Technical issues
Legal structures for employee ownership
Contents
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.
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.
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.
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.
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.
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-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.
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Introduction