Employee ownership FAQs - frequently asked questions

Essentially, a company is employee-owned when the majority of its shares are held by staff members. But there is more to the prospect than that. 

The Nuttall Review opens in a new window defines employee ownership as “a significant and meaningful stake in a business for all its employees... [which] goes beyond financial participation. The employees’ stake must underpin organisational structures that ensure employee engagement. In this way employee ownership can be seen as a business model in its own right.”  

Employee ownership is more than just a technical business structure; it’s a way to involve staff in the everyday running and management of the company. This increases engagement and helps create a stronger, more productive business.  

What does employee ownership look like?  

Employee ownership can be direct – when employees own shares directly in the company – or indirect – when shares are held by a trust on behalf of the employees.  

Many staff-owned companies combine indirect and direct ownership in what is sometimes called the hybrid model.  

Direct

Shares held directly by employees are usually managed through one of the tax-effective schemes: Share Incentive Plan (SIP), Enterprise Management Incentives (EMI), Company Share Option Plan (CSOP) or Save as you Earn (SAYE). Non-tax advantaged plans are sometimes used where appropriate.   

Indirect 

Shares are held in a trust, and the employees are beneficiaries of that trust. In 2014, the Employee Ownership Trust was introduced as a shareholding vehicle designed specifically for employee ownership. As long as it meets certain requirements, the Employee Ownership Trust offers tax advantages.  

Hybrid

The Trust holds the majority shareholding, but there are also one or two share plans in operation (usually SIP and/or EMI schemes). In this way, the company has a stable collective ownership structure but individual employees also have a tangible stake in the business. 

Are employee-owned companies structured differently from other businesses?

Employee-owned businesses are organised like any other private firm, with a Board of Directors and a professional management team. The key difference is the presence of the Employee Ownership Trust.  

The Trust exists to make sure the Board operates in the long-term interests of the employees. Trustees are tasked with holding the Board to account, just as shareholders would in a corporate enterprise.  

As well as these governance matters, there is likely to be more focus on employee voice and engagement. More information is shared with staff, and they’ll be given more scope to comment on the company’s performance and propose new ideas.   

Why do companies choose employee ownership?

Most companies adopt employee ownership as a succession route. By selling to their employees, exiting owners can get a fair price for their business while providing continuity for the company and its staff, customers and suppliers.   

Employee ownership is increasingly being used as way to engage the workforce and create a competitive advantage in sectors where attracting the best talent is paramount.

If the company is a sound, successful business, then an employee buyout should allow the owner to receive the fair market value for the company.

Other reasons vendors choose to sell to an EOT include:

Preserving the company location and culture

Selling to a competitor may result in the relocation of the business or significant changes to the way it operates. Many business owners are very proud of the unique nature of their company and they – and their employees and customers – don’t want to see that change.  

There are no suitable buyers available

For example, if it’s a niche business, there may not be a buyer at the time the owner chooses to exit. The EOT provides an immediate buyer for the company and the transaction can occur reasonably swiftly. 

Avoiding the hassle of a commercial sale

The demands of a commercial trade sale can prove frustrating. Gruelling due diligence exercises, restrictive tie-ins, long earn-out periods and other red tape can all deter the owner from selling.

Keeping existing management

The company’s directors can remain in place after the transaction. In a commercial sale, the management team are often replaced by the buyer’s own executives.

Flexibility in structure

The EOT is a very flexible structure. It can sit alongside executive incentive schemes, all-employee share schemes and family trusts.

The owner wants to keep some shares

In a trade sale, usually all issued shares are sold to the buyer. A sale to an EOT allows the seller to retain a minority shareholding. Many owners do this in order to secure a future capital gain or demonstrate an ongoing commitment to the company.  

Maintaining ties with the local community

The stable nature of the EOT is attractive if a company has strong ties to the local community. Indeed, some Trust Deeds will stipulate that the company must remain in its local area and require, for example, that 75% of employees agree to any proposed relocation.

Safeguarding a family legacy

Family businesses often have a long history or legacy. If there is no new generation able or willing to take the reins, selling to an Employee Ownership Trust can be the best alternative, ensuring the future of the company is in the hands of those who know it best, the employees. 

Owners can exit gradually

Some business owners have no desire to retire immediately, and the EOT option allows them to phase their exit from the company at their own pace. This is particularly relevant where there is a good but inexperienced management team in place. A gradual exit by the owner allows time for any coaching and development necessary for the managers.  

Improved performance and employee well-being

Importantly, the EOT is a proven business model that delivers enhanced performance on almost every business metric, including productivity, profitability, innovation, employee happiness and customer satisfaction.

In a typical employee ownership transaction, there are two parties: the sellers (the current owners) and the buyer (the Trust, on behalf of the employees).   

Setting up an Employee Ownership Trust

The Employee Ownership Trust (EOT) is a new form of Employee Benefit Trust introduced in the Finance Act 2014.  

The trust is set up through a Deed of Trust. This deed explains how the trust meets the requirements of the legislation, and sets out the rules of the trust.  Essentially, the trust deed outlines: 

• The purpose of the trust 
• What the assets of the trust are 
• How these assets will be looked after and disposed of  
• Who the trustee will be 
• The nature of the relationship between the trust and the trading company    

Selling the shares

The company’s total shareholding is valued, usually by an external adviser. Once this valuation has been agreed by the buyer and seller, it becomes the selling price for the company. The shareholders (that is, the existing owners) sell their shares to the trust at the agreed price.  

The Share Purchase Agreement (SPA) sets out the details of the transaction. Usually the agreement contains certain protections for the seller while the transaction is still in process. These protections may include:  

• The right to remain a director and/or trustee
• The power of veto over certain decisions regarding expenditure, investment, remuneration, borrowing or divestment
• The right to access company information 

Funding EOT transactions   

Generally, employee ownership transactions are funded from future trading profits. Any surplus cash can be used to make a payment to the sellers upfront, with the remainder being paid out from after-tax profits at annual, quarterly or monthly intervals. 

There must always be enough working capital left in the business to allow for normal operations and investment to secure the company’s future. 

External funding   

It is unusual for mainstream banks and lenders to fund an EOT transaction in its entirety. More often, bank funding will be supplemented by loans from other sources. However, there are some specialist lenders who provide funding specifically for sales to an EOT.   

Governance

Many owner-managed businesses take a relaxed approach to corporate governance. The move to employee ownership usually means the board structure and organisation must be formalised. The relationship of the board to the trust must be clarified and processes put in place to ensure accountability.  

Individuals may need development and support to help them step up to their new roles and responsibilities. 

Employee involvement 

The plans to sell to an EOT are usually kept confidential until the decision has been confirmed and the model agreed. However, owners may wish to include key staff in some of the discussions regarding the terms of the deal and the future shape of the business.  

Once the way forward is clear, owners can decide on the most effective means to communicate the new ownership structure to the employees.

Tax incentives were introduced in 2014 to encourage more company owners to consider employee ownership.  

The Employee Ownership Trust (EOT) has been designed specifically for employee-owned companies. When owners sell their business to an EOT, the transaction is exempt from Capital Gains Tax, providing the following conditions are met: 

• The relevant company is a trading company or the principal of a trading group. 
• The trust meets the all-employee benefit requirement: the application of any settled property is restricted to the benefit of all eligible employees on the same terms.
• The trust meets the equality requirement: any trust assets must be applied only for the benefit of all eligible employees, other than excluded participators.  
• The trust meets the limited participation requirement: the number of continuing shareholders, and any other 5% participators who are directors or employees (and any connected persons), must not exceed 40% of the total number of employees of the company or group.
• The Taxation of Chargeable Gains Act (TCGA 1992) Section 236H does not apply in relation to any related disposal by the claimant or a person connected with the claimant which occurred in an earlier tax year.

Tax benefits for staff in employee-owned companies

• There is an income tax exemption of up to £3600 per employee each tax year on certain qualifying bonus payments (with NIC liabilities continuing to apply).
• It is the employing company and not the trustee that must pay the qualifying bonus.  
• Every eligible employee must participate on the “same terms”. This requirement will not be infringed if an award is determined by reference to remuneration, length of service or hours worked. 
• A combination of these factors can be applied, but must be applied on the same terms to all qualifying employees. 
• Because the bonus is paid from the employer and not the Trust, all eligible employees are entitled to receive the bonus, even if the employee is an excluded participant.  

HMRC clearances  

In order to avoid falling foul of anti-avoidance legislation, owners usually get a clearance from HMRC explaining the nature of the employee ownership transaction, emphasising that the prime purpose is to transfer control of the enterprise from the owners to the EOT and not to secure tax advantages.  

Disqualifying event  

In the event of a breach of the trust requirements – for example, if the company is sold in future – then the trustee of the EOT would incur a Capital Gains Tax liability based on the market value of the shares in the EOT at the time of the disqualifying event and the inherited base cost.

Attitudes to funding employee buyouts have changed in recent years, with more lenders recognising the benefits of employee ownership. However, it is still unusual for the entire transaction to be funded by an external source.  

The key factor in deciding on any funding source is to ensure that the debt is manageable. Repayments should be set at a level that is easily affordable by the company, while still allowing sufficient working capital to support future growth and investment.  

It’s possible for employees to fund the company sale, usually by buying shares direct from the shareholder. However, it’s unlikely that employees would have access to sufficient cash to fund the entire share price, and the tax regime does not make this an attractive proposition to employees. More usually, there is an element of deferred consideration in place.  

Deferred consideration by vendor

Almost all employee ownership transactions involve at least an element of deferred consideration, and many are totally funded this way. Basically, this means that the current owner exchanges some of their equity in the business for debt, which is eventually repaid with surplus cash from the company’s after-tax profits. 

The advantage to the company is that the lender is someone who knows the business and is committed to its long-term success. Repayments can be structured to fit with the cash demands on the business: if revenues fluctuate, an annual payment may be best, whereas steady profits may allow for a monthly repayment schedule.  

The seller can apply interest payments on the deferred consideration and penalties for any missed or late payments.   

External lenders

As well as mainstream lenders such as banks, there are an increasing number of specialist lenders who support employee ownership transactions.   

Any lender will want to feel comfortable that the loan is affordable based on the future earnings of the business. They may look for a personal guarantee for the loan, which can be challenging when the company is collectively owned through an Employee Ownership Trust, with no one individual holding the majority stake.    

The lender may also want to apply a charge on the company’s assets. Where there is a vendor loan, any external lender will likely insist on taking priority over any claims from the seller.   

Vendor protections 

The seller obviously takes on some risk during the deferred consideration period, so normally some protections are incorporated in the deal to mitigate this. These protections can include:   

• Veto over certain decisions, including further lending, spending over a certain level, hiring of staff over a certain salary level, payment of bonuses, divestment and investment 
• The right to remain a director and/or trustee, or to appoint an alternate (without contravening the change of control clause) 
• The right to information/to access company accounts, etc 
• Consent to change of company lawyer, accountant or bankers  

The seller usually also seeks security against the payment of the deferred consideration (typically a guarantee from the company of the Employee Ownership Trust’s payment obligations, supported by a floating charge, and perhaps also a standard security if the company owns property).   

It’s also common to include an anti-embarrassment clause, entitling the vendor to a percentage of any profits from a future sale. This clause is usually limited to a period of two to five years.

Many owner-managed small and medium-sized businesses take a “relaxed” approach to corporate governance. Moving to employee ownership means that a more robust and transparent governance structure needs to be put in place.  

The following elements are involved in governing a staff-owned business: 

The Employee Ownership Trust   

The trust exists to hold shares on behalf of the employees. In companies where the majority of the shares are held in the trust, the trust has the same powers as any majority shareholder.  

The trust’s role is to ensure that the company is run in the best long-term interests of the employees it represents. The trust is responsible for holding the company’s board to account, in line with the purpose of the trust as set out in the trust deed.   

Some companies prefer to set up a separate corporate entity, a company limited by guarantee, to serve as the corporate trustee. Individuals are then appointed as directors to the board of the corporate trustee. Other companies prefer to appoint individual trustees.    

Appointing trustees    

According to the legislation, it must be apparent that the controlling interest has passed from the sellers to the trust. For this reason, the sellers must not have the strongest voice in the trust.  Other than this, there are no rules as to who should serve in the trust.  

Normally, the trust includes a board-appointed trustee, employee trustees, and an independent trustee. The employees are usually elected for a fixed term of two or three years. The board-appointed trustee is often one of the sellers, with the right to hold the position for as long as the debt is outstanding. The addition of an independent trustee is recommended to bring a neutral viewpoint to discussions and to ensure that the trustee adheres to the trust purpose.    

The Board of Directors 

As with any other private business, the Board of Directors are charged with delivering a successful business that meets all its legal obligations. If there is a well-functioning board already in place, there is no need for that to change when the company transfers to EOT ownership.  However, the change in ownership can present an opportunity to review the composition of the board, promote senior managers or recruit externally as part of the company’s leadership succession planning.     

Some companies choose to elect employees to the Board of Directors. This is not required, but many feel it reinforces the employee-owned status of the business. If there are employee directors, it’s important that they receive any training and support necessary to participate fully in board business.    

Employee representation

Successful employee-owned businesses make communication a priority. Additional, more informal structures – such as employee councils, weekly or monthly all-employee meetings, newsletters and training – are often put in place to promote a positive, productive ownership culture.