Forms of employee ownership
Employee ownership ('EO') is a successful business model as demonstrated by Arup, the John Lewis Partnership, Swan Morton, Wilkins & Sons (Tiptree Jams) and many other companies. Various articles in Company Secretary's Review have explained the benefits of EO and since 2012 tracked the regulatory and non-regulatory changes made as a result of the Nuttall Review of Employee Ownership (BIS, 2012) (the 'Nuttall Review'). These changes have helped raise awareness of EO in the UK and include new tax exemptions when a company is or becomes controlled by an employee-ownership trust ('EOT') (37 CSR 10, 73) and changes in company law (38 CSR 23, 184). It is timely to look again at the wide choice of EO forms that now exist for private companies.
What is EO?
The Nuttall Review definition is:
'a significant and meaningful stake in a business for all its employees... What is "meaningful" goes beyond financial participation. The employees' stake must underpin organisational structures that promote employee engagement in the company.'
Employee-owned companies usually have a board of directors that is chosen in the usual way for their skills and experience. This article considers the different ways the employees' stake may be owned.
What forms may EO take?
Broadly speaking, there are three forms:
1. Direct - where employees become individual owners of shares through one or more tax-advantaged or other share plans;
2. Indirect - where shares in a company are held collectively on behalf of employees, in-variably, in an employee trust; and
3. Hybrid - where there is a combination of direct and indirect EO.
Successive Governments have encouraged the direct ownership of shares by employees through various tax-advantaged share and share option plans (see the choice here). Individual ownership of ordinary shares can provide each employee with:
(a) scope for financial participation in the form of either or both:
(i) a capital gain (when shares are sold); and
(ii) dividends; and
(b) influence, through voting rights.
There is flexibility to have, say, one plan aimed at incentivising selected key employees and another in which all employees are participants. If the aim is to support EO, rather than just employee financial participation, then all the elements in the definition of EO must exist eg the total shareholding held by all employees should represent a significant stake in the company and be used to underpin employee engagement.
There are issues to take into account when deciding on direct EO:
- some companies may reject direct EO because of the challenges of financing it. They do not want individual employees to make a personal financial investment or place additional costs on the company. Any company using the direct EO model must, in particular, be aware that the company is likely to need to finance an internal share market. The company may, at some stage, need to provide the funds to ensure a leaver's shares are bought back;
- there may be a concern that individual ownership makes it more likely the company's independence will be put at risk and that a sale to a third party becomes more likely, when this is not part of the strategy for the company;
- arrangements to introduce direct or indirect EO may be similar in complexity. But, in comparison to indirect EO there will be more administration on an ongoing basis. Each award of shares typically requires a share valuation, award allocation decisions and a check on the tax and accounting consequences prior to rolling out the required communications and implementation programme. Each subsequent disposal of shares by a participant will involve its own administration. An annual return or returns will need sending to HM Revenue & Customs; and
- there is research to suggest that some form of 'collective' employee voice, in addition to individual employee influence helps achieve the best EO outcomes.
Notwithstanding these issues, many companies believe firmly that direct EO is the best form for their business. In these companies the belief is, usually, that when each employee has shares registered in their name, especially if they have bought the shares using their own money, then the benefits of EO are more likely to be achieved.
The Nuttall Review has helped achieve greater prominence for the indirect (or trust) model of EO. The new capital gains tax exemption, on qualifying disposals of a controlling interest to an EOT, together with the income tax exemption for bonuses paid by EOT controlled companies have especially attracted attention to this form of EO.
The benefits of trust ownership are that employees of the relevant company (or group):
(a) know that the shares in the trust are held on a permanent basis on their behalf; and
(b) have a collective voice, through the trustee of that trust, in how the company is owned and governed.
Provided the trust has a significant shareholding, one that underpins good employee engagement, then this will meet the definition of EO.
In contrast to direct EO, when a shareholding is held in an employee trust:
- once the original share acquisition by the trust has been financed there is no further need for finance. Trust ownership therefore avoids the challenges of financing EO on an ongoing basis;
- this helps maintain the independence of the company. Instead of a decision to sell shares being made by individuals (acting according to their own wishes) it is made by a trustee, in accordance with the terms of the trust;
- the complexities of operating direct EO are avoided; and
- there is clearly a collective voice on the part of employees, through the trustee of the trust.
Many companies believe the trust form of EO is the best form, for the above reasons.
There are issues to take into account when deciding on indirect EO, such as:
- the scope for financial participation by employees is much more limited. Employees will not realise any capital gains, although the new income tax exemption for certain cash bonuses paid to all employees of an EOT controlled company (or group) provides a simpler and tax-effective way for employees to receive a reward from an employee-owned company, than acquiring shares in order to receive a dividend; and
- because employees do not have direct shareholdings, it may be more difficult to demon-strate 'ownership' to those individuals and achieve the full benefits of EO.
Some companies adopt a hybrid form of EO, in which some shares are held directly by employees and others are held indirectly by an employee trust. This is to achieve the benefits of both forms of EO. There is more flexibility with the hybrid form to design a plan that meets the particular requirements of a company (or group). It is possible, for example, to provide some of the above direct EO benefits by using a class of share that only provides those required benefits, although this may mean that a tax-advantaged share plan cannot be used. A company might wish employees to hold only voting rights directly with an em-ployee trust holding shares carrying all the economic rights (or vice versa). Although, if an EOT is used, then it must hold a controlling interest (as defined) in order to obtain the tax exemptions.
Every company should consider carefully which from of EO is right for its business and its employees. There are many employee-owned companies willing to share their experiences to help the decision-making process. In the authors' experience, companies know instinctively which form of EO is right for them. Nevertheless it is vital to seek specialist advice before confirming which form to adopt. Existing employee-owned companies should keep their ownership and governance structures under review. As a company develops it may find the best form of EO changes. Companies with direct or hybrid EO may move to indirect EO, or trust-owned companies may introduce an element of direct EO. If employee ownership is of interest to you and you would like further information, please contact Graeme Nuttall OBE, Partner, Fieldfisher or Jennifer Martin, Senior Associate, Fieldfisher.
For further information on the Nuttall Review of Employee Ownership click here.
This article was first published in Company Secretary's Review Tolley's Practical Business Fortnightly For Companies 39 CSR 21, 162 on 1 February 2016 © Reed Elsevier (UK) Ltd 2016
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