Hybrid Employee Ownership: More than just an Employee Ownership Trust

This is a guest blog written by Postlethwaite Founder Robert Postlethwaite for J Gadd Associates, a trusted business partner. It first appeared on their website.

The options available

If you’re thinking about what legal structure to use when moving your company into employee ownership, the simplest approach is to use an employee ownership trust (EOT).  The EOT’s trustees own the company but for the benefit of its employees (the beneficiaries), so employee ownership is indirect ie through the trustees.  Ownership by an EOT means there are few moving parts: all employees (and new joiners who’ve completed an initial period of employment) automatically enjoy the benefits of ownership,  leavers automatically cease to do so.

For many employee-owned companies this works perfectly well, the EOT permanently holding all the shares in the company (or all of them apart from any that the company’s founders have retained).  Some, however, choose a different arrangement, where alongside  the EOT’s indirect ownership sits a separate direct form of ownership under which all, or some, employees each have their own personal ownership stake.

This is often called a hybrid: a mix of indirect and direct employee ownership.  What are the advantages of choosing hybrid, how can it be done, and what are the challenges involved in making it work?

Why choose hybrid?

Most companies choose hybrid because they want their senior leadership team or other key people to have a targeted incentive and reward to grow the business, the business being more heavily reliant them than on other employees.  Of course this could be achieved by a special bonus arrangement and often this is the chosen solution.

But some companies wish to go further and create a long term reward arrangement for key people involving personal share ownership.  This has two potential financial benefits for participants: it enables them to receive a dividend on their shares if linked to company profit (on top of any general employee profit share) and gives an opportunity to enjoy capital growth, that is the ability to sell their shares at a profit in the future of the company’s performance means it grows in value.

The UK tax regime provides incentives for companies doing this (see further below).

So we sometimes see a hybrid arrangement under which (for example) an EOT will hold a minimum of 80% of a company, with up to 20% allocated to key people.

There is another form of hybrid under which all employees – not just the key ones – are able to hold shares personally alongside the EOT’s majority stake.  This is occasionally seen but it not common.  A company might do this because it feels some personal share ownership for each employee will make ownership feel more real and make it easier to engage employees as owners.

It is even possible to have hybrid ownership involving both of the above, or hybrid ownership plus some shares retained by founders.

How to do it?

For key employees, a good starting point for most companies will be EMI share options.  Participants can be selected and will be granted a right (option) to purchase shares at a fixed price (normally their value at that time) from a future date (eg after three years).  If the shares’ value grows over that period, they may then take up the right to buy the shares (exercise their option).   Participants enjoy a reduced rate of tax on any financial benefit through growth in the value of their shares.  Not all companies are eligible to grant EMI share options.

A company looking to create personal share ownership for all its employees might consider doing this though a share incentive plan (SIP), under which employees can be awarded free shares without this being taxed as a benefit, or given full tax relief to buy shares (or both).

What are the pitfalls?

Any hybrid arrangement is going to involve more administration.  There will be work to do to create individual share ownership, administration and record keeping,  and when participants leave (or simply wish to sell their shares) further work to do to bring their share ownership to an end.

Every participant will (unless they leave relatively soon after acquiring shares and are therefore required simply to forfeit them) eventually wish to turn any growth in the value of their shares into cash.   If the company has grown significantly, those shares could potentially be very valuable.  It is vital to avoid the arrangement becoming a victim of its own success because the company cannot afford to pay for the shares to be bought back.  This can partly be addressed by a mix of advance planning (financial modelling to predict future repurchase values and building a cash reserve) and terms of ownership (for example, employees who are selling are paid in instalments).