Diminishing Returns Productivity Gain Dilution 16

Founder’s Net Worth = Market Capitalization * Founder’s Ownership Does employee ownership always increase founder’s net worth? More wealth is shared, more wealth is created at a diminishing rate. More wealth is shared, more dilution occurs. No, when too much ownership is granted past a certain threshold, the dilution effect can outweigh the productivity gain, thereby lowering stock price and the founder’s net worth. 17

What Combinations of Salary and Stock Grants Outperform the Base Market Capitalization? Best Same as Base Case Better Worse 18

Employee Ownership as a tool to conserve cash and finance growth Stock Grants 1. Lower Productivity Salary 3. EO Loop 2. More Hiring 19

UNINTUITIVE!! High salary needs hig stock grants for base performance Stock Grants 3. EO Loop Salary Use high salary without EO underperforms 1. Limited Productivity Increase CAVEAT: Table function, Non-differential Pay Most 2. Fewer People Least 20

What Combinations of Salary and Stock Grants Outperform the Base Founder’s Net Worth? Worse Dilution Dominates Same as Base Case Better Best 21

What Combinations of Salary and Stock Grants Outperform the Base Employee Net Worth? Same as Base Case 22

Best Most Better Worse Least Objective Stock Grants Strategy ? Best MC, EW: Worse FW S+ G Best FW: Mediocre MC S+ G Win-Win: S+ G Lose-Lose: or S+0 G Salary 23

Contributions Research Question: 1. Causal model of HPWS 1. What is the casual mechanism of HPWS? 2. Dynamic theory of shared capitalism policies 3. Simulation method to SHRM 4. Estimation of EO effects 2. Under what conditions do shared capitalism policies improve firm performance? Future Research System Dynamics Model of HPWS NBER survey data Startup case study Model Insights 1. Disaggregation of EO Recipients 1. Employee ownership has mediating effect that closes firm performance-employee behavior reinforcing loop. 2. Decision Rules of Shared Capitalism Policies 2. Salary effect is sensitive to the non-linear relationship between compensation and job satisfaction. • Tax regulation • Corporate governance • Venture capital control • Effect of going public Stock Grants 3. Empirical Validation • Calibration with time-series data • Empirical testing of the dynamic hypotheses • Case studies of the scenarios Salary 3. Stock grants have productivity gain, diminishing returns and dilution effects. 4. Tipping points of where EO out or underperforms depend on the dynamic tradeoffs of 24 these three effects.

BACKUP SLIDES 25

Sensitivity Analysis 1: 95% Confidence Bound 26

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Sensitivity Analysis 2: Decrease in Sales Productivity 10 20 30 40 50 % 28