Legal structures for employee ownership

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Contents:

Introduction

There are a number of legal structures that can be adopted to facilitate employee ownership. The most appropriate generally depends on factors such as the purchase price of the business, the finance that is available to the employees, the number of employees, the size of the business, and the management structure they wish to adopt.

The purpose of this sheet is to explain the different options that are available. Advice should be sought on which is the most appropriate for your venture.

The process of achieving employee ownership usually involves the employees either buying the assets and undertaking of the business which employs them, (the target company) or the employees purchasing the shares in that business, directly or indirectly. There are advantages and disadvantages to each option which should be explored with advisers.

Company limited by shares

A company limited by shares is the most common for of company for business purposes. Employee ownership in a company limited by shares is usually facilitated by the employees becoming the shareholders. The employees may establish a new company (Newco) to purchase the assets and undertaking of the target company. The employees may purchase the shares in the target company directly from the retiring owners. The employees may establish their own company which purchases the shares in the target company from the retiring owners. The proportion of share capital held by the employees will dictate the amount of control they have over the company as a whole as owning shares entitles the employees to vote at general meetings of the company.

In a purchase of a small company the employees may expect to own all the shares. Where the purchase price is high and there are a larger number of employees the employees may establish an employee benefit trust which also becomes a shareholder in the new company or they may seek an outside shareholder. Less frequently, the owners might facilitate a purchase by selling their shares in stages, with a majority of shares passing to employees at the beginning.

Some of the employees will usually become directors of the company, and in larger companies non-executive directors may be appointed. Retiring owners may be asked to stay on as directors for a year or so after selling the business to assist in an effective transition.

There are two common types of shares – ordinary shares and preference shares. Ordinary shares usually carry one vote for each share. Their value depends on the size of the shareholding compared with the value of the company as a whole. Preference shares have a fixed value. They usually have preferential rights to a dividend and to repayment. Preference shares are often considered as a loan in the form of shares. They are more commonly used in purchases of larger companies.

Industrial and Provident Society

An industrial and provident society is an alternative structure to the company limited by shares. Although it is very similar, it being a corporate body with share capital and limited liability, a fundamental principle is that of democratic control by its members. In an industrial and provident society, regardless of the number of shares owned by a member, the society is governed on a one member one vote basis. This business option can be appropriate where the employees are anxious to ensure that the business is run on a co-operative, democratic basis. Alternatively it may be useful if the employees are taking over a social service or leisure service function of a local authority, as a not for profit body. The regulator, the Registry of Friendly Societies, requires that the rules of the society comply with the seven co-operative principles (established by the International Co-operative Alliance) if is to be a co-operative, and examine the rules on registration to ensure this is the case. If it is to be not for profit body the Registry considers whether its constitution prevents the distribution of assets to members.

Company limited by guarantee

Sometimes a company limited by guarantee is established. A company limited by guarantee does not have share capital. It is the structure that is often used by not for profit organisations and is also used where the employees wish to establish a co-operative. Since a company limited by guarantee has no share capital its capital must be obtained from loans, grants and retained profits.

Partnership

It is of course, open to the employees to form a partnership to purchase the assets and undertaking of the business, and to carry on the business as a partnership. Obviously, entering into a business as a partnership can be a risk for the partners as they are not protected by limited liability.

Employee Share Ownership Plan (ESOP)

A more sophisticated method of ensuring employee share ownership is to create an ESOP. This is the most complex of the structures that are available, but it can provide several tax advantages for the retiring owners, the company and the employees. An ESOP can be used in conjunction with a company limited by shares and an industrial and provident society established as a co-operative. It cannot be used in a company limited by guarantee.

There are two principal elements to an ESOP – a profit sharing trust and an employee benefit trust. Either can operate independently without the other. They can also be used together. A profit sharing trust might be more appropriately called a share distribution trust since its purpose is to put shares into the hands of employees.

A profit sharing trust can simply be used to incentivise employees without connection to a succession strategy. A profit sharing trust is allocated profits from the company which uses the money to purchase shares. The company can agree with the employees that if the profits reach a certain amount then the employees can participate in them in this way. The shares can be purchased from existing shareholders or by the issue of new shares. The shares are allocated to employees in accordance with a formula agreed by the company with the Inland Revenue. The longer the shares are kept in the profit sharing trust, the greater the tax advantages are for the employees.

As part of a succession strategy a profit sharing trust might be introduced by retiring owners to incentivise employees before a sale as well as to provide a mechanism for the dilution of their shareholding. It might also be introduced by the employees’ own Newco so that new employees of Newco can become shareholders. It can also be used together with an employee benefit trust.

An employee benefit trust is another trust whose purpose is to hold shares on behalf of employees and to facilitate their purchase or allocation to employees. Some tax incentives are available to retiring owners who sell (or gift) shares to an employees benefit trust. It can therefore be used as part of a succession strategy in companies, particularly those with more than 10 employees. One of the differences between the employee benefit trust and the profit sharing trust is that the employee benefit trust can borrow monies to purchase shares from the retiring owners. The repayment of these monies can be more tax efficient for Newco than the Newco having a direct loan.

Co-operatives

Co-operative ownership often appeals to employees because each shareholder has one vote regardless of the number of shares held. It is possible to structure a company limited by shares or an industrial and provident society in a democratic or co-operative way with employee shareholders benefiting from an increase and suffering any decrease in value of the shares. Alternatively the shares can always retain a fixed value. This is known as a common ownership co-operative.

A common ownership co-operative is one which is controlled by its members (in this case the employees) and the assets of the business may only be used to further the objects of the business, although members can receive a distribution of profits. On winding up, the assets must be donated to another common ownership business rather than distributed amongst the members. Common ownership co-operatives can be registered as companies limited by shares and industrial and provident societies but more frequently they are registered as companies limited by guarantee although this is less tax efficient than companies limited by shares and industrial and provident societies in profit distribution to employees.