16 min read
Employee Ownership (EO) is now an established structure when shareholders seeking an exit sell their company shares to their employees. Since 2014, such sales have been 100% Capital Gains Tax (“CGT”) free. This is because the Government believes, quite rightly, that EO increases company productivity and sustainability and closes the social gap.
Take up, however, has been slow. Since 2014, approximately 500 companies only have adopted the approach – but there are potentially more than 240,000 businesses employing more than 7 staff, that could take advantage of the EO structure. So why is the take-up so slow? We believe there are three primary reasons:
- Advisors can make EO’s seem highly technical, which can result in shareholders thinking that they are ‘contrived and difficult’. The lack of simplicity also combines with the poor education of shareholders, making many believe that a trade sale is the only way to maximise their value.
- Some EO supporters over amplify the reward aspects of giving back to employees, creating a perception that EO structures are uncommercial. This is incorrect as a full commercial value can be secured by EO sales and the management have a key responsibility to ensure that the business retains a fully commercial outlook. Additional employee engagement and trustee roles may add paperwork, but their involvement is highly positive if utilised correctly to support and not undermine management’s focus on the agility and competitive advantage of the business going forward.
- Many shareholders believe that they need employees to lead the sale. Again, this is incorrect as most of the transition can be vendor-led, securing employee buy-in only at the end of the process, pre-completion. Some management may prefer a management buy-out route, but the key downside to an MBO is that managers take the risks and guarantee the deal. EO’s do not have this challenge as whilst shareholders may correctly believe that their management team is not ready to lead as owner shareholders immediately, they can exit gradually and train the second-tier management as well as ‘backfill’ management.
Employee ownership is highly attainable and if structured correctly, can provide a simple transition with a highly effective sale delivered with full shareholder value. Therefore, let us dispel the myths.
Are they contrived and difficult?
No. The sale is straightforward – a corporate trust is established to buy the company and the sale is financed out of distributable reserves, a vendor loan and/or third-party debt. The technicalities depend on each business’s structure, history, and culture, but a good advisor can easily navigate these. The 0% CGT rate represents Government encouragement for EO businesses and therefore, it cannot be regarded as a contrived sale. Research shows that EO businesses are more productive and sustainable than most non-EO businesses, which makes them excellent tax contributors in the long-term, hence the Government’s tax break encouragement.
Most owners are not altruistic, they live well, perhaps to the detriment of the growth of the business. EO businesses do not have this challenge and are proven to make longer-term, positive investments.
Are they commercial?
If by ‘commercial’ we mean legal, competitive, focused, and capable, the answer is yes – when EO businesses are set up correctly. There is, however, a flaw and some advisors and companies who have trodden the EO path focus too much on employee engagement as part of the transition and new structure. They fail to appreciate that the real key to success is by establishing a succession backed by an exceptional business plan.
Therefore, no business should transfer to an EO without a full business review to establish where it really ‘is, what the potential strengths and risks are, and to identify the real opportunities. This review should be combined with a skills analysis of the second-tier management team to identify personnel who could move to the front line. While employee engagement and technical transition, including HMRC clearance, is important, the development of the management team, their governance and decision-making capability in the new EO model are critical to success.
Some managers may not convert to leaders as they are not strategically trained and may strive simply towards reliability rather than creating plans for a better business model. Most often a business will disrupt itself to improve and EO managers who have no management training may not have the instinct or analytical skills to judge when this is appropriate. Having advised on management buy-outs for many years, it is striking how few management buyers can secure significant growth. This is often because the management team lack the experience to understand the limitations of their skills (unless private equity-backed) and change their decision-making from manager to owner – or even entrepreneur.
As ever, the long-term success of a business depends on the quality of its management. The real success of an EO business rests with how the shareholders hand over and nurture the top talent in the organisation. Ideally, they will provide ongoing, external board support to help focus on the competitive advantage and drive growth by identifying what tomorrow’s customers want and how they can be serviced better and more profitably than their competitors.
Are EO sales below value?
A trade sale to a buyer with deep pockets and a ‘we want, we need’ motivation will be higher than most EO sales but often not by significant sums. EO sales can be competitive if buyers need funding and high earn-out deals to be encouraged to acquire. When structured correctly, with the right finance and vendor loans repayable with market interest rates over an agreed period, combined with the 0% CGT encouragement on EO sales (as opposed to the 10 and 20% capital gains tax rates on-trade sales), EO sales can achieve better shareholder value than many trade deals. In certain circumstances owners choose to reward staff and sell ‘low’ – but this is a choice, not an obligation.
Is there more paperwork and less agility?
The Trust and employee engagement may add to the information and data requirements, but these aspects are easy to manage if set up correctly from the start, with as much focus on transition as on the structure. Far from being an extra burden on the business, employee engagement and trustees can contribute to the commerciality of the business, if it is understood that communication requires decision and action on all sides.
There is an argument that many of the proponents of EO are driven by values and social inclusion. While this is potentially a positive view, it can result in EO firms being built around the people rather than the needs of the market and customers and creating a more profitable business. It is therefore important to separate employee engagement from the management board and trustees and create a clear understanding of each party’s roles and responsibilities from the start. All sides must understand that management steer the business plan and are responsible for its implementation. The trust paperwork and employee engagement should be light to enable all parties to focus on the business’s commercial success.
Ultimately, a new company is established as a Corporate Trust, which buys the trading business and owns it on behalf of the employees. Shares are often not granted directly, with the trust company retaining ownership of the shares for the benefit of the employees – think of the trust company as the steward. As with all contracts and structures, there is a myriad of complexities to be navigated but the basis of the sale is simple – the trust buys the trading company for the benefit of the employees and operates it for their benefit. This is essentially the same as any M&A deal where a company buys for the benefit of shareholders. Yes, advisors can have all sorts of diagrams that make it look complex and yes, the technicalities can be time-consuming, but really, the structuring of the funding is the most complex element, particularly ensuring HMRC clearance and sustainability, combined with converting the culture to an EO-owned business while maintaining that all-important quest for a competitive advantage.
Are they social enterprises?
No. EO businesses are commercial enterprises that make money for the benefit of all employees rather than a few shareholders, who may, or may not, be involved in the running of the business. Arguably, this is a more logical outcome than the few who founded the business or had the initial capital and reaped all the rewards. Rarely are all profits distributed and usually, EO businesses invest more profits in growth than lifestyle-driven, owner-managed businesses. Employees may benefit from later share value, although EO businesses are less likely to be resold, therefore profits are more often reinvested for growth for the benefit of the business. Professional managers may be less motivated to do this when they own shares and are rewarded more by remuneration and bonuses. Most EO businesses pay salaries in the upper quartile for their sector to senior management, along with the potential tax-free incentive bonus of £3,600 per annum to all employees.
When we consider EO, we should also consider the purpose of the business, particularly as consumers become more driven by ethics and transparency. Capitalism mostly has a free-market economy, which means that people buy and sell goods. Consumerism is the assumption that the more goods or services exchanged, the better off that society is. However, increasingly over-consumption and greed are being negatively attributed to both capitalism and consumerism.
The context of this negative view is that perhaps too many of us in the world are materialistic and acquire too much for ‘vanity’ as opposed to ‘need’ or even ‘comfort’. EO businesses seek to equal distributions amongst all who have worked for success rather than the few, often fortuitous, shareholders. In this respect, they are socially driven, but they are far from social enterprises as the businesses can be driven by management to grow, ensure success and advantage with more success achievable as all employees are involved in the gain.
Uneven wealth distribution and overt consumption are both significant challenges in our economies. The rich get richer and the poor poorer while materialism or consumption damages the planet. The solution is for capitalism to select moral self-responsibility; that is a free market where people and companies compete to create wealth, combined with leaders who are more ‘values’ driven, leading to a more altruistic form of capitalism. EO could be a major force here. Not only is it a great succession solution for businesses, but it is potentially a way to help to solve the economic challenges we face, both social division, productivity and competitiveness on a global stage.
Are EO sales employee-led?
Unlike an MBO an EO does not require employees to guarantee payments or directly buy shares and invest money. Over time the company can simply guarantee to buy itself for the benefit of the employees. This means the process can be broadly vendor-led with ‘buy-in’ from staff through the tax-free bonus, the ability to move toward the upper quartile of pay for managers and the attraction of increased employee engagement. Most EO’s sales are planned and structured first by vendors and advisors, presented to management before completion and later to employees with significant success. The transition will take time, but the sale remains attractive for all even when vendor-led, particularly compared with a trade sale, which may result in a loss of independence, a significant culture shift and job losses around economies of scale.
Can founders step back straight away?
Usually, the answer is no, or at least not all of them straight away. A succession plan around roles and responsibilities, training, mentoring is developed, and a new board is established, ideally with professional board support in managing the commercial change. Professional support is needed in the trustee role but conducted correctly, it is the trustees, and the management board who should take on the challenge of gently shifting the culture and building employee engagement over time.
Ideally, sales should be structured to secure 0% CGT for all shareholders. Shareholders may remain involved in the EO business by becoming employees if they choose. More often, however, it is beneficial for the founders to step back during the transition period. We encourage that this occurs gradually, thereby enabling the ‘ideas gap’, the risk analysis and final decision skills that new managers often lack initially to be built over time with mentoring. In many respects, the transition is about building awareness and open discussion. Managers may not even know their risk profile and the board may be used as an autocratic owner whose withdrawal will take time to replace. Training, frank discussions and outside objective support all create a framework for this change and thus support the conversion of managers to leaders.