Record-breaking profits. Heightened employee engagement. A clear path to the future. Those are the kinds of benefits reported by some companies that offer their workers a greater stake in the business. And when a shift to greater employee ownership occurs, the finance team has a critical role in the process.
Businesses have long offered their people the chance to get involved in company ownership through employee stock ownership plans. However, a growing number of generally smaller to medium-size private companies are choosing employee ownership trusts (EOTs) to give workers a meaningful stake in the organisation. In the UK, the professional services sector has been a leader in this movement, accounting for one-third of conversions since 2020. Recent conversions to EOTs have also included businesses involved in construction (18%), retail and wholesale (12%), manufacturing (10%), and information and communication (9%), according to the UK-based White Rose Centre for Employee Ownership. While this option is popular among SMEs, UK retailing giant the John Lewis Partnership PLC demonstrates that it can be feasible in a large business.
Rising employee ownership
In the UK numbers of EOTs have grown significantly since 2014, when the UK government introduced legislation to promote them. The existing owners in these transactions typically prefer to sell to preserve the business they have built, rather than, for example, sell to a lifelong competitor, according to Graeme Nuttall, partner of the law firm Fieldfisher in London and founder of its employee ownership solutions practice. Nuttall’s report for the UK government, Sharing Success: The Nuttall Review of Employee Ownership, was influential in policymaking in this area, and he consults on EOTs with companies in the UK, Australia, and Canada. Elsewhere, the Southern Africa Employee Ownership Association and the National Center for Employee Ownership in the US are promoting this model.
How an EOT works
In a typical EOT, the founders sell their company shares to a trust that holds them on behalf of all the employees. Employees don’t purchase any shares and don’t own any directly, so there is no need to buy or sell shares when someone joins. Among other benefits, the lack of these capital transactions is one key advantage over other employee ownership options, such as employee stock ownership plans. Workers become beneficiaries of the EOT when they join (sometimes after an initial vesting period), and they lose trust beneficiary status when they leave, with no further claim on profits. The trust holds the shares, and the selling founders are paid off — usually over a number of years — by the business, based on an agreed-upon company valuation.
The finance team in a leadership role
While the founders and managing directors are often the centre of attention in a shift to an EOT, the CFO’s critical role may be overlooked, according to Nuttall. “The finance director’s role is very important in getting things right at the start,” he said. For example, the company valuation — and the consideration paid to those owners — will depend to a great extent on the cash flow and profit projections that the finance leader supplies. And while share valuation should be performed by an external expert, the finance team will be called upon to contribute to the effort.
Other roles for finance include considering the impact of the transition to an EOT on areas such as overall financial performance, tax issues, and legal and human resources concerns, said Mangaliso Mithi, ACMA, CGMA, the CFO at Jaltech, a South Africa-based fund management firm. He consults with other fund management companies that are considering or undertaking EOTs.
At UK-based software developer NC Squared, financial controller Abi Knight, ACMA, CGMA, who is now managing director, was the only employee told about the transaction before it was announced because her expertise was important in the planning process. In addition to preparing forecasts and other information for the valuation and the legal team, she reviewed documents such as a required share-purchase agreement and a trust deed to ensure they were realistic and accurate.
Best practice for EOTs
Experts in EOTs offer these tips for finance leaders to keep in mind.
Gain early buy-in by demonstrating the benefits
Employees should get a taste of the financial benefits early on, Nuttall said. “The employees should not just be watching the payment money going to the founders,” he said. “There should be a plan for how employee profit sharing works from day one.” He insists that, when profit-sharing bonuses are paid, they go to all employees, because it is a key characteristic of EOT ownership that all employees benefit. Companies may choose to pay each person the exact same amount or vary payouts based on factors such as hours worked or length of service. The finance team will need to be involved in projecting profits and how bonuses are allocated. In addition, while most companies Nuttall has worked with prefer to avoid taking on external debt, when they do borrow, finance provides data for bank loans or other financing.
Management must also buy into the EOT concept if it is to work. In addition to providing a succession solution that maintains the company’s unique team and culture, an EOT can give companies an edge in employee retention and continuity, Mithi said. “These companies have many highly skilled professionals with a lot of institutional knowledge,” he said, as well as varied specialised skillsets. The businesses are seeking to reward their people so they will continue to be part of their growth. In addition, a sale to an EOT may be as much about management succession as business succession because it enables promotion on merit rather than based on someone’s ability or willingness to buy a share in the business.
Consider the impact of local regulation
Decisions on the structure of an EOT and the buyout of founders will be influenced by laws and regulations in the home country. For example, the UK law introduced in 2014 exempted the sale of a controlling interest in an EOT from capital gains tax and created other tax incentives. “The UK wanted to encourage awareness of these structures, among companies and their advisers,” according to Nuttall. In Australia, though, EOT payouts are not exempt from capital gains tax, so this was a consideration for Meld Studios (see the sidebar, “Case Study: Meld Studios”). Elsewhere, guidelines on Broad-Based Black Economic Empowerment are a consideration for employee ownership in South Africa, Mithi noted.
Get the valuation and timing right
EOTs should not start out drowning in debt. The timeframe for owner repayment should offer fair consideration to the departing owners without overburdening the company with too much debt to repay in a short time, Knight recommended. At the same time, if the payout period is too long, the employee owners may feel that the company will never really become their own, dampening some of the excitement and engagement of ownership. Especially during uncertain economic times, “make sure the payback schedule doesn’t ruin the business”, she said.
Keep in mind, too, that the transition to a new management team is one major cause of delays in the EOT transition process, according to Nuttall. This is something to consider in financial planning. “The new team should not only be ready to take on a leadership role but must also adjust to an environment where decisions are more collaborative,” he said. “An authoritarian approach would not work in an EOT.”
To be clear, the point of an EOT is to maintain company culture and not typically to significantly change how decisions are made within the organisation to a workers’ collective model, Nuttall said. Instead, the point is usually to provide a forum for employee voices and enable them to benefit when the company does well.
On the compensation front, he noted that the new EOT-owned companies still have to pay market-rate salaries to recruit and retain staff, and he is not aware of any research showing that some deliberately offer lower pay. “The concept is that this is a great place to work and get market-rate pay, good work conditions, and personal bonuses, plus, if there’s a surplus, you can get an all-employee bonus as well.”
Communicate early and often
Knight has been called on to explain financial concepts to her colleagues and to respond to their scrutiny of the financials. “It’s been really useful to have them understand how we make money and what our profit looks like,” she said. The new governance structure required her to do more reporting than previously, but it helps employees to make better decisions on spending, bringing in new customers, and other key considerations. “If the leadership team is considering a decision, we put it on our wiki page to let everyone know this is what we’re making decisions on,” she said. She recommended that finance leaders should expect questions and be open to challenges.
Meld Studios has viewed the transition as an opportunity to raise financial literacy amongst employees who are not used to financial statements. “If we have discussions about where to spend money or an initiative that might require an investment, they have the financial background they need to understand the impact on financial performance,” co-founder, principal, and director Steve Baty said. At the same time, the decision-making process should ideally allow for a diversity of contributions, since some employees may not want to be involved in financial decisions.
Finally, as employees get used to the new structure, it’s important to regularly reinforce the EOT’s purpose so that they remember the mission and its value, Mithi advised.
A continuing process
The finance team is pivotal at the start, and its role will remain important as the business moves forward to creating and maintaining its EOT. The team will have to assess whether employee and company performance remain in line with business objectives and to develop the right KPIs for its purpose, Mithi noted.
And while the process may seem daunting, it’s worth it, Knight said. “It can be brilliantly successful,” she said. “It can offer a real impetus for your business to carry on in the long term.”
Case study: Meld Studios
The company: Founded in 2009, this Australia-based company consults on service and organisational design and capability building. “We tackle the same issues that a management consultancy would, but we take a human-centred design approach,” said co-founder, principal, and director Steve Baty.
The challenge: The three founders, all in or nearing their 50s, began considering the company’s future. They had been approached about potential buyouts by large multinational consulting firms but were concerned that company culture and the work environment would not survive being swallowed up by a bigger entity. They also rejected the idea of a leveraged buyout by insiders, in part because it would only install a new management team that would be facing its own succession concerns down the road. “It just shifts the problem to someone else,” Baty said.
The founders also wanted to make ownership available to all employees, including those who were younger or less financially secure. Direct share ownership models wouldn’t work because in Australia they create an immediate capital gains tax burden for the owners before they receive their full payout and for employees before they receive any of the financial benefits of ownership.
The solution: In 2021, Meld Studios became the first Australian company to adopt the employee ownership trust (EOT) model. Employee input is facilitated by the presence of one employee representative on the company board of directors and one on the EOT board, both chosen by employees. Profits are shared equally, with all 25 current employees each receiving an equal share of the profits in any given year. Salaries, which remain the same no matter what profits are shared, are paid at a flat rate, depending on job title, so that they reflect the employee’s responsibilities and not their negotiation skills.
In addition, a “Meldster Forum” is an all-hands meeting where employees ask questions of management and offer ideas and solutions. Suggestions are voted on and submitted to the company board for consideration. One key discussion included issues related to a planned restructuring of employee and founder roles and remuneration. In addition, employees receive a fully transparent financial update every two weeks, including a 13-week rolling cash flow forecast. (There is not always this level of transparency; companies may decide not to share information on compensation, the company valuation, or other details.)
The result: “It’s been a period of rapid expansion,” Baty said. The company expects to grow from 25 employees today to 34 within the next year. It has opened new studios in Perth and Canberra and grown its teams in Sydney and Melbourne. “It’s tough to pin success on individual factors, but we set record revenue levels in ten months during the last calendar year,” he said.
Anita Dennis is a freelance financial writer based in the US. To comment on this article or to suggest an idea for another article, contact Oliver Rowe at Oliver.Rowe@aicpa-cima.com.