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Sharing Success - Employee owned structures

28/02/2020

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United Kingdom

Graeme Nuttall contributes to CISI The Review magazine article on employee owned structures.

With 40% of UK financial advisors expected to retire in the next four to ten years, according to libertatem's Heath Report Three, should advisory firms adopt an employee-owned structure to aid staff retention and succession planning? Gill Wadsworth Reports.

Ever since the UK government deregulated financial markets in October 1986 – known as Big Bang – private share ownership has been commonplace among UK businesses. However, the legislation of the time encouraged mass share ownership – typically by institutions on behalf of investors – rather than by individuals in the companies for which they worked.

As a result, according to the Employee Ownership Association (EOA), there are just 370 employee-owned firms out of the more than 4.2 million registered businesses in the UK. But this number could be set to grow in response to predictions of a “huge drop” in access to advice in the coming years, according to the Heath Report Three, published in January 2019. It examines the availability and future of professional financial advice in the UK, covering 249 adviser firms representing 865 advisers. It says that unless advisers are replaced, the number of consumers accessing advice could be under one million within a decade, and it outlines key actions to take including training and retaining advisers.

The EOA defines employer ownership as relating to British firms where “25% or more of the ownership of the company is broadly held by all or most employees (or on their behalf by a trust)”. Under direct employee ownership – or substantial share ownership – employees become registered individual shareholders of a majority of the shares in their company using one or more tax-advantaged share plans. Reasons to consider a direct ownership arrangement include a need by the retiring owners to retain some shares because the employees cannot afford to purchase their whole shareholding in one go, or capital may be needed to bridge a purchase price gap. In such cases, employees are invited to buy shares through a tax-efficient employee share incentive plan to make up the difference.

Under an indirect employee ownership model, shares are held collectively on behalf of employees, normally through an employee trust. Combined direct and indirect ownership means a combination of both. Of those 370 firms that the EOA identifies 60% converted from private to employee ownership following the 2014 Finance Act, which introduced a complete exemption from capital gains tax on the sale of shares to an employee ownership trust (EOT) – see box below for definition.

The 2012 government-commissioned Nuttall review of eployee ownership also had an influence Among the 28 recommendations, the review advises that government should encourage take up of EOTs and raise awareness of the benefits reduce the complexity of the structure, and avoid regulatory burdens. Its author, Graeme Nuttall OBE, a partner in Fieldfisher’s Employee and Mutual Ownership Team, says the number of EOT businesses can only increase and believes financial planners are well suited to the model.

Since the [2012] review, there are hundreds more employee-owned companies. Many architects adopted the employee-owned model, and now there is real momentum. I foresee something similar within the world of financial planners,” Graeme says. He explains that architect practices follow similar structures to financial planning firms therefore he believes the model will work well for this sector, too.

Moving to an employee ownership structure is not just about benefits for the companies and owners. Employees also stand to gain substantially from taking a share in the business. First, there is the opportunity to benefit financially Profits made will be returned to employees, and there is also the opportunity to gain tax breaks on bonuses and make contributions to retirement savings at no extra cost to the employee (see table below). Employees are also more directly involved in the company’s objectives, since shareholders naturally have more of a say in how the business is run.

Whether the existing structure of a financial planning or advisory firm is a limited liability partnership (LLP) or a limited liability company, it is possible to convert to an employee-owned arrangement. There is no size limitation. For example, consulting firm BDO says it worked with numerous companies from all sectors in 2019, including LLPs and groups, to establish EOTs. They have ranged from companies with just 20 employees to over 1,800, with values from £1m to over £80m.

Options to exit

Financial planners wishing to exit the business can enter a trade sale, a management buyout (MBO) or sell shares to employees directly or indirectly.

Chris Budd, who moved his own financial planning firm Ovation Finance, to an indirect EOT structure in 2018, says the reasons for moving to an employee-owned arrangement are twofold: money and legacy. “I wanted my business to continue after I had left, and I wanted to receive a fair value. An EOT offers both those things,” he says. "Neither a trade sale nor an MBO appealed to him, because with the former there was a danger that the “business could disappear along with your employees and clients”, and the latter because “it needs requisitely skilled employees with money”.

Getting buy in

Moving to a direct or indirect employee-owned arrangement is a relatively simple process, but it cannot be rushed. “It is easy to set up and it is an approved HMRC model, so it should be straightforward, but success depends on employee engagement,” says Chris, adding that it is a cultural shift and future profitability depends on employees buying into the new conventions. “You get paid from the future profit of the business, so you need to take time to prepare the business and the employees so that it will continue without you and therefore pay you.”

This success also depends on securing client support; they must be reassured that their service levels and access to expertise will not be jeopardised by the new structure. “The owner needs to make themselves the least important person in the business so that they can leave but the clients will stay,” Chris explains. “This is key to the process and may take a few years.”

Retention tool

If firms scan achieve it, however, moving to either a direct or indirect EOT model is very powerful as an employee incentive, since their own motivations are aligned with those of the business. Critically, it is not just the typical fee-earning employees that are rewarded, which is a key difference from traditional performance-related bonus structures. Chris says all employees have a voice in an employee-owned business, with those who cannot earn fees still receiving a bonus, which helps them to stay motivated, remain with the firm and ensure its success.

And unlike share incentive plans, which often require employees to sacrifice salary to own the shares, employees do not have to come up with money to receive profit from the EOT. Selling shares to just those employees who can afford it can be divisive, whereas employee ownership arrangements are designed to motivate everyone equitably.

Not for everyone

Moving to an employee-owned arrangement will not be suited to every business. Barry Horner CFP™ Chartered MCSI, founder and CEO of financial planning firm Paradigm Norton, which moved to an EOT structure in 2019, says, “We have a collegiate style of operating, so the EOT works well, but if you have a dictatorial management style, moving to an employee-owned model would be challenging.”

Graeme Nuttall agrees that employee ownership is not suitable for every business and highlights several other challenges with the model. “Once the majority of the shares are locked up indefinitely it makes it less attractive to sell the company to a trade buyer and makes it harder to attract private equity investment, as there is no exit for the company.

He adds: “Owners must be willing to share their profits with the many rather than the few, and they will mostly need to rely on loan finance because they won’t want to issue shares to third parties.” Ultimately, there is no hard and fast rule as to which companies are more suited to employee ownership, but companies need to have strong management teams delivering robust financial results to stand a chance of success.

Despite Chris’s view that employee-ownership structures are straightforward to set up, there can be challenges in finding legal support with the requisite skills, which may deter businesses from continuing. The Employee Ownership Association’s Employee ownership impact report says that “most professional advisers, drawn from legal, tax and accounting professions … lack a developed understanding of employee ownership” and because of this, “they often perceive that the legal complexities and financial barriers outweigh the benefits and advise clients accordingly”.

Employee ownership has received a boost since 2014 and offers another option for financial planners wishing to exit the sector. But there is more to the EOT model than that; companies with an eye on securing the long term for themselves, their clients and their employees could do worse than give the workforce a true slice of the success.
 
Table 1: Defining the business model 
Model  How it works Pros Cons
Direct employee ownership Staff become shareholders, each holding a set number of shares and using one or more tax-advantaged share plans.
 
Shares cannot be sold for more than the 
valuation, but can be sold for less.

Owners do not need to sell the entire 
company, but more than 50% must be 
employee-owned.
Employee motivation through engagement 
and cash bonuses.
Can reinvest profits sin the business.

Buying shares in the business directly is motivating for employees when the business goes well.
A direct share ownership policy can burden the owners with the obligation to use reserves to buy shares from departing employees.
 
There are costs associated with the 
establishment and administration of an 
employee ownership share plan.

Share ownership, specifically yoption 
plans, can be dilutive, as with each share 
issued, individuals gradually own a smaller percentage of the company.

A minority shareholding is more difficult to sell and less attractive to potential buyers than a majority holding.
Indirect ownership via an employee-owned trust The trust manages shares on behalf of 
the employees. Shares cannot be sold 
for more than the valuation, but can be 
sold for less. The trust must have control 
of a minimum of 51%. Employees can 
indirectly buy the company from its 
shareholders without them having to 
use their own funds, thereby creating 
an immediate purchaser and addressing succession issues.
There may be tax incentives for a seller of 
the business to an employeeownership trust (EOT). If a business is 51% owned by an EOT, it can pay certain bonuses free of income tax.  
Demotivating when the business is doing badly, causing shares to decline in value. The business pays no dividends and there is no market for theshares.

Problems can arise from employees seeking to sell shares and finding gno buyers among employees, the company or the EOT.
Hybrid A combination of direct and indirect 
share ownership.
Trust ownership is structured, while also 
offering individual share ownership.

Provides a modest amount of capital 
growth and a direct feeling of ownership.

In limited companies, financial lliabilities fall on the company, rather than on the person(s) running the company. 
As above. 
Limited companies A company comprising one or more people. One person can be both the sole shareholder and director. Companies are registered at Companies House and must meet filing gand reporting requirements for security by the public. The liability of members of a company is limited to the nominal value of their shares. Other advantages include increased 
credibility and trust, financial lprotection, 
and potential for savings and professional 
improvement.
Minor disadvantages include a need to pay registration fees to Companies House, while personal and corporate information must also be disclosed. 

Accounting requirements may be more complex, and accountants may need to be hired as a result.
Limited liability partnerships  Must have two members at all times. Members’ liability is determined between them in the partnership agreement. Limited liability protects the member’s personal assets from the liabilities of the business.

You can have an unlimited number of members.
You cannot pay yourself wages.

It could be hard to raise financial capital, as investors may favour corporations.

Renewal fees or publication requirements can 
be expensive.

Case Study: Paradigm Norton

Paradigm Norton’s move to an employee ownership trust (EOT) was five years in the making and finally came to fruition in 2019. Barry Horner CFP™ Chartered MCSI, Paradigm’s founder and CEO, says it was critical to the management team that if anyone left, their legacy would be intact and that employees could shapetheir own future and that of the business for themselves. At the same time, clients had to receive equivalent service and support. Fortunately, the 2014 Finance Act had given new legitimacy to an age-old solution – the EOT – which was, Barry says, perfect for Paradigm.“Employees could direct the future of the business, but the clients would not notice any difference,” he explains. Employees have already received their first bonus and the EOT is working well. “The team doesn’t need to think about what is around the corner, they can invest for the future and see they have a career here until they retire,” says Barry. It is also reassuring for clients. 

We have created a structure to allow team members to just continue with clients, and there is no fear that 
we will be taken over in the future.”Barry says setting up the EOT was straightforward, but concedes that the firm benefited from having its own in-house tax and accounting specialists. However, Paradigm hired  an external lawyer to ensure all the contracts were in place.“The EOT won’t be for everyone,” Barry admits, “but it has ticked all our boxes
.”
 

This article was originally published in the CISI members' magazine, The Review. Republished with permission.

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