Contemporary management theory claims that the primary aim of a business is to generate profit, and this is linked to maximising shareholder value and returns. However, this view overlooks the interests of a diverse array of stakeholders beyond the shareholders, such as society, employees, and creditors. Ethical and social governance principles advocate for a more comprehensive approach that recognises the importance of balancing financial goals with the well-being of all stakeholders.
An Employee-owned business is now viewed as a viable alternative to the more traditional shareholder value model. By structuring organisations with employee ownership models, companies can prioritise contributions to society and employee welfare alongside commercial success and returns. Unlike traditional profit-centric businesses, employee-owned enterprises are not solely focused on shareholder returns.
Many proponents argue that employee-owned businesses should still aim to be valuable and advocate for enterprise management schemes that align with shareholder-oriented principles. In essence, they view employee ownership as the ultimate share scheme thereby overlooking its broader objectives. Whilst shareholder value is traditionally emphasised, employee-owned businesses should also prioritise local investment, wealth distribution, and the long-term benefits of employees.
Are employee-owned businesses commercial?
Employee-owned businesses aim to provide equitable wealth distribution amongst their employees and whilst employees may have a greater voice in company affairs, achieving a fully democratic business model may not be feasible in today’s fast-paced environment. Employee-owned businesses must remain competitive and commercially successful to thrive, with an emphasis on strong management, a well-considered strategy, and maintaining market share and profitability. Therefore, yes, an EOT is fully commercial, albeit with different beneficiary owners.
Although employee ownership often leads to increased productivity and employee satisfaction, economic challenges can still cause these businesses to fail. Therefore, maintaining a competitive advantage through strategic planning is of paramount importance. New employee-owned businesses are particularly vulnerable, often facing financial strain as they transition to employee ownership with cash flow restricted by loan notes or third-party debt obligations put in place to pay out the former shareholders who want to achieve commercial and ‘open market’ values. This often results in there being long-term vendor loans to repay the sellers.
Management needs to balance reliability with long-term strategic risk and adaptability. Whilst some fear that employee ownership structures may hinder commercial competitiveness, when properly established, employee-owned businesses operate very similarly to traditional enterprises, with management driving decisions for profitability whilst considering employee interests. Additionally, the speed at which the sellers can go “hands off”, and how they recruit or train the management as they step back and implement a strategic business plan are all critical factors in successfully transitioning to a team-driven business.
What is the long-term strategy, and can employee-owned businesses resell?
In most cases, the long-term goals of employee-owned businesses will focus on being commercial and successful, but should maintaining shareholder value continue to be a primary objective? There are significant reasons why a focus on increasing shareholder value might not be optimal in an employee-owned business, in fact, it might be more beneficial to downplay or even disregard this aspect. We believe there are five material reasons to support this stance, which all centre on the fact that employee-owned businesses may not resell well in the future and therefore this should not be the primary goal of the strategic business plan going forward.
1. The buy-out to transition: Many employee-owned businesses are vendor-led buyouts structured to secure 0% Capital Gains Tax (“CGT”) at full commercial value. This setup usually involves loan notes being paid to the sellers over a long period. This automatically creates a barrier to a possible resale within the first 5-10 years as these loans would typically need to be repaid in full prior to or as part of any resale.
2. Tax: The 0% CGT break that the sellers benefit from through the initial EOT sale requires the company to qualify as an EOT for two years from the end of the tax year in which the business is sold to the trust. This means that for this qualifying period, the sellers will insist on having the right of veto concerning any potential sale. Once this qualifying period has expired, the CGT passes to the trustees of the EOT and therefore a sale could take place without impacting on the 0% CGT break the sellers achieved.
After this period the EOT will take over the ‘base’ cost of the shares in the company from the sellers. This could be at the nominal amount paid for the shares on the incorporation of the company which could mean the whole of the increase in value of the company since inception is taxed as a chargeable capital gain at the prevailing rate on a resale.
After the payment of CGT and the initial seller buy-out, any proceeds left from the company sale will be distributed as PAYE income to qualifying employees. This is because most EOTs are ‘indirect’ trusts and as such, there are no actual shareholders, just employee beneficiaries, therefore the proceeds will usually be treated as income subject to Income Tax and National Insurance. With a double charge of CGT and PAYE, this significantly discourages resales.
3. The original EOT driver: Many businesses explore employee ownership as a succession route when they are unsuitable for trade or an investment sale. If a company was challenged in securing a trade or investment sale before the EOT transition, why would it be more desirable to resell as an EOT later? Many sellers also want to secure a local legacy through a ‘letter of wishes’, and resales can contradict this.
4. The Trustees: Neither ex-sellers nor employees can control whether a business will be resold. The ultimate decision is with the trustees, whose responsibility is to ensure that any resale benefits the employees and the organisation. Short-term financial gains from a resale might not align with long-term employee welfare and stability.
5. Culture: Employee-owned businesses have a unique culture that may not match with potential buyers in the future. Transitioning from an employee-owned culture to a corporate one could create tension and impact talent retention. Additionally, once proceeds from a sale are distributed equally amongst qualifying employees, this could lead to a drain on talent if the post-tax proceeds are sufficient for an employee to take a break, or career change.
Summary
We have demonstrated how an employee-owned business can be fully commercial, but it may lack the share scheme or equity flavour that some advisors and sellers expect. One can question if it is better to promote change management within an employee-owned business to ensure the long-term sustainability of the EOT structure rather than contemplating a possible resale or shareholder value as strategy goals and this in turn is why many sellers would do well to transition to an employee-owned model to ensure team alignment through increased salaries and bonuses in the short term. Over-emphasising that all qualifying employees have shares on which the value may never be realised may create low morale and dissatisfaction.
The positive impact of the EOT for employees can be made tangible by increasing rewards for both employees and management and enhancing perks such as insurance and healthcare. However, the overall message should be clear in the decision to transition to an employee-owned business is geared towards establishing a longer-term strategy rather than focusing on equity or shareholder value. Communication with employees could emphasise that employee ownership is about long-term rewards, rather than succumbing to short-term financial gains often associated with concerns about price earnings, multiples, and potential buyers, which can be hugely distracting for management.
Despite the increasing number of employee-owned businesses in the UK today, with just over 1,400 in June 2023 according to the EAO, and 1,600 at the start of 2024, very few have been resold or floated on the stock market and this trend can be attributed to the material reasons already identified in this article.
Redirecting the focus of employee-owned businesses towards better rewards for teams, clearer roles and responsibilities, improved training, and stronger business planning, whilst limiting thoughts regarding the potential of shareholder value, may achieve greater alignment within the team and create businesses that are more likely to thrive, reinvest and grow.
In the same way that a home should be lived in rather than purely viewed as an investment, we can draw a parallel with employee ownership — an evergreen company that has a full and good life and is not seen merely as an investment.
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