Employee ownership - the future?

When a business founder was looking to move on from their company, options would historically include trade sales and management buy-outs (MBO). Today a growing number are moving to employee ownership (EO).

EO is a unique form of industrial democracy pioneered in 1929 by John Spedan Lewis when he transferred ownership of his company, John Lewis, to its employees. Since then, well-known names  such as Lush Cosmetics and Richer Sounds have made the same transition to giving their staff a larger stake in the future of the company they have helped to build.

Last year, the sector grew by a record 28%, bringing the number of UK EO businesses to around 470, according to figures from the White Rose Employee Ownership Centre survey. In spite of the pandemic, the sector is on target to reach 500 by the end of the year.

There is a compelling business rationale for EO. The Employee Ownership Top 50, an analysis compiled by RM2 and published by the Employee Ownership Association (EOA), shows that EO businesses continued to outperform the rest of UK business with productivity rising by 6.9% compared to -1% in the UK as a whole and combined sales up 4.3% compared to 1.2% in the UK as a whole. The introduction of Employee Ownership Trusts (EOTs) six years ago, an indirect EO model with generous tax incentives, has encouraged more businesses to become employee-owned.

Financial business benefits aside, behind this growing trend is the recognition that EO creates a ‘power of ours’ culture (see box, opposite page) that builds trust, boosts engagement and performance, increases resilience and safeguards the long-term future of the business, as Deb Oxley, CEO of EOA, explains:

The EO sector is particularly important to the economic fortunes of the UK because it is in the SME/mid-market sector, which accounts for the vast majority of employment as well as business activity up and down the supply chains of many large companies – which is where EO is having its biggest impact.

“Initially, it was very small organisations that became EOTs in 2014,” says Oxley. “Now we have a solid group of companies in the 50-249 employee range, and some with more than 250 employees. EO is still a relatively immature market, but starting to become more mainstream as a model. If we had more businesses like this in the economy, we would be a more resilient nation in terms of jobs and dealing with crises.”

All sectors are represented within EO, but it has proved particularly attractive to people-intensive industries such as the services sector, and where there are high-value jobs, for example, in IT, architecture, engineering, design and marketing. Manufacturing, wholesale and retail are also embracing EO.

There are three main forms of employee ownership: direct, where shares are held by employees individually; indirect, where shares are held in a trust, and a hybrid of the two. EO businesses also have different management structures.

The 1:1 Diet by Cambridge Weight Plan became an employee-owned business in 2014 and employs more than 240 people and 7,000 independent consultants across the UK. The business was purchased via MBO from the original owners in 2005. In 2009, the three new owners, long-time directors of the company, wanted to retire from the day-to-day running of the business and chose EO as a way of preserving the company’s unique culture and identity. In 2009, they sold 49% to the EO Trust and the remaining 51% in 2014.

The leadership structure and process resemble that of most non-EO companies, directing and managing the business, without seeking approval from the employee owners for the commercial decisions that are made. Where it differs, however, is in the level of communications and engagement shared by everyone across the business.

The company pays an annual stakeholder dividend of 10% of its pre-tax profit split equally with each employee. An annual profit share is also paid, which last year was 20% of salary for each person.

The business is rebounding from a difficult April and May, however, McDermott insists that lockdown was the litmus test for its version of EO. “As a food manufacturing business, many of our employees had no option but to come to work to run our factory,” he says. “But they have been magnificent and are the major reason for recovering so well.”

However, EO isn’t suitable for every business, for example where there is an historic command and control style of leadership. “Some business owners have been successful with that and will be reluctant to change,” Oxley explains. “But for a business that already has a strong sense of ‘us’ and ‘we’, open communications and an open-door culture, it makes sense to consider EO. The process requires time and careful planning, and the most successful transitions are where the employees are fully involved, the management team are prepared and the owners are ready”.

Nevertheless, the pandemic has forced many businesses to rethink the way they operate. In an uncertain market, moving to an EO model offers business owners an opportunity to realise value through a sale of shares on their own terms – which can also benefit from a statutory capital gains tax exemption.

 Sara Cohen, Partner at law firm Lewis Silkin, says: “Successive governments have recognised the importance of employee share ownership and introduced tax breaks to encourage it.” These range from tax-advantaged option plans such as enterprise management incentives, company share option plans, save as you earn schemes and share incentive plans, under which employees can be given free shares and/or buy them from pre-tax salary. “There is also a plethora of other ‘unapproved arrangements’,” adds Cohen. “Such as the upfront acquisition of shares subject to forfeiture on certain events and a variety of long-term incentive plans. Many unlisted companies operate a share market via employee benefit trusts.”

The transition to EO can provide an exit for the business owner and, depending on the structure of the transaction, may involve an upfront payment and deferred consideration for their shares. This deferred consideration is effectively debt due by the business payable over a period of time to the previous owner.

This may present a cash flow challenge to the ongoing business as it will be required to service the debt,” says Rod Mathers, Partner, corporate finance at MHA Henderson Loggie. “However, the benefit of the EO structure is that it can be very flexible, and the sale agreement can incorporate provisions to either delay payment depending on the cash flow requirements of the business, or could allow for accelerated payments if the business performs well.”

In the current economic uncertainty, the options for a trade sale may become more restricted due to the lack of availability of investment funds and appetite for acquisitions from purchasers. The benefits of selling a majority of shares to an EOT are clearly appealing. And while tax should not be the main reason for transitioning to EO, it will help the owner achieve their financial objectives for retirement.

Mathers adds: “The recent changes to entrepreneur’s relief, now known as business asset disposal relief, has meant that the 10% rate for capital gains tax (CGT) will be limited to the first £1m, whereas before 11 March 2020 the lifetime limit was £10m. This clearly has an impact on gains in excess of £1m and makes EO an increasingly attractive option from a tax perspective where the CGT rate could be nil. There are rumours that further changes to CGT will be implemented in the autumn of this year by Chancellor Rishi Sunak, which may or may not enhance this benefit.”

Oxley is optimistic about the future of EO, which she believes has been enhanced by the COVID-19 crisis and its exposure of some of the most pressing economic issues; the current state of wealth inequality in society and a lack of business resilience.

She says: “Spreading the proceeds of success in a business more widely, through shares, dividends and bonuses associated with the input of work or company results, not only helps to reduce inequality, but through wealth sharing also increases the wealth in the local economies and communities where the employees live.”

Unlike other business models, where short-term profit motivation is aimed at maximising profit for a single owner or group of shareholders, EO companies are looking at long-term returns and creating long-term value for the many, not short-term financial rewards for the few. They also have deeper reserves. As far back as 2008, research into the resilience of EO businesses by City’s Business School, formerly Cass Business School, concluded that they were better equipped and able to survive and bounce back from a recession than non-EO businesses. 

In 2013, Paul and Isobel Schofield sold 90% of their business, Leeds-based high-speed door manufacturer Union Industries, to its employees via a deferred payment model on a long-term loan from the owners.

Managing Director Andrew Lane says: “They were hugely innovative and had created a business out of nothing. They also knew that with a trade sale a lifetime’s work would be discarded, but through EO we could build on their foundations for the long term, investing in R&D and employing people to come up with new ideas to keep us ahead of the competition.”

But the real value of employee ownership and the ‘power of us’ became crystal clear for when a fire devastated its factory in August 2019.

Last year’s fire claimed virtually all of the firm’s manufacturing capability. At six o’clock the next morning, the entire workforce turned up to salvage what they could from the building and continued to build that week’s products in the car park.

“They were desperate not to let our customers down,” says Lane. “Over the next year they had to beg, steal or borrow the parts they needed to get temporary capacity. But we didn’t miss a single order. The factory has been rebuilt, but for a year we’ve had people working out of garages and tiny spaces, and it’s been our best year ever for sales and profits.”

Lane is under no illusion that the ‘power of us’ culture drove everyone, from managers to machine operators, to roll up their sleeves to protect the business. “We truly were all in it together, which further strengthened the trust that had already been established,” he says.

Turnover has risen sharply, up from £5.1m in 2015, to £9m for year ending March 2020. In July, the company distributed £400,000 in dividends and tax-free bonuses among its 84 employee owners as a result.

To other business owners considering EO, Lane says: “By going down this route you can realise your value in the business – and reward those who helped you create it. You will have a sustainable business with a long-term future that supports the local community and the people who helped you to be successful.”

The government introduced the Employee Ownership Trust (EOT) in 2014 to encourage more businesses to become employee owned.

Paul Twist (pictured), associate director of BDO in the West Midlands, explains: “Owners who sell 51% or more of their shares to an EOT do not pay capital gains tax and the company can pay employees tax-free bonuses of up to £3,600 a year. However, they aren’t suited to every business and many will need to find a different way of sharing ownership with employees that works for them.

“Not all shareholders are required to sell their shares to the EOT and existing company directors can remain in place after the sale and continue to receive market-competitive remuneration packages. It allows employees to indirectly buy the company from its shareholders without them having to use their own funds, thereby creating an immediate purchaser and addressing succession issues.”

To carry out a qualifying sale to an EOT, there are five key conditions that must be met.

The company whose shares are sold to the employee trust must be a trading company or the principal company of a trading group.

The trust must be for the benefit of all eligible employees.

The trust must retain, on an ongoing basis, at least a 51% controlling interest in the company.

The number of continuing shareholders (and any other 5% participators) who are directors or employees (and any persons connected with such employees or directors) must not exceed 40% of the total number of employees of the company or group.

Trust property must generally be applied for the benefit of all eligible employees on the same terms, but the trustees may distinguish between employees on the basis of remuneration, length of service and hours worked.

The ICAEW Library & Information Service provides full text access to leading business, finance and management journals, as well as a selection of key business eBooks. Further reading on employee ownership is available through the resources below.