As a business matures, it will inevitably need to explore new ways of optimising its structure to best support its current activities and prepare for the coming years. One increasingly attractive way for SMEs to do that is by transitioning to employee ownership (EO).

In its 2018 report The Ownership Dividend – a comprehensive study of EO in the UK – the Employee Ownership Association highlighted a wide range of compelling benefits that businesses can realise through this model. Evidence gathered for the report by Cass (now Bayes) Business School showed that EO not only provides staff with a more resonant voice in corporate governance, but enhances long-term strategic thinking.

That rings particularly true in the context of succession, which in recent years had become a critical issue for JDDK Architects, a close-knit, Newcastle-based practice founded in 1987. In October, the business announced that it had transitioned to EO to safeguard the longevity of the ethos that had led it to win more than 100 industry accolades, including the Royal Institute of British Architects’ prestigious Building of the Year Award (now the Stirling Prize).

Removing barriers

“We’d had some conversations at senior level about succession planning,” explains JDDK Director Nicky Watson. “There are four directors here, and we’re all in the same age range. We knew that we had to think about ways of opening up the field. At the same time, we’d read a lot about the EO model – mainly because a couple of local architecture practices not dissimilar to us had recently taken that route.”

As JDDK pondered how best to rework its structure to resolve the succession issue and set itself up for the future, it sought assistance from business advisory firm Haines Watts. Initially, the firm advised JDDK about a number of potential ways forward, and the accountancy implications around each option. One route was some form of external shares purchase.

“We felt very strongly that we didn’t want to do that,” Watson notes. “JDDK is a 20-person team, with very low staff turnover. We’re all at different stages of our careers, but most of us have been here for almost all our professional lives – and many of us worked alongside our two founders before they retired. So, we as directors took the view that we were custodians of something to pass on to others.”

In addition, Watson says: “We were concerned that an external shareholding influence, with someone new coming into the practice at a high level, would change the organisation’s values. Plus, we really like the idea of internal growth and development, and removing barriers to that.

“We wanted to look ahead with the aim of having the right people in the right place – rather than people who could afford to be in the right place.”

Majority stake

As Haines Watts had already advised other companies on EO transitions, JDDK asked the firm to guide its own process – whereby the business would reorganise under an employee ownership trust (EOT). 

“There has been a significant uptake of EOTs in the creative wing of the professional services arena,” says Haines Watts Tax Partner Jonathan Scott, “and it continues to rise.” Under the company’s planned new model, the biggest change would be the directors selling their shares in JDDK to the EOT. Instead of being shareholders with dividends, they would become non-shareholding, salaried staff.

“Each EOT has its quirks,” Scott says, “but the qualifying criteria for any EOT to operate is that it must take a majority stake in the business. In JDDK’s case, that stake was 100%.”

Scott notes that a transitioning company is free to determine the makeup of its EOT. For example, it may comprise a blend of board members, external advisers – eg, accountants or lawyers – and key employees to provide staff with a voice. In its work with JDDK, Haines Watts helped the business appoint solicitors who would manage the legal aspects of its EOT’s creation and composition. Scott explains: “We reached out to our network and gave JDDK a few options of legal specialists who’d worked on transitions before. In the first instance, our aim was to provide the client with an indicative price.”

JDDK went with Haines Watts’s preferred recommendation, rather than the cheapest option. “In my advice to the directors, I’d said that they needed a legal team who’d been there and done it, and could answer complex questions quickly and directly, without having to research the answers,” says Scott.

Further benefits

While Scott reinforces Watson’s point that the objective of the transition was to preserve the legacy of JDDK’s ethos, he highlights some additional, financial advantages that stem from the EOT model. “When the shareholders sell their shares in the business to the EOT,” he says, “they pay a 0% tax rate. In the past, Entrepreneurs’ Relief – which is now Business Asset Disposal Relief (BADR) – was set at 10%, up to £10m. Now, BADR is down to a ceiling of £1m at a tax rate of 10%, and 20% thereafter. That’s relatively low compared to income tax, but still quite a large sum out of a shareholder’s pension fund, which is what most entrepreneurs build up their businesses for.”

Another advantage of being owned by an EOT, Scott points out, is that the business can pay employees tax-free bonuses up to £3,600. “There’s still National Insurance on that, but it’s a huge benefit at this point in time. And JDDK has already paid its team a bonus under those terms.”

Furthermore, the model enables directors to leave ownership without saddling the business with external debt. Scott explains: “The EOT owes the exiting shareholders money for their shares, and to minimise strain on the business, future profits can be used to honour that obligation over a longer period of time. We provided JDDK with some cash-flow modelling to gauge the value of the directors’ shares and the potential timeframe the EOT would require to settle up. To keep the business as stable as it was prior to the transaction, the directors actually decided to take less than the market valuation.”

That answered JDDK’s hopes for how clients would perceive the practice going forward. “The biggest change is that our ownership and management are now separate,” Watson says. “But to anyone viewing us from the outside, we look exactly the same as we did before. That was important to us from a continuity perspective.”

ICAEW Director, Corporate Governance and Stewardship, Peter van Veen says: “EOTs can offer an elegant solution to the question of who will succeed the founders of a business, and a great means for protecting their legacy. But setting up an EOT correctly and managing the myriad stakeholder concerns and interests requires skill and diligence. Getting the right advisers involved is essential to making the transition a success.”