Your business and succession that works

Business owners of all types can often struggle with succession. This issue can be even more of a challenge in family owned businesses where, at the point when family members are thinking about disposing of their interest, it can be difficult to find a suitable purchaser.

More and more, the issues of culture, identity, core values and continued retention of staff in the business are the key drivers for a successful transition.

Here are a brief rundown of 2 options we have been talking to our clients about in relation to succession and company ownership, where the aim is to incentivise and bring into ownership the people working in the company.

These are both a good way of telling people how valuable they are and can tie them into the business and aligning them to the business’ financial goals.

Share Options – how do they work?

The first option is to grant key staff options to acquire shares in the company.

An employee share option at its most basic, is the right to acquire shares in a company (usually the employing company or a member of the same group) at a pre-set price, known as the exercise price. For example, an employee may have an option to buy 100 shares at a price of £1 per share. Normally, the exercise price is the market value of the shares at the time the option is granted. Sometimes the exercise price is less or greater than the market value at that time. An option to acquire shares for nothing is known as a nil-cost option.

Share Options – Headline Take Aways

Companies often grant options using a scheme or plan. The scheme contains the contractual terms of the options in a set of rules. The rules cover key features of the options such as:

  • When can the company grant options?
  • Which employees can be granted options?
  • Are there any limits on the number of shares over which options can be granted?
  • How is the exercise price determined?
  • Are there any service or performance conditions on the options?
  • When can the option holders exercise the options?
  • What happens if an option holder leaves the company?
  • What happens on a change of control?

The terms of employee share options vary widely, but most share some basic common features:

  1. Employees must usually wait before exercising share options – Options may become exercisable after a set period of time expires (commonly three years). Alternatively, options may become exercisable only if an event occurs (such as a sale or listing of the company).
  2. Employee options are usually non-transferable – In theory an option can be sold. However, normally the terms of an employee share option prevent the employee from selling the option. Generally, employee share options can only be held and exercised by the employee to whom they are granted, or by the employee’s estate after death. They usually cannot be transferred and will lapse automatically if the employee tries to transfer them or uses them as security. They also usually lapse if the employee becomes insolvent. Exceptionally a company may agree to permit options to be held by a nominee or trustee on behalf of the employee’s family.
  3. Dividend and voting rights – Dividends and votes attach to shares, not share options. There are no voting rights or dividend rights attached to employee share options.
  4. Dilution – Typically employees holding share options will not be protected against dilution. If an option is granted over, say, 5% of share capital, if the company subsequently issues new shares, the employee’s overall percentage will be reduced. If the company issues shares at less than market value, or grants further employee share options, then the value of the employee’s underlying shares may also be reduced.
  5. Leaver provisions – Most share option schemes will provide for what happens when someone leaves employment. Typically employee share options will lapse when an employee leaves, but share option terms often allow for an option to be exercised early for good leavers (or allow the employee to retain part of the option until it becomes exercisable in the ordinary course, which is the usual approach for listed companies).
  6. Lapse provisions – The option will usually lapse when certain events happen. These events might include:
  • The employee leaves (usually with exceptions for good leavers).
  • The employee does not exercise the option within a time limit specified in the terms of the option.
  • The employee is made bankrupt.
  1. Company events – Most share option schemes will include details of what happens to options when certain corporate events occur, such as a takeover.
  2. Reasons for granting share options – There are many reasons an employer might want to grant share options to employees. All types of share incentive, including share options, can help align the interests of employees with shareholders, by ensuring that employees have an interest in the value of the company’s shares increasing, or an interest in getting the company to a sale or flotation. Share options that are lost when an individual leaves employment can aid retention, while offering share options can help recruitment.

There can also be disadvantages to granting share options though. They might encourage senior employees to focus solely on share price increase at the expense of underlying business performance in the longer term, for example, or a company might need to issue more shares than it would need to if it used different types of share incentive.

The key takeaway from the above is that a share option should have clear and targeted performance conditions which need to be satisfied before the option can be turned into shares. So, if you want to sell your company for more than £1million, then make it a pre-condition of exercising any share options that the company is sold for more than £1million. If you want to increase profits, then tie the options to a certain level of profitability being achieved.

Share Options – The tax bit

Get it right and you can make share options incredibly tax efficient. If your company is in the right sector (which the overwhelming majority of companies are) and is not controlled by another company, so long as your gross assets aren’t too big and you have less than 250 employees you can use the tax efficient EMI route. For most of our clients who go this route, they see staff paying just 10% tax and the company itself gets a tax refund.

Employee Ownership Trusts – how do these work?

The, perhaps less obvious, solution that many previously family owned businesses have already chosen is Employee Ownership. The Employee Ownership sector has grown by 10% a year since 2014 with its highest growth to date in 2019 when the sector grew by 28%. The latest evidence suggests that the sector is represented by approximately 470 businesses and we think Employee Ownership Trust (“EOTs”) will slowly and surely come into their own over the next few years.

They are a great way of extracting value from your business, motivating the next generation of managers who slowly take over without burdening them with debt yet allowing the exiting generation to retain control during the transition. In essence, you can sell your business to an entity which you remain in charge of and receive full value funded by tax free dividends (or bank finance).

Any business can become EOT owned and it doesn’t matter if you are currently operating through a partnership, LLP or company.

The only real pre-condition is you can’t do this just to pass the company to your children or other close relatives and you need a good number of non-family members employed by the business. In practice, it doesn’t work well for businesses whose value is made up of property or other physical assets, it works best for people businesses.

Employee Ownership can also be a compelling recruitment and procurement tool. EOA research shows that the model greatly appeals to the values of a millennial workforce and that employee owned businesses are inherently deemed to be more trustworthy. The benefits to employees are mostly found in the altered culture of an employee owned business where longer-term thinking, transparency and collaborative behaviours result in higher levels of innovation, employee wellbeing and greater job satisfaction; all factors of particular importance following the devastation of COVID-19.

EOT – Headline Take Aways

The owners of a business set up an employee ownership trust which purchases all (or most) of the shares in the business for either cash on day one or the price is left outstanding to be paid from future profits.

The sellers become the trustees of the EOT and can remain as the directors of the business whilst this transitions to the next generation. In, say, 5 years from now the current owners have received all their value and the business is now held on trust for the remaining employees. Just like John Lewis, the company’s profits are the staff’s profits.

To be an EOT, it is necessary to meet specific statutory criteria. An EOT must:

  • hold more than 50% of the ordinary share capital and voting rights of the company and be entitled to more than 50% of profits distributed and assets on a winding up; and
  • subject to limited exceptions, benefit all eligible employees of a company or group on the same terms.

Setting up an EOT is a substantial project and involves careful thought about several issues, particularly:

  • Who will be the trustee? There may be the potential for a conflict of interest if an employee or director of the company is also a trustee.
  • What will be the governance structure of the company and the EOT?
  • What is the market value of the shares that the trustee must acquire in order to have a controlling interest in the company? The trustee may need independent expert valuation advice.
  • How will the trustee raise the funds to acquire the shares? How will the trustee repay any indebtedness it incurs and any interest on that debt?

It is likely that the vendor, the company and the trustee will each need separate advice.

EOT – The tax bit

Where the legislative requirements are met, qualifying shareholders can transfer their shares into the EOT and enjoy the gains arising free of Capital Gains Tax charges. This is an increasingly attractive prospect following the recent reduction to the Business Asset Disposal Relief (previously Entrepreneurs’ Relief) lifetime limit from £10m to £1m.

It is perfect as a vehicle for a people business as it motivates staff by showing them they have a real stake in the business. In addition, qualifying employees of a company owned via an EOT may be paid tax free bonuses of up to £3,600 per employee per annum.

Usually, high street banks are now willing to lend to EOTs with interest rates closer to those on mortgage products than private equity loans.

Conclusion

Good planning can make the succession process much easier than otherwise it would be and often the best successors to a business are those staff who have helped build the entity up and supported the value acquired. Study after study shows that employees whose interests are aligned with the owners work harder, smarter and more efficiently than before especially if they have ‘skin in the game’. In time, profits will have risen up with the result that HMRC also wins; more profits means more corporation tax, greater number of employees paying more income tax and NIC receipts and overall a more thriving economy.

Please drop me an e mail or call if you need any further details and stay safe and well.

Roger