Hybrid Ownership Structures for Employee Trust-Owned Companies

About Us

Fieldfisher LLP

Fieldfisher is a law firm with extensive experience in supporting organisations, and their owners and stakeholders, as they seek genuine alternatives to traditional business structures. Our work has focused particularly on creating and sustaining employee ownership solutions, and our employee ownership specialists have been at the forefront of the drive to make employee ownership mainstream in the UK and elsewhere for over 30 years.

Cwmpas

Cwmpas is a development agency working for positive change, in Wales and across the UK. Our economy and society could – and should – work in the interests of people and the planet. Established in 1982 as the Wales Co-operative Centre, at Cwmpas we’ve made it our mission to change the way our economy and society works. We have been supporting employee ownership in Wales for over 25 years.

This article is authored by Jennifer Martin with content and editing input from Mark Gearing and Branwen Ellis. Jennifer is a former member of the Employee Ownership team at Fieldfisher and, until the end of 2023, was involved in advising EOT-owned companies since the “employee ownership trust” was introduced in 2014. Mark Gearing is co-head of the Fieldfisher Employee Ownership Team and Branwen Ellis is a business consultant at Cwmpas, specialising in employee ownership.

Introduction

Since the introduction of "employee ownership trusts" (EOTs) to the UK in 2014, the employee ownership (EO) sector has seen exponential growth with many more company owners choosing to transfer their businesses into employee trust-ownership. There is an ever-increasing body of evidence which highlights the benefits that collective business ownership by employees can bring. For example, last Autumn Fieldfisher was proud to share the findings of a new report into the significant productivity benefits of employee and worker owned businesses (EOBs) in the UK "Exploring the potential of the Employee Ownership business model".  To date, this is the most in-depth study of its kind into the benefits of EO, in which independent researchers surveyed around 9% of the UK’s 1,650+ employee owned businesses (EOBs) and compared results to a control group of non-EOBs.

The report found that, amongst of things, EOBs:

• return twice as much in bonuses and dividends to employees compared with non-EOBs;
• were five times less likely to make people redundant in the last three years;
• tend to pay higher minimum annual wage by roughly £2,900 and are over twice as likely to hold accreditation for fair pay;
• provide more supported access to private healthcare, mental health resources and flexible working; and
• invest on average 12% per annum (£38,000) more in on-the-job training and skills.

Further information and links to the report can be found on Fieldfisher's website. 

The ownership of EOBs generally can take different legal forms but the most common form of EO in the UK is ownership through an EOT. An EOT is a special type of trust which is established by a company (referred to as the settlor company) wanting to transition to employee-ownership. The EOT has a narrow class of beneficiaries who are the current employees of the settlor company (and, if relevant, its group); former employees and certain family members can only be beneficiaries of the EOT in specific circumstances.  The growing popularity of EOTs since they were introduced almost ten years ago is largely attributed to the two tax incentives associated with this type of employee trust. The first is a capital gains tax exemption on qualifying sales of shares to an EOT and the second is an income tax exemption for qualifying bonuses paid to employees of EOT-owned companies.

Typically, an EOT will be established to acquire shares in the settlor company/group and the purchase price for the business will be funded by the company over time out of profits (with or without the benefit of debt finance).

In addition to having a narrow class of beneficiaries, there are some other key differences between an EOT and an employee benefit trust (EBT) which, prior to 2014, was the benchmark for employee trusts:

• in order for the tax incentives to be available, an EOT must acquire (and retain at least in the short term), more than 50% of the shares in the settlor company (a “controlling interest”);
• the terms on which the EOT is established must restrict how any trust property can be distributed; and
• for bonus payments to qualify for the income tax exemption they must be paid in accordance with strict statutory requirements. Further information on these requirements can be found in the joint Fieldfisher / Cwmpas article  published last summer.

Some companies choose to adopt 100% EOT-ownership. This means that all shares in the settlor company are held by the EOT and there are no other shareholders. Other companies prefer to adopt a “hybrid” structure; this is where up to a maximum of 49.9% of the shares can be held by others. The rest of this article will focus further on “hybrid” structures and examine: (i) what factors might lead a company to adopt a hybrid structure (and also what percentage of share capital to hold outside of the EOT); and (ii) possible risk areas consider.

Choosing the right ownership structure for an EOB

Every business must consider what ownership structure is the right one based on its own unique circumstances; any company considering a re-structuring of its ownership, including establishing an EOT and/or offering shares to employees must take appropriate professional legal, tax and valuation advice in order to ensure that the chosen structure is fit for purpose.

1.          100% EOT-ownership

100% EOT-ownership is the simplest form of EOT ownership; all of the shares in the settlor company/group are held by the EOT. Each current employee is a beneficiary of the EOT, but no employee has an identifiable direct interest in the shares held by the EOT or in relation to any other trust property. This is designed to provide a stable, long term ownership structure. Ordinarily, the only assets of the EOT are the company shares and these are “locked up” for the foreseeable future with no further transactions in shares taking place. For EOT-owned companies, “qualifying” (income tax free) bonuses are paid directly by each relevant employer company in the group to employees; they are not paid via the EOT.

This ownership structure has a number of possible advantages including:

• tax complications associated with direct share ownership are avoided (see further below for a discussion on these);
• there is a much lower administrative burden for the settlor company because there are no practical consequences (in relation to the EOT) of employees joining and leaving); 
• all employees are on an equal footing and have the same discretionary interest in the EOT (this does not of course prevent an employer company making normal commercial salary and bonus awards in accordance with role, seniority etc); and
• any available excess profits can be shared amongst employees of the business (in the manner determined by the directors) (and taxed as employment income).

We hear from our clients that there are also possible disadvantages to 100% EOT-ownership – for example:

• a “notional” interest in an EOT may not provide a sufficient link between business performance/growth and reward to incentivise effectively senior employees;
• in the (unlikely) event of an onward sale of the business out of an EOT, any individual who (in a non EOT-controlled company) would or might have been a shareholder, will not benefit directly from the sale; and
• there is no possibility of structuring rewards or incentives that provide for gains to be taxed as capital rather than income.

2.          Hybrid ownership

Introducing direct share ownership for employees alongside EOT ownership is a potential way of overcoming the actual or perceived disadvantages of 100% ownership by an EOT. For many of our clients, a “hybrid” model of ownership is the best commercial outcome, where an EOT retains control (i.e. it owns more than 50% of the shares), with the remaining shares available to be held directly by employees. Usually, any shares not held by the EOT are held by employees (or former employees), but it is also possible in principle for shares to be held by external investors.

The potential advantages of this approach are, essentially, the opposite of the disadvantages of 100% EOT-ownership:

• more demonstrable link between employee reward (in the form of shares) and business performance;
• individual employees can benefit directly from the growth in capital value of the business; and
• (if structured correctly) an opportunity for capital gains tax treatment on any disposal of employee awards.

**Note that the sale of companies by EOTs is discussed in the third article written jointly by Fieldfisher and Cwmpas.**

Since the introduction of "employee ownership trusts" (EOTs) to the UK in 2014, the employee ownership (EO) sector has seen exponential growth with many more company owners choosing to transfer their businesses into employee trust-ownership.

Working through the challenges of hybrid ownership

There are a number of challenges associated with introducing direct share ownership to EOT-controlled companies; these will be a mix of commercial, tax and legal implications which should all be carefully thought through. Some of the issues we have come across and worked through with our clients are discussed below. To achieve the best outcome, a feasibility analysis should be carried out by the business, and supported with appropriate professional advice.

What is the commercial aim of holding shares outside of the EOT?

What does the business hope to achieve by introducing direct share ownership? Where a company has recently adopted EOT-ownership, there is likely to be an obligation to pay consideration to the former owners over time. This is a period where a large proportion of profits will leave the company to pay down that consideration – perhaps there is a need to incentive key members of the management team in the short-medium term? Or perhaps there is a longer term aim? Who will be offered the opportunity to hold shares directly? Will this be a small number of key employees? If so, does treating certain individuals differently have potential to cut across some of the wider benefits of EOT-ownership? Is there a need for “all-employee” direct share ownership (such as through a tax-advantaged Share Incentive Plan).

What percentage of shares should be held outside of the EOT?

In principle, this can be anything up to 49.9%. A number of factors will feed into this decision – for example:

• ensuring continued compliance with the statutory EOT requirements (including ensuring that no “disqualifying event” occurs”*) and any historic clearance applications made to HM Revenue & Customs;
• what percentage is needed to achieve the commercial aims of direct share ownership?
• how will a financial benefit ultimately be delivered to employees? In the absence of external funding, what is manageable / affordable to the business?

*  “Disqualifying events” are events which trigger a deemed disposal and immediate re-acquisition of the EOT-owned shares; if the shares are sitting at a gain relative to the original base cost (which is likely), this will trigger a CGT charge, even in circumstances where there has been no actual disposal of the shares.

Where shares are issued by an EOT-owned company as part of a hybrid structure, it will be particularly important to check (and continue to monitor) the “participator fraction”. This is (very broadly), the ratio of (i) persons who are both participators (shareholders) and employees/office holders of the company in question (plus their connected persons (if any) who are also employees or office holders of the relevant company) to (ii) the total number of employees.  A disqualifying event occurs if the ratio exceeds 2:5. Hybrid ownership will introduce more participators/shareholders and this is why particular care is needed here, especially where there are multiple classes of shares in issue.

How will shares be delivered to employees initially?

Will they take the form of shares or options to acquire shares? Will they be gifted or purchased? What are the tax implications of each route for both individuals and the business? Are there any tax-advantaged equity incentive schemes available*? It is worth noting that the EOT legislation specifically provides for EOT owned businesses to operate tax-advantaged share plans. What are the qualifying conditions for each and are they met? Do they assist with achieving the commercial aims of direct share ownership?

*There are a number of discretionary and all-employee share/share option plans which, if all relevant requirements are met, can be structured to achieve tax advantages for both employer company and employee. Enterprise management incentive (EMI) arrangements and company share option plans (CSOPs) are discretionary option based plans that are becoming increasingly common incentivisation tools for EOT-owned companies. Share Incentive Plans (SIPs) can also be helpful to provide benefits to all eligible employees which are potentially tax free. A detailed discussion on the operation of these plans is outside the scope of this article – however, further information can be found at Guide to incentivised share plans or can be obtained by contacting Fieldfisher or Cwmpas directly.

Are any consents or changes to the current constitution required?

If a company has recently converted to EOT-ownership, the desire for direct share ownership may already be anticipated and provided for in relevant documents. If not, what consents are required? If the EOT has a corporate trustee, its directors will likely be required to consent to the proposed or actual issue of new shares. Is consent from a wider group of individuals required? This will depend on what has been agreed in advance.

How will direct share awards deliver an effective incentive to employees?

Once shares or options are awarded to employees, when will there be an opportunity for employees to realise actual value and how will this be funded? How does this assist with fulfilling the commercial aims of direct share ownership? Ownership by an EOT is designed to be a long term succession solution; if there is no future external exit, can the business create sufficient opportunities for employees to realise actual value such that the commercial aims of direct share ownership are supported and fulfilled? A company may need to design an “internal market” for its shares, in order that employees have opportunities to sell shares at relevant times.

What are the valuation issues associated with making shares available to employees?

In our experience, valuation can often be one of the trickiest issues for companies to work through when considering direct share ownership.

Specialist valuation advice is likely to be required; this is to ensure that the tax and funding implications for direct share ownership are understood and managed. In addition to valuing the business as a whole and each share to be awarded / offered, it will be necessary to consider the impact of discounts, both on the shares when they are acquired by employees and if they are sold. When shares are awarded to employees, typically a full company valuation is discounted to reflect that the individual employee’s stake is small and uninfluential (often referred to as a “minority discount”). If employee shares are sold as part of a sale of the full company (whether to an EOT or otherwise) this discount is no longer relevant and so the minority shareholder receives, in effect, an uplift on their original share award (or purchase). If an employee holds shares in an EOT-controlled company and therefore there will be no full exit opportunity, this may mean it is appropriate to apply a discount when shares are sold. Failure to assume a discount (or to assume a discount which is too low) may result in an employee receiving an amount for their shares which is more than the market value for tax purposes of those shares – this can have income tax and possibly also national insurance implications for both employee and employer. Companies should ensure they have consulted with their advisers to determine an appropriate approach on valuation (including discounts) in order to minimise the likelihood of there being any nasty surprises further down the line.

There may also be a need to consider whether a different class of share is needed to manage valuation implications of individual share ownership for EOT-owned companies. It may be helpful to model introducing a new class of share with, for example, limited capital rights on day one (often known as “growth” or “hurdle” shares) which can potentially be used to achieve a lower share valuation at the outset. This could help with, for example, making the purchase of shares by employees more affordable, or making it easier to fit within EMI or CSOP financial limits. Although growth shares can be a powerful incentive in the right circumstances, they should be approached with caution because the complexity (and costs) associated with introducing them may out-weigh their ultimate benefit. For more information on growth shares or equity based incentive structuring generally, please contact Fieldfisher.

Moving forwards with hybrid ownership

A number of the issues mentioned above are also relevant to non EOT-owned companies. However, EOT-controlled companies face a set of additional challenges which are unique to this type of company. There are several examples of EOT-controlled companies operating direct share ownership arrangements successfully; they have designed hybrid structures which are manageable from both a tax and practical perspective and which achieve their commercial aims. Thorough consideration of all relevant issues will lead to a much higher chance of implementing a successful structure.

For more information on how Fieldfisher and Cwmpas can assist with hybrid structures, please get in touch using the contact details below.

Note: The information contained in this article is not intended to, nor does it, constitute legal, tax or other professional advice or services. The contents of this article are provided on an information basis only and should not be relied upon. If you need advice or services on a specific matter, please contact us.