Employee ownership has proved itself a successful UK business model for decades. The introduction of employee ownership trusts in the Finance Act 2014 has raised interest in employee ownership as a business succession solution. The following article looks at the advantages of an employee buy-out over a trade sale or MBO.

I. What is Employee Ownership?

According to "Sharing Success, The Nuttall Review of Employee Ownership" (BIS, 2012) (the "Nuttall Review") employee ownership ("EO") is defined as: "a significant and meaningful stake in a business for all its employees. . . What is "meaningful" goes beyond financial participation. The employees’ stake must underpin organisational structures that promote employee engagement in the company."

In an employee buy-out ("EBO") this means that the employees acquire at least a majority shareholding in their company and that this stake is used to perpetuate an EO ethos in the company. This broadly involves an ethos in which employees assume responsibility for maximizing their contribution to the business, receive full information on the business and where opportunities are given to employees, whether individually or through representatives, to influence the development of the business. There will typically be a board of directors of the company chosen for their skills and experience although sometimes there is an employee elected representative on the board. There is flexibility to design the management and governance arrangements in a way that works best for that particular business. The recent White Rose Centre for Employee Ownership report on Employee Ownership In Britain Today highlights the variety of models of EO.

II. Employee Ownership Trusts

Employee benefit trusts ("EBTs") have been used by companies to support the direct ownership of shares by employees. An EBT of this sort is typically closely controlled by a company’s board of directors and has been used as a share warehouse and for buying and selling shares as part of a share or share option plan. But there is a different way of using an employee trust: as a part of the ownership and governance arrangements of a company. This approach involves the trust holding shares permanently on behalf of a company’s employees.

The John Lewis Partnership is a flagship example of an employee trust owned company. There are many others, such as Arup and Swann Morton. Notwithstanding the success of these businesses, until recently there was a general lack of awareness of this way of owning a company. The Nuttall Review was an independent report to the Government in 2012 on what was needed to drive EO into the mainstream of the UK economy. Following its publication, the Government agreed to promote EO in all its forms and in particular the trust model of EO. Since 2012, the Government has shown its support by a number of regulatory and non-regulatory measures (click here to read about these). One of these measures was the introduction of employee ownership trusts.

An employee ownership trust or "EOT" is a particular type of EBT introduced by the Finance Act 2014. It gives rise to two helpful tax exemptions which in outline are:

  1. a capital gains tax ("CGT") exemption, available to individuals who sell a majority shareholding in a trading company to an EOT (sections 236H to 236U of the Taxation of Chargeable Gains Act 1992); and
  2. an income tax exemption for certain bonus payments made to all employees of a company controlled by an EOT, of up to £3,600 for each employee per tax year (Chapter 10A, Part 4 of the Income Tax (Earnings and Pensions) Act 2003).

There are conditions which need to be met in order for an employee trust to qualify as an EOT. These are detailed and technical in nature but, in broad terms, they restrict the ability of the EOT trustee(s) to apply trust property for the benefit of only selected beneficiaries—any distributions must be made to all employees, on the “same terms’.

III. EBOs

EO could be achieved by all employees buying shares directly in a company from the existing owners. But, in practice, EBOs often involve an employee trust as the purchaser of shares, with a corporate trustee holding those shares indefinitely on behalf of all employees. The new EOT CGT exemption was designed to encourage EBOs of this sort, and to raise awareness generally of EO. Typically someone selling a private company would expect to benefit from entrepreneurs’ relief and pay CGT at 10%. The new EOT exemption means that the idea of an EBO should get considered as an alternative to a management buy-out or other form of exit. An individual or group of individuals can sell shares to an EOT and, provided all conditions are met, that sale will be free from CGT - this is an important incentive, in particular, for individuals who wish to perpetuate the independence of their business rather than, say, sell to a competitor.

IV. Advantages of an EBO

In some respects, the purchase of shares by an EOT is the same as any other sale. There are, however, some key differences in addition to the EOT tax exemptions, which help make an EBO attractive.

An arm’s length sale to a third party would typically involve the selling shareholder in the following:

  • a full due diligence exercise, involving disclosing confidential information;
  • detailed negotiations on price;
  • agreeing comprehensive long form sale documents;
  • accepting that at least part of the consideration for the sale is dependent on the future profitability of the business being sold;
  • losing their influence over how the business is operated and developed in the future;
  • a lack of control over the timing of the sale; and
  • uncertainty over the support for the business going forward from all its employees (which may impact on any "earn-out" payments).

A management buy-out can also involve much of the above and the use of a "Newco" as the buy-out vehicle.

By contrast, because there are no third parties involved, a typical EBO (using an EOT to acquire at least a controlling shareholding) would involve:

  • no detailed due diligence and no disclosure of confidential information to third parties;
  • quicker agreement on the value of the company;
  • shorter form sale documents;
  • agreed instalment payments for any consideration not paid upfront;
  • continuity regarding the existing ethos and independence of the company;
  • complete control over the timing of the EBO;
  • support from all the employees for the business following the change in ownership; and
  • no need for a "Newco".

The above is a very brief overview. There are risks with an EBO. In a sale to a third party the funding for the purchase depends on the financial strength of the buyer. An EBO is usually funded by the company itself and so the sellers are dependent on the company’s continued success to finance any deferred consideration.

V. Carrying out an EBO

There are various legal, tax, financial and practical issues to work through when implementing an EBO. A thorough analysis of these is outside of the scope of this article however, the following illustrate a couple of these issues.

A. Financing

Is external finance needed? Typically the company itself will provide funds to the trustee of the EOT which will, in turn, use those funds to pay consideration to the selling shareholders. Careful consideration should be given to the company’s current and projected cash flows in order to ensure that sufficient cash remains in the business. The consideration can be paid in instalments and, depending on the circumstances, external (e.g. bank) finance may be available on terms compatible with the EBO’s aims.

B. Employee Engagement

The new EOT controlled business needs to understand how best to maximize the potential benefits of EO. There should be as much focus on this element as on the terms of the EBO. It can be useful to become a member of the Employee Ownership Association or other sector bodies at an early stage in order to learn from the experience of existing successful employee-owned companies (click here for details).

EO is a growing part of the U.K. economy. Employee-owned companies of all sizes across a diverse range of sectors contribute over 30 billion pounds to U.K. GDP annually. The introduction of EOTs is helping to promote the concept of EO more widely and it should be considered by anyone looking at business succession solutions.

This article was first published by Bloomberg BNA in Tax Planning International, European Tax Service, International Information for International Business, Vol 18, No.2 Feb 2016.