Employee ownership trusts (EOTs) were created in 2014 and allow business owners to pass majority control of their business to a trust without incurring capital gains tax. Despite this financial incentive for owners to sell a controlling stake of their business, EOTs didn’t take off as a popular exit strategy straight away. However, in recent years their popularity has increased significantly. In fact, the UK’s employee ownership sector has more than doubled in size since 2020 and this growth shows no sign of slowing down.
Employee ownership trusts don’t just have financial benefits for selling shareholders but can also improve overall employee engagement which in turn can lead to improved staff retention and increased productivity levels, due to employees feeling more involved and valued. The Employee Ownership Association found that increases in wages in the top 50 employee owned companies saw a 5.2% increase in productivity (double the UK average). This shows the effect that the introduction of an EOT can have in helping boost employee engagement and performance.
Types of employee ownership
There are three types of employee ownership, direct share ownership, indirect share ownership, and hybrid share ownership.
Direct share ownership
This is where employees own shares directly in the company in their own name. It is possible to create a new class of shares with different rights to those of the existing shareholders e.g. shares with no voting rights, or with limited rights to share in the proceeds if the company is sold. The legislation also allows for various ways in which employees can obtain shares in a way that benefits from favourable tax treatment such as via a Share Incentive Plan (SIP), a Save As You Earn (SAYE) share option scheme or Enterprise Management Incentive (EMI) share option scheme.
How does direct share ownership work
Shares can be offered to employees in one of three ways:
- Direct purchase - Employees buy shares in the company they work for. This gives them immediate ownership of shares in the business.
- Gift - This is where shares are given to employees for free (though unless this is via a SIP the employee will probably have to pay tax on the gift) and can be a part of a bonus or attached to hitting a performance milestone.
- Share options - This is where employees are given the opportunity to buy shares in the future at a price fixed today, such as under an SAYE scheme or EMI scheme.
Important things to consider
When thinking about direct share ownership there are a few things you need to consider, such as:
Buying back shares when employees leave
Most companies will want anyone that leaves to sell their shares back to the company or another shareholder. Generally speaking, it is best if the shares are not sold to an EOT, as there are strict rules on what the trustees of an EOT can do with such shares. However, there are other types of employee trust which can be created. The most common of these is an employee benefit trust ('EBT') also known as an employees' share trust ('ESOT'). This can either just act as a ‘warehouse' buying and storing shares sold by leavers until they can be bought by a new employee, or it can be used in conjunction with other share option or incentive schemes.
You’ll also need to decide the value or price paid to a leaver for their shares. This can be skewed to be more favourable for those that are considered good leavers, such as those who leave due to death or incapacity and less favourable for those considered as bad leavers such as those that commit misconduct or join a competitor. Rules on leavers will normally be set out in the company’s articles of association and may be different for holders of different classes of share.
Valuing shares for purchase by employees
If an employee receives shares there may be tax to pay unless the employee has paid the full market value of those shares or acquired them under a tax advantaged share scheme. HM Revenue & Customs (HMRC) will agree a share price where options are granted under a Company Share Option Plan (CSOP), SAYE scheme or EMI scheme. In other cases, the directors of the company will need to determine the market value themselves. This may be done by instructing a firm of valuers to undertaking a valuation exercise whenever necessary or the company may agree on a valuation formula, such as taking a multiple of the company’s earnings, or calculating its net assets. It is important to have a consistent approach to valuation and to keep good records as to how each value is determined.
Rules around the disposal of shares
Encouraging longer term ownership is important for a variety of reasons. At Legal Clarity, we advise that you add provisions that guard against an over-active internal market to help you control and ideally minimise the cost of ad hoc share trading. This essentially means that you’ll need to agree when employee shares can be bought and sold and by whom. You could do this by scheduling periodic ‘trading days’ for when staff can buy or sell.
You’ll also need to outline how staff can sell shares and at what value, during circumstances where they can exit outside of permitted windows.
Corporate governance
When inviting more shareholders into your business you need to be completely clear about how your business is governed. This should be included in a shareholder's agreement or the company's articles of association. This can incorporate things like how shares can be transferred, the respective powers of the trading board and shareholders, the ability to ‘drag’ or force a sale by other shareholders and more. If you need further help with this, our team at Legal Clarity are happy to help!
The ongoing costs of direct ownership
Direct employee ownership can be costly to adopt and run, partly as a result of the business needing to deal with share transfers or issues for joiners and leavers on an ongoing basis. These cost implications can also be dependent on the flexibility you adopt, whether all shareholders have voting rights and so need to be kept informed and involved in shareholder decisions, and the volume and frequency of your share dealings.
Key takeaways
- Shares are registered in each employee's name.
- Employees can buy shares, be offered share options and be gifted shares as a part of a rewards scheme.
- Organising share purchases through arrangements such as SIPs or EMI schemes can have tax advantages.
Indirect ownership
Indirect ownership involves employee shares being held collectively in an employee trust (normally either an EOT or an EBT). This gives employees an indirect stake in the company, as they are not on the register of shareholders and have no rights to vote, receive dividends or buy and sell shares, but the trustees own the shares on the employees’ behalf. This also avoids some of the downsides of direct share ownership, such as the need to buy back shares when staff leave.
How does indirect ownership work?
Important things to consider
Tax efficient trusts
Theoretically, you can use any type of trust to facilitate indirect employee ownership. However, if you create an EOT you can qualify for two government backed tax breaks:
- When a majority of a company’s shares are sold to an EOT there is no capital gains or inheritance tax to pay.
- When a company is owned by an EOT, it can pay annual bonuses of up to £3,600 to each employee free of income tax.
Appointing Trustees
All trusts must have trustees. Trustees can be individuals, but it’s more common to use a company as it provides better legal protection and avoids the problems that can arise if an individual trustee dies or becomes unable or unwilling to act. The role of a trustee is to hold and manage shares and other assets held within the trust on behalf of the beneficiaries – the people for whom the trust has been set up. For an employee trust, the beneficiaries will be the employees of the company and possibly also their dependents. When making decisions the trustees must always be aware of the interests and needs of the beneficiaries. Most of the time it will be clear that certain actions are in the best long term interests of the business and employees collectively, but if there is a conflict the trustees must act to safeguard the employees.
Picking a trustee director
Deciding who should be your trustee directors is important and you can choose from founders or selling shareholders, directors from the trading company or group, independent trustee directors and employee trustee directors. How appointments are to be made will be set out in the company’s articles of association. There are no legal requirements as to who the trustee directors should be, at least not at the moment, but there are some guiding principles in terms of good governance that you should keep in mind. We can support you with this.
Creating boundaries to avoid conflicts
The trust company and trustee directors won’t run the business, that’s up to the directors of the trading group or company. The role of a trustee director needs to be clearly defined so that the boundaries of power and responsibilities between the trading company and trustee directors are clear. This may be set out in the articles of association of the company and the trust company, in a shareholders’ agreement, or in less formal policies and procedures. Being clear at the outset will help to avoid any potential future confusion or conflict.
Changes in accountability
There’s often a misconception that an EOT should act as a cooperative and get votes from employees to confirm decisions. This isn’t the case and while sale documentation should include protections for the selling shareholders, and there may an employees’ council or employee representatives that can bring employee concerns to the trading company board, it’s essential that directors can make day-to-day decisions that effectively run the business.
One change is that once a business is owned by an EOT the trading company directors are accountable to the trustee of the EOT as the majority shareholder. Furthermore, the articles of association or any shareholders agreement may spell out any special protections required by the EOT, including certain matters on which the trading company board may need consent from the trustee.
The employee council and employee representatives.
In some cases an employee council is set up to represent employees and act as a two-way channel of communication between staff and leadership. Such a structure can be very helpful, particularly in larger organisations where employees may be based in different geographic locations.
The exact remit, responsibilities and powers of the employee council will need to be decided by the business. How members are elected, terms of service and other governance issues will also need to be clearly agreed upon.
There is no legislative requirement to have an employee council, and most smaller EOT-owned companies do not do so. However, they often either have employees appointed as directors of the trading company or trustee directors, or else have employee representatives whose role is to act as a sounding board and way for ideas to be shared between employees and the directors.
Key takeaways
- Shares are collectively held in a trust set up for the employees. The trustee(s) - typically a trust company – are the registered shareholders but have to make decisions for the benefit of the employees.
- Selling a controlling interest in shares to an EOT unlocks tax breaks.
- An owner who sells to an EOT need not stand down and may choose to become a trustee director or remain on the board of the trading company.
- The directors of the trading company remain responsible for day-to-day decision making.
Hybrid Ownership
This is an increasingly popular model that offers tax benefits and allows employees the option to purchase shares directly.
How does it work?
Important things to consider
The company doesn’t have to be completely employee owned
A hybrid structure means a trust (normally an EOT) acquires and holds a majority stake on behalf of employees. This therefore leaves a minority shareholding that can be retained or acquired by individual shareholders directly. These shareholders can include the original selling shareholders or new shareholders from the management team or wider employee group.
It can be challenging finding the right balance and making sure governance is clear and watertight. Legal Clarity can help with this.
Finding the right balance
While indirect and direct share models are more straightforward it doesn’t necessarily mean it’s the right choice for your business. When you navigate the complexities of a hybrid share model you can achieve long-term value for founders, unlock EOT tax benefits and introduce employee incentive programmes. Equally, the needs of the business may change over time. Just because an EOT owns 100% of the Company it does not prevent the directors and trustee directors working together to put new employee share incentives in place.
To access the tax benefits of the EOT model you’ll need to make sure you meet HMRCs criteria, particularly around ensuring that the EOT trustee keeps control of the company and that the assets in the EOT are used to benefit employees on a similar terms basis. Any direct purchase elements will therefore need to be structured using new issue shares, or shares held outside the EOT either by minority shareholders or by another trust such as an EBT.
Making a sale without an immediate exit
Hybrid models are a great option for owners who are not looking to exit a company completely but wish to realise a portion of their investment now. Opting for a hybrid model means the founders or selling shareholders can retain an equity stake and maintain some involvement in the future prosperity of the company. This is great in situations where their ongoing involvement and influence is integral for driving the business forward and achieving its full growth potential.
Offering shares as an incentive
Providing share rewards is an attractive incentive for a business's senior management team. But you will need to think about how you structure this. For example, you could offer tax-advantaged Enterprise Management Incentive (EMI) options and growth shares that offer equity value above the current market value only or a scheme where the value is linked in some way to the outstanding debt due to selling shareholders.
Key takeaways
- An EOT acquires a majority stake in the Company to unlock tax breaks but the owners may choose to retain some shares.
- Owners and employees also have the option to acquire additional shares individually, possibly through EMI options or a growth share scheme.
- A hybrid model provides flexibility to help create a bespoke structure that meets the aims of the business and selling shareholders as well as incentivising the workforce going forward.
Questions to ask before selling the company to an EOT
Like any major business decision, there are some questions you should ask when you’re considering selling a controlling stake to an EOT, such as:
- What is the long-term strategy for the company?
- The legislation is intended to encourage sales to EOTs for the longer term.
- Is the company likely to require significant investment from venture capital or other investors in the medium term? If so, sale to an EOT may not be the best route.
- Is there a suitable management team in place to take the business into the future once the owners cease involvement? If not, perhaps more time is required to build up a suitable team before moving on to a sale.
- What percentage of the company’s shares will be sold?
- Do all the current shareholders want to leave the business? If they are remaining involved, do they want to retain a small shareholding?
- How will the shares be paid for?
- How long will it take if the company is to fund the trust to buy shares?
- Are the current shareholders willing to wait for their shares to be paid?
- If they’re not willing to wait, is it possible for the trust to borrow the purchase price from a bank or other lender and repay the loan from future contributions by the company?
The dos and don’ts of employee ownership trusts
When you’re implementing an EOT there are a few do’s and don’ts you need to consider:
Do
Look at other companies that have introduced an EOT
Looking at other companies that have introduced an EOT and how they did it can help businesses identify a path where an employee ownership trust boosts business growth and success. For example, you can look at companies like John Lewis and ARUP group limited, both of which are in the top 50 employee owned companies in the UK for 2023, during your research.
When conducting your research, you should also consider some of the challenges they may have faced and the lessons they learnt along the way to help you understand whether an EOT is the right option for you and how you can implement it if it is.
Review which type of employee ownership model will truly work for your company
It’s important to think about which type of employee ownership model (direct, indirect or hybrid) is best for your business. Legal Clarity can help you with this decision. If you find that this may not be the best option for you, we can also work with you to find the right alternative for your company.
Don’t
Appoint trustee directors exclusively from the trading company board
Appointing trustee directors exclusively from the board of directors is likely to create conflicts of interest that could result in tensions in the decision-making process as well as making it harder for employees to believe that the ownership of the business has undergone a fundamental change. Instead, you should think about appointing employees, perhaps through an employee election, as well as an independent person. If the only suitable candidates for trustee directors are the directors of the trading company, consider having some of those directors step down from the trading company board so that the personnel of the two boards differ.
Try to hide bad news
Staff in an employee-owned company should be treated in the same way as any other shareholder. An example of this is that employees should be informed of bad performance promptly and be informed of the steps being taken to tackle the problem.
Let tax benefits dictate the structure of your scheme
While we understand that for many businesses the tax benefits of an EOT are highly attractive, this shouldn’t be your primary reason for introducing one. While tax benefits are useful, if an EOT doesn’t truly benefit your business growth and success, this shouldn’t be a route you go down.
Tax advantaged share schemes
The table below explores a variety of tax advantaged schemes which a business can choose to implement in order to provide their employees with a route to direct share ownership.
|
Income tax and National Insurance treatment |
Capital Gains Tax (CGT) |
Who can benefit? |
Further notes |
|
|
Share Incentive plan (SIP) |
Shares held within a SIP trust can be gifted to employees with no income tax or National Insurance. Employees can also give the trustees money to buy shares by deductions from their gross salary. |
There is no CGT applied on growth in value of the shares for so long as they remain within the SIP trust. |
Shares offered under a SIP must be offered to all employees or everyone that has completed a minimum period of employment on a similar terms basis. |
Shares are typically required to be retained for 5 years or income tax and National Insurance contributions can arise when the shares leave the SIP trust. |
|
Save As You Earn (SAYE) |
Employees can choose to enter into a 3 year or 5 year savings contract and are given an option to acquire shares using the funds from that saving contract at a price fixed at the outset. The savings are deducted from net salary each month. At the end of the saving period employees can choose either to use the money to buy shares without triggering any liability to income tax or National Insurance or take the cash and allow the option to lapse. |
When shares are eventually sold, CGT is due on growth in value. Depending on whether the employee is a basic rate or higher rate taxpayer 18% or 28% is the normal rate, subject to the annual exemption. |
Each time a new savings period begins all employees or those that have completed a minimum employment period must be given the ability to enter into a savings contract and receive an SAYE option. |
When a savings contract matures (after either three or five years) the employee has six months in which to decide whether to use the savings to exercise the option or take the cash and allow the option to lapse. Therefore where a business is cyclical, or the rate of growth is uneven, having such a small window in which to exercise an option may mean that an SAYE scheme is not the best choice. |
|
Enterprise Management Incentive (EMI) options |
Selected employees are given the option to acquire shares at a future date. If the option exercise price is at least equal to the market value of the shares on the date the option is granted, no charge to income tax and National Insurance will arise when the option is exercised. If the exercise price was less than the market value at grant, a charge to income and National Insurance will arise when the option is exercised, but only on that initial discount. |
CGT will be payable when the shares are sold on the difference between the market value of the shares when the option was granted and the value on sale. Under current rules if there is at least two years between the date of grant of the option and the sale of the shares the CGT rate may be reduced to just 10%. |
Any employee who works for at least 25 hours per week, or if less, who spends at least 75% of their working time working for the company may receive an EMI option, but the company can choose which employees options are granted to. |
This isn’t available for companies with more than 250 full time equivalent employees or those with gross assets of more than £30 million. It is only available for trading companies (though some trades are not permitted). |
|
Company Share Option Plan (CSOP) |
This allows a company to grant options with an exercise price set at the market value on grant to employees up to £60,000 per employee. Provided the option is exercised within 3 to 10 years after the option is granted no charge to income tax or National Insurance will arise on exercise. |
When shares are eventually sold CGT is due on the growth in value since the grant date. Depending on whether the employee is a basic rate or higher rate taxpayer 18% or 28% is the normal rate, subject to annual exemption. |
This doesn’t need to be offered to all employees and can be targeted at specific staff members. This works for companies that want to create greater levels of share ownership for employees where EMI isn’t available. |
The shares must be in an independent company, the holding company of a trading group, or a company controlled by an EOT. |
How can employee ownership trusts boost business growth?
Employee ownership trusts can help boost business growth in various ways such as:
Tax benefits
One of the most attractive things about EOTs is the favourable tax regime that they enjoy, both enabling existing owners to pass the majority control of a business to a trust without CGT and enabling the trading company to pay bonuses to staff free of income tax. This is highly attractive to many businesses and has played a part in the popularity of Employee Ownership Trusts over recent years.
Enhanced business performance
Many businesses have found that being an employee owned business has made them and their staff more resilient, profitable and sustainable. Furthermore, incentives offered to employees heightened motivation and improved performance on top of boosting employment standards. This highlights that EOTs don’t just provide tax benefits but also help your business and staff develop and grow.
It can help you attract and retain employees
Employee ownership, with its emphasis on putting employees at the heart of the business and seeking to increase staff engagement. can attract and retain employees looking for a work environment in which they will feel valued. The likeness of better career progression and incentives, as well as the stability that comes from working for a company which is unlikely to become the target of an unwelcome takeover can all aid recruitment and retention.
How Can Legal Clarity Help with employee ownership trusts?
At Legal Clarity we have a wealth of expertise and experience that can help you navigate becoming an employee owned business. While working with you we will:
- Evaluate your exit plan - We’ll explore all disposal options to ensure whether an EOT meets your goals and expectations, and if so, how that can best be structured.
- Explore EOT design and formation - We’ll work with you and your other professional advisers to ensure that the EOT and its surrounding legal framework doesn’t just meet the EOT qualifying conditions for favourable tax treatment, but also provides your business with a stable governance structure.
- Support the sale process - We’ll prepare all of the legal documentation as well as project-managing the sales process to make the EOT transition as easy for you as possible.
What if an EOT is not the right route for my business?
We at Legal Clarity are aware that there is no “one size fits all” and that whilst an EOT is a good choice for many businesses, it is not always the best route, even where a company is keen to increase employee engagement and to use shares in the company as part of that process. We will discuss other solutions with you, and are equally at home advising on more conventional management buyouts and third party sales, as well as the implementation of both the share incentives discussed in this article and other types of arrangement which cannot be combined with an EOT .
In short, if you are looking to exit from a company or secure an orderly succession, speak to us to see how we can assist.
So if you’re looking for support with an employee ownership trust, get in touch with us today to see how we can help.
