(FORTUNE Magazine) – EMPLOYEE STOCK ownership plans -- ESOPs, for short -- are the corporate mania of the moment. Since January nearly 80 of them, 85% of all such plans, involving more than $15 billion worth of shares, have sprouted at FORTUNE 500 companies. Formerly confined mostly to small private firms and employee buyouts such as Avis and Weirton Steel, ESOPs are now in place at such goliaths as Procter & Gamble, ITT, Bell South, Xerox, and Delta. Predicts Polaroid CEO MacAllister Booth, an ESOP booster: ''Twenty years from now we'll find that employees have a sizable stake in every major American corporation.''

The stampede has sparked a fierce debate: How much do ESOPs really benefit companies, shareholders, and employees? And why should taxpayers subsidize them? Publicly owned companies could reap $13 billion in tax breaks from their ESOPs over the next five years. At first glance, the ESOP rush looks golden. Turning workers into owners is appealing for the same reason as turning managers into owners: Insiders' interests are more closely aligned with those of outside shareholders. With everybody wanting the same thing -- a higher stock price -- corporate profits should grow. Unfortunately, ESOPs don't always work as advertised. Some hurt shareholders in the short term because their primary purpose is to be an effective raider repellent. Says Gregg Jarrell, a University of Rochester economist: ''The fact that a big block of stock in large public firms is locked up is a disadvantage to outside shareholders.'' ESOPs can also do long-term damage to shareholders because the plans can entrench management while offering little motivation for employees to become more productive. Worse, management's infatuation with ESOPs can cause it to overlook potentially better worker incentives such as employee stock options. To understand why managers love the critters, you'll need a short course on ESOPs. Invented in the 1950s by lawyer Louis Kelso, an ESOP is a trust set up on the employees' behalf. The trust uses the proceeds of a long-term loan guaranteed by the company to buy shares in the open market or from the company treasury. It pays off the loan with cash contributions from the company. The workers meanwhile earn the stock in trust for them over a seven-to-15-year stretch according to a formula based on pay or seniority. On average, employees get $1,300 worth of stock a year. They can't take physical possession of the shares they've earned until they quit, retire, or die, but they can vote or tender the stock they own in their ESOP accounts. The trustee, usually a bank, manages and votes the stock that has not yet been allocated to the employees, a key feature of most ESOPs. The trusts have some very appealing tax advantages. Lenders, for example, can deduct half the interest they receive on an ESOP loan, so trusts can borrow at below-market rates. Companies can deduct both the cash they give their ESOPs to pay off the principal and interest on the loan and the ! dividends on the ESOP stock. But a revenue-hunting Congress seems certain to take the honey pot away this year. A measure to gut the most generous tax breaks for ESOPs recently sailed through the House Ways and Means Committee. The bill would affect ESOPs that own less than 30% of a company, which includes almost all those set up by large corporations. If Congress passes the legislation this month -- a likely prospect, says Corey Rosen, director of the National Association for Employee Ownership -- the ESOP birthrate is bound to plunge for a time. The post-New Year's ESOP stampede was set off not by rich tax breaks, however, but by an uncommonly attractive hare sprung last January by the Delaware courts. The decision in Shamrock Holdings v. Polaroid signaled for the first time that ESOPs could be used as a takeover defense. Polaroid successfully fought off Roy Disney's Shamrock by putting 22% of its shares in the newly created employee plan. The court concluded that Polaroid's ESOP made sense as a business decision and was not purely a defensive ploy. The essence of the ESOP defense is placing a big block of voting stock in friendly hands fast. Employees are the ultimate friendly hands because they fear for their jobs if a raider comes calling and are unlikely to tender their shares. The trustees are normally obliged to vote the shares that have not been allocated to employee accounts as the employees vote theirs. What's more, management can create an ESOP defense virtually overnight and without shareholder approval. ESOPs acquired 22% of Polaroid, 15% of Lockheed, and 11% of Boise Cascade in single transactions. THIS DEFENSE WORKS because Delaware, where most FORTUNE 500 firms are incorporated, passed a tough antitakeover law in 1988. It requires that hostile takeovers be approved by 85% of all nonaligned shareholders -- defined as stock owners who are not corporate insiders -- for a raider to take control of the acquired company's assets right away. Otherwise he has to wait three years to gain possession. As long as employees can vote their ESOP shares confidentially -- a standard feature in most large plans -- they are defined as nonaligned. Thus, an ESOP that owns 15% of a Delaware corporation can block an unwanted bid. The ESOP defense isn't airtight. Pillsbury workers voted for Grand Metropolitan over their own management when the British company made its bid last fall. But adroit takeover targets can soup up their plans with other classic defenses. Dunkin' Donuts, now fighting a hostile bid from the Canadian Kingsbridge Group, set up an ESOP last April that owns 1.1 million shares, or 16%, of the company. Simultaneously, Dunkin' Donuts enlisted General Electric Capital as a white squire by offering the finance company convertible preferred shares that pay more than twice the dividend of the common. ''We're delighted to welcome a long-term investor,'' says CEO Robert Rosenberg. Defensive ESOPs can cost a company's shareholders plenty: Not only do they lose the premium that a raider would pay for their stock, but their long-term prospects for gain can suffer since management is far more effectively insulated from takeover pressures. The damage to shareholders is documented in an intriguing study by consultant Lilli Gordon of Analysis Group in Belmont, Massachusetts, and John Pound, an economist at Harvard's Kennedy school. They analyzed 60 ESOPs set up since January 1 and found that in 12 companies the employee plan controlled 15% or more of the nonaligned shares. Almost all of these ''control'' ESOPs were put in by companies confronting takeover threats. Among them: Aristech Chemical, Dunkin' Donuts, Horn & Hardart, Kysor, Lockheed, and Tribune, the Chicago-based media company. Investors reacted to news of these ESOPs by selling their stock. Share prices of the 12 fell within two days of the announcement by an average 4.6%, reducing their collective market capitalization of nearly $1 billion. By contrast, ESOPs that came close to but were not quite large enough to change the status quo provoked declines of around 2%. And plans that did not shift the balance of control in the company produced average stock price gains of 1.4%. Gordon and Pound conclude that in using voting shares to create an ESOP, management appears to be deliberately cornering the stock. Says Pound: ''There is absolutely no reason, other than a defensive one, for companies to use voting stock to set up an ESOP.'' In fact, a number of corporations -- FMC, May Department Stores, Federal-Mogul, Ball, and Melville -- have chosen to set up their trusts with nonvoting convertible shares that convert to common only when they are parceled out to the employee accounts over seven to 15 years. Workers still get to cast their votes just as in other plans, but the trustee can't vote the big bulk of unallocated shares. To keep managements from employing ESOPs to entrench themselves, Gordon and Pound suggest that shareholders urge companies to use nonvoting stock for an ESOP or else compensate the outside shareholders by having the trust pay a premium for the stock it buys.

ASIDE FROM from their debatable charms as a takeover defense, do ESOPs offer any long-run value to management, employees, and shareholders? The state of affairs at large public companies is too recent to generalize. Certainly the tax breaks, more generous than for other employee benefit plans, can lower the IRS levy and improve cash flow, particularly if the company substitutes an ESOP for part or all of an existing 401(k), profit-sharing, or pension plan. And if the tax savings are passed along to employees and shareholders in the form of higher benefits or dividends, all the constituencies come out ahead. But the gains in cash flow from funding benefits in advance -- which a company does when it creates an ESOP -- are greatest for those with highflying stock. An excellent example is Procter & Gamble's $1 billion ESOP, which is replacing part of the company's profit-sharing program. Analysts estimate that its plan will increase the company's projected cash flow by $850 million over the next 15 years if P&G stock appreciates at its historic rate of about 9% annually. If the stock stays flat, on the other hand, projected cash flow wouldn't be affected by the ESOP. The reason is simple. The plan calls for each employee to receive shares in fixed proportion to his annual wage or salary. When the share price is rising, the trust allocates fewer, but more valuable shares to each worker and more stock remains in the unallocated pool, collecting dividends with which to pay off the loan. To the extent that the dividends can repay a larger share of the interest and principal, the cash contribution that P&G makes to the trust for this purpose can be smaller, thus boosting cash flow. Trouble is, this equation also works in reverse, and should the stock tumble, the company will be on the hook for a larger contribution. Fortunately, since P&G announced its plan in January, its shares have soared from $88 to $131 -- an increase of 49%, far outpacing the S&P 500. ESOPs are improving the cash flows at Whitman, Ralston Purina, and Boise Cascade by helping them contain their growing liabilities for retiree medical care. All three companies are phasing out post-retirement medical benefits for current employees and setting up ESOPs that retirees can tap to pay the premiums on their own insurance or for any other purpose. For example, Boise Cascade, whose liabilities for retiree medical benefits range upwards of $21 million, makes a special annual contribution to each salaried employee's ESOP account and has raised the amount it matches in its 401(k) plan. The present value of the company's expected cash flow savings over the next 15 years is about $50 million to $100 million.

HOWEVER BENIGN their effect on corporate cash flows, there's scant evidence so far that ESOPs by themselves boost either productivity or profits. There are two stirring examples of ESOP-owned companies where the trusts bought all the stock in a leveraged buyout. And the highly motivated employees of Avis and Weirton Steel have wrought bottom-line miracles. But expectations that ESOPs at large corporations will have the same dramatic effects are unrealistic. The General Accounting Office, in its 1987 study, considered the largest and most thorough, found there was no correlation between ESOPs and productivity growth. In a more recent study, limited to plans at publicly held companies, economist Michael Conte at the University of Baltimore discovered no evidence that trusts would lift return on equity or stock prices in the long run. These results are consistent with two earlier reports by the National Center for Employee Ownership. Other research suggests two likely reasons for these findings. Employee surveys in companies with ESOPs have shown repeatedly that workers equate meaningful ownership with adequate wages and day-to-day participation in decision-making, not with having voting stock or employee representation on the board. The few corporations that have ESOPs as well as long traditions of employee decision-making -- P&G, Quaker Oats, and McKesson, among others -- are more likely to achieve productivity gains from their plans than the bulk of companies that use them merely to restructure existing compensation packages. Like a restricted stock plan for executives, an ESOP's power to motivate is inherently limited and for the same reason: The worker gets his shares even if the stock's price goes nowhere. In fact, he gets more stock, the lower the price. A recent study for FORTUNE by Graef Crystal, the dean of compensation consultants, concluded that the shares of companies with restricted stock option plans underperformed the shares of companies that did not have them. BUT WORKERS should own stock in their companies and be able to prosper when the firm does. A better method than ESOPs for accomplishing this goal is employee stock options. Last July, PepsiCo became the first FORTUNE 500 company to grant stock options regularly to all of its full-time workers. ''It's been part of our whole culture to say 'You are important' to every employee. This says it,'' declares D. Wayne Calloway, PepsiCo's CEO. In devising the program, the company tried to meet twin goals of employee stock ownership and some form of incentive pay. So when the plan was presented to employees, it was accompanied by up to 15 examples of how workers' individual efforts could affect the company's profits. The incentive is straightforward: If the stock goes up, employees gain. If it doesn't, they don't. The program is an add-on, and it does not replace other wages and benefits. Each year workers will get options equal to 10% of their wages or salaries priced at the stock's current value. Subject to vesting requirements, employees can exercise their options anytime within ten years after the options are granted. When they do, the company will pay out the profit in the form of Pepsi shares. If employees hang on to their stock rather than sell it, employee ownership will climb at the rate of about four percentage points a decade. The company considered, and then rejected, the alternative of expanding its small ESOP. Says Roger King, senior vice president of personnel: ''Options are totally driven by appreciation. ESOPs are right for some companies. But we didn't want another entitlement program.'' Not coincidentally, the idea came from human resources, not the company's financial side. Says compensation and benefits vice president Charles Rogers: ''I thought of it, would you believe, at a stoplight one morning on my way to work.''

CHART: NOT AVAILABLE CREDIT: SOURCE: NATIONAL CENTER FOR EMPLOYEE OWNERSHIP CAPTION: MORE MONEY IN ESOPS ESOPs in public companies have escalated this year.