Employee Ownership or Management Buy-Out?

Business owners looking at succession have a range of options available to them. Bishop Fleming’s Paul Morris looks at two options on the table: employee ownership or a Management Buy-Out (MBO).

These options are commonly discussed in exit planning meetings with owners of successful, privately owned businesses.

Indeed, the notion of ‘employee ownership’ has moved higher up the agenda, as more and more businesses aspire to the merits of the ‘John Lewis’ model.  

Only recently, the owner and founder of Richer Sounds, Julian Richer, announced the transfer of 60% of the company to an Employee Ownership Trust (EOT), with up to 500 staff also benefiting from a £3.5m handout.

Other recent converts include the organic veg box company, Riverford, and Bristol-based Aardman Animations - the studio behind Wallace & Gromit.

From a political perspective, the major parties have also sought to reinforce increased employee ownership as a policy objective.

Labour’s shadow chancellor, John McDonnell, recently announced Labour’s plans to consult on the idea of forcing companies with more than 250 employees devolve up to 10% of a company’s equity to a fund for employees in order to give staff a share of profits, a say in how the business is run, and also to require dividends to be paid to a ‘social fund’ to finance certain Government spending plans.

The extent to which genuine employee ownership or revenue raising is the over-riding political rationale remains to be seen, but employee ownership is clearly moving up the agenda.

A number of businesses are recognising the benefits of employee ownership, and this may perhaps be symptomatic of the times for many owner-managed, particularly professional businesses, where succession remains a key challenge.

To remain profitable and relevant, the pressure to innovate and improve long-term productivity has never been greater, and all this coming at a time when the younger generations are looking for genuine involvement and with a better work-life balance.

Employee Ownership Trusts

The initial tide of businesses considering the employee ownership model have been prompted partly by the generous tax breaks associated with “Employee Ownership Trusts” (EOTs) introduced in 2014, and there is no doubt that the headline tax benefits from selling to an EOT are compelling.

For Mr Richer, he is receiving an initial £9.2m for transferring a controlling interest in his company to an EOT, and this gain is entirely ‘tax free’!   What’s more, once the company is owned by an EOT, it is able to pay ‘income-tax’ free bonuses to employees of up to £3,600 per year each. So what is not to like?

Well, as ever, it is important not to allow the ‘tax-tail to wag the commercial dog’ and instead focus on the key business considerations and overall impact on the business longer-term.   Whether it’s an EOT, MBO, Merger, Trade sale or listing, the key objective is normally to secure the future longevity of the business through the development and implementation of an effective ‘succession strategy’.

This is a key issue in certain sectors, such as professional services, where the younger generation are not always ready, willing and able to take on the financial and wider commitments to buy out retiring partners or directors.  Merger is often the fall-back position, but this may not necessarily fit with the independent culture and ethos that has served many of these businesses so well over many years.     

So is the EOT the perfect solution for this dilemma?

Certain businesses think so, such as architectural practices which have been quick to adopt the EOT model as the way forward.

In many cases, employee ownership will indeed tick the box, and the EOT will be the right structure for all involved. In other cases, a ‘Vendor-funded’ or ‘leveraged’ MBO, merger or indeed trade sale may better fit the bill, or an EOT/MBO ‘hybrid’ could be considered.

So the answer is: ‘it depends’.

Key strategic questions

To determine how the business should move forward, it is important to focus on key strategic questions, including:

• The wider market and industry trends, and competitive pressures - in terms of size, brand, business Unique Selling Point (USP), funding etc. What is the appropriate direction for the business over the longer term, which can include remaining independent, merging, acquiring or indeed being acquired?
• Who will be the key people and drivers of the business, both today and going forward, and what are their aspirations in terms of involvement, ownership and reward?
• How will key management and strategic decisions be made in the absence of the current owners, and how will any entrepreneurial flair be maintained?
• What is the business really worth and what is a fair price?
• How will funding be secured to pay the Vendors, and what effect will that have on the business, particularly in terms of its ability to remain profitable and to invest for the future etc?

With regard to funding, the EOT structure is now more widely recognised by the Banks and there is more of an appetite and flexibility to seek to accommodate this type of structure, as opposed to the traditional leveraged MBO route.

That said, any commercial funder will still want to see a carefully thought through and robust Business Plan, and understand the credentials of those who will be running the business going forward.

A key requirement that is often expressed is for the key people to have sufficient ‘skin in the game’, so this aspect may need to be accommodated within the overall structure that is put forward at the outset, if suitable funding is to be secured.

Overall, an EOT structure should certainly be on the radar of business owners looking to exit, alongside the more traditional routes such as MBO or trade sale.

Whilst the tax treatment of the EOT certainly grabs the headlines, it is also important to consider the wider commercial aspects to ensure that the best possible outcome is achieved for all stakeholders, both initially and over the longer-term.