An employee ownership trust is an amazing exit strategy hidden for all but the best entrepreneurs. This article shares the details of this employee ownership option for your business.
“Employee ownership as a core exit option is a significant benefit to the business. It recognizes the contributions of the people who make the business successful and it offers a vehicle for the owner to exit at almost any time.” – Nicola Gelormino, Co-Founder of Exit Success Lab
The best time to think about an exit strategy for your business was the day you started it. The second best time to think about it is today. At the Exit Success Lab, we work with our clients to establish three core exit strategies early in the business lifecycle. One of the core exit strategies is an employee ownership exit.
ESOPs Have Been the Default Employee-Based Exit Strategy
An Employee Stock Ownership Plan (ESOP) is often ideal for this purpose in larger businesses. In an ESOP, companies provide their employees with stock ownership, often at no upfront cost to the employees. Companies use an ESOP as a corporate finance strategy and also to align the interests of their employees with those of the company’s shareholders.
ESOPs are a valuable tool exit strategy option in closely held companies. By providing a market for the shares of departing owners, ESOPs can facilitate ownership transitions in a tax-efficient manner.
There are a couple of significant drawbacks to using an ESOP as a small business exit strategy. ESOPs are highly regulated and require substantial legal work to establish and maintain compliance. This can be expensive.
The second drawback to using an ESOP for small business exit planning is the need to reserve for employee share redemptions. In businesses with many employees, redemption events are common. An employee can redeem stock for retirement purposes or if they choose to leave the company. In the event of an employee’s death, that employee’s family may be eligible to redeem the shares. The company must have the cash on hand to support this process. This is a substantial commitment.
What is an Employee Ownership Trust?
An Employee Ownership Trust (EOT) is a form of business ownership structure where a trust holds shares of company ownership on behalf of the employees of a company. This approach to company ownership gives employees a stake in their company. EOTs have gained popularity as a means of ensuring business continuity, aligning the interests of employees with those of the business, and providing a succession plan for business owners. Here are the key features of an EOT:
1. Trust Structure: An EOT establishes a trust to hold the employees’ interest in the company. The trust acquires shares in the company, either by purchasing them from existing owners or through new share issuance.
2. Beneficiaries: The trust’s primary beneficiaries are the company’s employees. Unlike direct share ownership schemes, employees do not own the shares individually; instead, they are beneficiaries of the trust that owns the shares.
3. Employee Benefits: Employees typically benefit from the trust through profit-sharing arrangements or other benefits rather than direct share ownership. This might include annual bonuses or other financial benefits linked to the company’s performance.
4. Governance: The trust is usually governed by trustees who are responsible for managing it in the best interest of the beneficiaries (the employees). The trustees can be a mix of company directors, external professionals, and sometimes employee representatives.
5. Succession Planning: EOTs are an exit strategy that allows business owners to transfer ownership to employees to ensure business continuity. This makes them an effective succession planning tool. This can be especially appealing for owners who wish to retire or exit the business while preserving its independence and culture.
6. Tax Advantages: In some countries, such as the United Kingdom, significant tax advantages are associated with selling a business to an EOT. For example, sellers to an EOT in the UK can benefit from certain tax reliefs, and the EOT can operate with favorable tax conditions. These tax advantages are not currently in place in the United States or Canada but there are some tax planning tools available to help mitigate exposure.
According to Canadian tax expert and CEO advisor, Kim G.C. Moody, “Right now (January 2024) in Canada, Employee Ownership Trusts are not a practical option for most business owners. They’ve only been around in proposed form for about 18 months and the government regulations are not as favorable as they are in the UK or US. There is some proposed legislation that would make them more attractive as an exit strategy, but it is in the early stages.”
7. Employee Engagement and Retention: By providing employees with a stake in the business, EOTs can enhance employee engagement, motivation, and loyalty. This collective ownership model can foster a strong sense of community and shared purpose within the company.
8. No Direct Employee Share Ownership: Unlike ESOPs or other direct ownership schemes, employees do not own individual shares and thus do not worry about the complexities of buying and selling shares, share valuation, or individual tax implications of share ownership.
EOTs offer a unique approach to employee ownership, distinct from other models like ESOPs. They provide a mechanism for business owners to exit or reduce their involvement while ensuring the business remains in the hands of employees who understand and are committed to it. This model is particularly attractive for businesses where maintaining the independence and ethos of the company is essential and where direct share ownership by employees might not be practical or desired.
An Employee Ownership Trust as an Alternative to an ESOP
For several reasons, an Employee Ownership Trust (EOT) can be an excellent alternative to an Employee Stock Ownership Plan (ESOP) as an exit strategy. While both methods allow for employee ownership, they have distinct characteristics that might make an EOT more suitable in certain situations:
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1. Simplicity and Lower Costs: EOTs are generally more straightforward to set up and administer than ESOPs. ESOPs can be complex and expensive to establish and maintain due to their regulatory requirements, especially in the United States. EOTs, by contrast, tend to have lower administrative and ongoing operational costs.
2. Tax Efficiency: In some jurisdictions, EOTs offer significant tax advantages to the selling owners and the trust. For instance, in the UK, sellers to an EOT can benefit from tax reliefs, and the EOT’s income might be taxed favorably. This can make it a more tax-efficient exit strategy compared to other options.
3. Employee Benefits Without Individual Share Ownership: EOTs allow employees to benefit from ownership without holding shares directly. This can be advantageous in situations where direct share ownership by employees might be undesirable or impractical. For example, it avoids the need for share valuation and individual share transactions whenever employees join or leave.
4. Long-Term Stability and Succession Planning: An EOT can provide a more stable and long-term solution for business continuity. It avoids the potential fragmentation of ownership in ESOPs as employees leave and sell their shares. This can be particularly appealing for owners who want to preserve the legacy and culture of the business.
5. Alignment of Interests: Like ESOPs, EOTs align employees’ interests with the business’s success. However, since EOTs often distribute profits more uniformly among employees, they can be perceived as more equitable, potentially boosting morale and employee engagement.
6. Avoidance of Employee Stock Market: In an ESOP, a market for the company’s stock may need to be maintained to allow employees to buy and sell shares. This is not a requirement in an EOT, simplifying the management of the ownership structure.
7. Less Regulatory Burden: ESOPs, especially in the US, are subject to numerous regulations, including ERISA (Employee Retirement Income Security Act) compliance. EOTs can be subject to fewer regulations, making them easier to manage.
8. Easier Exit for Owners: For business owners looking for a straightforward exit strategy that ensures the continuity of the business and rewards employees, an EOT can be a quicker and simpler solution than setting up an ESOP.
However, the suitability of an EOT over an ESOP depends on the business’s specific circumstances, including its size, location, the goals of the exiting owner, and the financial and tax implications in the relevant jurisdiction. Business owners should consult legal and financial advisors to understand the best approach for their situation.
How to Set Up An Employee Ownership Trust
Setting up an Employee Ownership Trust (EOT) involves several key steps, and the process can vary depending on the jurisdiction and specific circumstances of the business. Here’s a general outline of the process to set up an EOT:
1. Understand the Concept and Implications: Before setting up an EOT, it’s crucial for a business owner to fully understand what an EOT is, how it operates, and the implications for the business, the owner, and the employees. This might involve research and preliminary discussions with advisors.
2. Consult with Professional Advisors: Engage legal, financial, and tax advisors experienced in employee ownership structures. These professionals can guide the feasibility, design, tax implications, and legal requirements of setting up an EOT.
3. Valuation of the Business: Obtain a professional business valuation. This is important to determine the selling price at of the shares to the EOT. The valuation should be fair and reflect the market value of the business.
4. Design the EOT Structure: Work with advisors to design the structure of the EOT. This includes deciding on the percentage of shares the EOT will hold, the governance structure of the trust (such as the appointment of trustees), and the mechanisms for how employees will benefit (e.g., profit sharing, bonuses).
5. Draft the Trust Deed: The trust deed is the legal document that establishes the EOT. It outlines the trust’s operation, the trustees’ rights and obligations, and the rules regarding the beneficiaries (employees). Legal professionals must carefully draft this deed.
6. Finance the Purchase of Shares: Determine how the EOT will finance the purchase of shares. Options include the owner selling the shares directly to the EOT, the business raising funds to finance the purchase or the EOT borrowing funds to buy the shares.
7. Create a Communication Plan: Develop a plan to communicate the change in ownership to employees. It’s essential to explain what an EOT is, how it works, and what it means for employees. Effective communication is critical to ensuring employee buy-in and understanding.
8. Implement the EOT: This involves formally setting up the trust, transferring shares into it, and implementing the agreed mechanisms for employee benefits.
9. Ongoing Administration and Governance: Once the EOT is established, there will be ongoing requirements for administration, governance, and compliance. This includes regular trust meetings, reporting, and ensuring the EOT meets its objectives and legal requirements.
10. Review and Adapt: Regularly review the performance and impact of the EOT on the business and its employees. Be prepared to make necessary adjustments to ensure the EOT continues to meet its objectives.
It’s important to note that the process can be complex and varies depending on the size and type of business, the country’s legal framework, and the specific goals of the business owner. Therefore, involving experienced professionals throughout the process is crucial for successfully transitioning to an EOT.
How is an Employee Ownership Trust Funded?
An Employee Ownership Trust (EOT) is typically funded through one of several methods or a combination thereof, depending on the business’s specific circumstances and financial strategies. Here are the common ways an EOT can be funded:
1. Seller Financing: The existing owner or shareholders of the company sell their shares to the EOT, often on deferred terms. In this scenario, the owner may agree to be paid over time from the business’s future profits. This is a standard method as it allows for a gradual ownership transition and doesn’t require immediate cash outlay.
2. Company Contributions: The company can contribute to the EOT to fund the purchase of shares. These contributions are typically made out of company profits. This method is often used in combination with seller financing. The company may allocate some of its annual profits to the EOT to gradually buy out the owner’s shares.
3. Bank Financing or Loans: The EOT can secure a loan from a bank or another lender to finance the purchase of shares. This loan is then typically repaid over time using the company’s profits. While this method can provide immediate payment to the selling shareholders, it also introduces debt into the business’s financial structure.
4. Cash Reserves: If the company has sufficient cash reserves, these can be used to fund the EOT’s purchase of shares. This method is less common as it requires the company to have significant liquid assets.
5. External Investors: External investors sometimes fund the EOT. This could be in the form of equity or debt financing. However, this approach might introduce additional stakeholders into the business, which can complicate the governance and operation of the EOT.
6. Combination of Methods: Often, a combination of these methods is used. For example, the selling owner might provide some seller financing, with the balance funded through company contributions or a bank loan.
The choice of funding method depends on various factors, including the company’s financial health, the owner’s needs and goals, and the business’s future profitability projections. The company needs to consider the long-term implications of each funding method, including the impact on cash flow and debt levels.
Professional advice from financial advisors, accountants, and legal experts is crucial in determining the most appropriate and sustainable funding strategy for an EOT.
The Value of an Employee Ownership Trust
At its core, an Employee Ownership Trust is more than a benefit; it’s a strategic pathway that ensures the continuity and growth of your business, even as you step away. This method isn’t just about securing an exit strategy; it’s a testament to the trust and confidence you place in your employees, the very individuals who have contributed to the success of your business.
From a business owner’s perspective, the emotional satisfaction derived from an Employee Ownership Trust is significant. Imagine handing over the reins of your business to those who have been integral in its journey. This transition isn’t just about finding a successor but about leaving a legacy. An Employee Ownership Trust enables you to preserve the culture and values instilled in your business, ensuring that these foundational elements continue to thrive under the stewardship of those who understand your vision. There’s a profound sense of fulfillment in knowing that the business you’ve nurtured will continue to flourish, guided by the hands of those who helped build it.
Finally, consider the tangible benefits of an Employee Ownership Trust as an exit strategy. This approach offers business owners a streamlined, less burdensome alternative to traditional methods, particularly suited to small and medium-sized businesses. The financial perks, including potential tax advantages, are coupled with operational benefits like heightened employee engagement and retention. This combination is financially astute and ensures a smoother transition with minimal disruption to the business’s operations. An Employee Ownership Trust represents a harmonious blend of financial foresight and a deep-seated commitment to the business’s long-term well-being, making it a compelling choice for any business owner plotting their exit strategy.
Dave is a renowned business strategist and the co-founder of Exit Success Lab, where he shapes the company's strategic direction and spearheads content creation, and business development initiatives. His responsibilities also include advising clients on capital acquisition and developing and maintaining relationships with family offices and private equity funds.
In addition to his leadership at Exit Success Lab, Dave is a celebrated author and speaker. His expertise and dynamic presentation skills earned him the title of New Speaker of the Year in 2022 by Vistage Worldwide, Inc., a testament to his influence in the field of CEO consulting and peer advisory.
Dave's client roster includes executives from numerous FORTUNE 500 companies like Pfizer, Marriott, Textron, and IBM.
Key Areas of Expertise:
-- Enterprise Value Enhancement: Drawing from his experience, Dave designs growth strategies that set the foundation for maximum value realization.
-- Organic Growth Enablement: Dave facilitates business expansion by understanding market nuances and capitalizing on the team's strengths, solidifying brand presence and market dominance.
-- Client Lifetime Value Augmentation: Emphasizing deep client relationships, Dave Lorenzo devises methods to optimize retention, purchase frequency, and profitability.
-- Strategic Exit Planning: Whether envisioning a sale, merger, or generational transition, Dave offers comprehensive guidance to ensure smooth transitions congruent with your aspirations.
-- Stakeholder Engagement: With a keen focus on relationship-building, Dave Lorenzo creates an environment of transparency, trust, and mutual respect.
-- Professional Network Connections: Dave's well-established circle connects CEOs to industry leaders, subject matter experts, and pioneers, minimizing risk while maximizing opportunity.
-- Family Office and Private Equity Ties: Dave's partnerships with financial professionals provide CEOs with invaluable resources and diverse strategic opportunities.
Dave Lorenzo received his MBA from Pace University. He also holds a Master of Science in Strategic Communications from Columbia University in New York City.
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