Why don’t more businesses start as an EOT?
Background
Most guidance re Employee Ownership Trusts is about established businesses being sold, by the founder, to an EOT.
Can you set up as an EOT from day one? If so, why don’t more businesses do that?!
Certainly it’s something businesses could do early on in their life, with the founder heavily involved long term afterwards…but there’s some issues.
“Skin in the game”
You may hate this phrase, but it’s especially relevant to start ups.
100% EOTs don’t give anyone skin in the game. If the business dies, employees don’t lose anything beyond their job.
That sounds like a positive thing…but it can mean people have little reason to hang around if things get tough (which they inevitably do!).
The impact of this can be reduced with a “hybrid” solution. I.E. the EOT owns less than 100%, with one/some key individual(s) owning some shares directly. This can complicate things, and give mixed motivations. Plus to get the tax perks of an EOT, like tax free profit share payments the EOT needs to have control, so >50%.
Where people own shares directly, it gives them incentive to stick around even when it’s hard. They have more to lose. Where this includes multiple individuals, we would recommend you seek legal advice. Consider things like what happens if a shareholder leaves, or isn’t pulling their weight.
Loss making?
Similar to the skin in the game point, start ups can be doing brilliantly but be loss making. Your typical Silicon Valley star being a prime example. It grows exponentially, and the potential is huge. But to fuel that growth they need to spend heavily on product development and marketing. They rely on the fact big income, and hence profits, will come later.
Third party investors are often fine with that. They’re happy to put cash in now, get nothing short term, hoping for a big pay-off further down the line.
With EOTs, this doesn’t work. There’s generally no third party investment. You need to make the business work from income it has, “bootstrapping”.
Doing this in an EOT business isn’t much fun. You’re asking staff to work hard for peanuts to build the business. Those staff won’t own anything.
Their efforts now aren’t rewarded now, as there’s no profit share whilst there’s no profit.
Their efforts now may be rewarded in 5 years time…but by no more than those who join in 4 years time. The Johnny-Come-Lately’s will enjoy future profits just as much as those with the battle scars from the early years!
Admin faff/layers of power
Whilst there’s no strict legal rules as to how many directors/trustees an EOT situation has, we’re firmly of the view that it should have at least 3 trustees:
– 1 director trustee (who knows all the finances/strategy)
– 1 employee trustee (who speaks up for the shop floor workers)
– 1 independent trustee (who gives balance).
For trading company directors it’s less important, but one sole director could lead to accusations of them having too much power.
Point being if the business is the tiniest of start ups, with (say) £50k turnover and one full time worker, the above may be painful overkill!
Participator rule
Linked to the above, to qualify for tax perks like the £3,600/year tax free profit share, the business needs to have at least 5 employees for every 2 directors/shareholders.
Again if you’re right at start up, this may be tricky to meet. In turn it’s perhaps also less relevant, as there may be no profits to share, and/or you’re not motivated by tax. But it also brings us back to the skin in the game point.
One thing that may be relevant to our next point, anyone with 5% or more share capital is deemed a participator for this purpose.
What on earth is the participator rule?!
What to do instead?
If you’ve got a few people that like the idea of pushing something forwards, perhaps in the very short term you give them some direct share ownership. From a future EOT perspective, we’d recommend that most have no more than 4%, and aren’t directors.
Of course 1 or 2 key people could have more, that’s fine…but if hypothetically you had 20 people with 5% each to own the 100% total, you’d then have 20 participators. Hence need 50 employees minimum to get any of the tax perks. If (say) you personally own 80%, and 5 people had 4% each, they still have incentive to make things work, but they’re not participators, and you still have control.
If a year (or a few years) in it’s all going well, then look at the EOT. If you feel guilty/don’t like the idea of the capital gain, you don’t have to sell to the EOT, you can gift (though you miss out on the tax free disposal). Those with shares can either sell/gift, or choose to retain their shares longer term. The tax free sale is only available in the year the EOT gains control though.
Do take care if giving shares in “your” start up to others. It can be very tricky/expensive to get those shares back, even if the person doesn’t do anything!
Summary
There’s no legal reason why a business can’t be EOT owned from day one. But EOTs work best when the company is both stable and profitable.
These two words don’t tend to correlate well with start ups!
Hence why normally the business will get off the ground with a more traditional ownership model. Once stability and profitability are achieved, then the founder looks to transition to an EOT.
Certainly there’s no reason why it has to be on retirement of the founder. It can be early in the business’s life, with the founder staying on long term (albeit now “just” an employee).
Read more about founder roles post sale.