Employee ownership for growth companies

This is a guest blog written by Postlethwaite Founder Robert Postlethwaite for LegalEdge, a business partner of Postlethwaite Solicitors. It first appeared on their website.

The rise of Employee Ownership

Many companies that have ambitious, scalable plans for growth will include their key employees and service providers as co-owners. Often this will involve a share option scheme, such as EMI, with a percentage of the company’s shares (typically 10-15%) reserved for this purpose.

An increasing number of companies are extending their employees’ involvement in the ownership by creating a trust (an employee ownership trust or EOT) which acquires a significant stake to be held on behalf of everybody on the payroll. The last few years have seen unprecedented growth in the number of companies that are wholly or majority employee-owned, usually through an EOT. According to the Employee Ownership Association, by the end of 2021 some 800+ businesses were employee owned.  Evidence shows that businesses with wider employee ownership tend to outperform their peers in a number of ways, for example enjoying higher levels of staff engagement, improved productivity and greater resilience.

The financial benefit for employees takes the form of a share of any dividends (linked to the size of the trust’s holding) and, should there be a sale or flotation, a share in the proceeds when the trust sells its shares. There can also be non-financial benefits, for example a clear shared purpose built upon the foundation of everyone having an ownership stake.

Currently, most companies choosing this route are doing so after several years of profitable trading, and it tends to involve the trust buying a controlling interest and so giving the current shareholders an exit in a way that creates a platform for further growth and preserves independence. The government encourages this by giving a full exemption from capital gains tax for the selling shareholders, and permitting any owned by an employee ownership trust to pay its employees an annual bonus free of income tax.

Should scaleups consider an EOT?

Whilst an EOT in the early years of a business is likely to be impractical, most growing businesses should be attracted to having a structure that helps with staff engagement, productivity and resilience.

However, if an EOT is to be set up, founders and investors will have to accept a reduction in their percentage ownership and will need to consider whether that is compensated for by the performance benefits.

If a majority stake for an EOT is not practical (and it very often won’t be) it might still be possible for an EOT to have a smaller holding (although neither of the tax exemptions would be available).

Consider an EOT as an exit?

An EOT should certainly be considered when a company starts to think about an exit. Whilst a sale to a trade buyer or private equity or an IPO is the traditional route, a sale to an employee ownership trust now represents a tried and tested alternative.

On a sale to an EOT the company can be sold for a price equal to its market value, normally funded from the company’s profits. In most cases this involves a down payment followed by instalments over several years. The total payment period may be longer compared with a third-party sale, but the price will often be fixed and not subject to an earn out.  Whilst it may be possible to increase the size of the down payment through bank borrowing, companies with external investors are likely to be seeking an exit that pays out in full, if not immediately, then certainly in as short a time as possible.

And there are several potential significant upsides. The company retains its independence and culture, its new ownership structure delivers a far greater share of the rewards of future success to those who have helped create it (which can partly be paid income tax free), and employees will have a new reason to increase their engagement in the company. And individual sellers to the trust can claim a full exemption from capital gains tax (compared with paying a 10% or 20% rate on any other sale).

There will be many companies for which an EOT will not be the right solution. But for those that think it could deliver performance and/or other advantages, it is certainly worth considering.