Long Term EO Business Sustainability

Many in the EO community believe that EO is a panacea for all businesses and their long-term success. The employees are engaged, the business will thrive, the future is rosy. 

Evidence from administrators tells a different story. 

There is nothing to stop an EO company from falling on hard times, and sometimes it is not possible to recover from these. The status of being employee owned does not stop any of the issues that befall unsuccessful companies. Businesses and EO experts would do well to be mindful of this.

In another example of a purist perspective, a well-known figure in the sector once included in their presentation that ‘an EO company isn’t there to make a profit’.

To be fair, many in the audience raised their eyebrows, and the speaker is unnamed here because (maybe) it was a provocation to the audience for a bit of self-reflection.

As we all know, trade without growth is a future failure.

Transitioning to EO, then believing that the company will magically continue to meet its obligations without leadership, entrepreneurial spirit or a growth plan is wishful thinking. This is why succession planning for the company, and for its leadership, is so important, to ensure that the skills are available and being developed for the future business, not just current operational delivery and efficiencies.

As a minimum, growth is needed to fuel increased costs. It is also needed to be able to deliver the benefits from being EO that employees expect … career progression, training, long-term employment in a sustainable business, a share of the profit, etc.

EO companies and their leaders ignore the requirement for growth at their cost. 

And if they fail to communicate the need for growth to their employees, they are doing the employees a disservice when they then expect employees to participate and contribute to growth, innovation and business development without understanding why it is important for everybody.  

Buried amongst the questions about employee ownership on the EOA website is the following question ‘Do companies ever stop being EO after they’ve transitioned?’

The answer in both its brevity and its content is quite telling of the EO sector as a whole being:

‘It’s rare, but sometimes businesses will undertake an onward sale. A small number have done so in recent years, normally with significant financial benefits for all employees involved.’

Purists believe EO is for life, not just for transition, and that any future exit to become non-EO is against all principles of the model.

In practice, it is not that simple. Employee ownership is an ownership structure and, like any other business, the business has to be sustainable.

To cover its growing costs, to keep meaningful employment for its employees to have a sustainable future, the business needs to look to the future and ensure that it can continue to trade.

The friendly tone to the EOA’s answer belies tough trading conditions, shies away from opportunities from selling and quietly tries to ignore a growing trend that EO companies evolve and mature like any other company, and their evolution may include a change in ownership model.

Disappointingly, it also implies that, if there is an onward change in ownership and sale of the shares, the employees will gain a 'significant' financial benefit. This slots neatly into the poor transition communication to employees that ‘don’t worry, it’s a small change and, in the future, when the business is sold, you will benefit financially.’

Not so in all cases, and whilst we’re a big believer in all options being on the table for discussion, setting an expectation amongst employees that a sale can only give them a positive, and ‘significant’, financial outcome, is setting false expectations for the future. If nothing else, the costs of the sale transaction plus the CGT that would need to be paid on an onward sale and their own personal tax obligations, can heavily impact the residual financial benefit to employees as beneficiaries.

It also creates ongoing uncertainty. Gone are the uncertainties around an individual founders’ future succession, instead a future sale is definitely in the plans creating a new uncertainty … but it’ll be sweetened so don’t worry. The majority of individuals don’t like change, how has this message reduced the fear of future significant change?

 

Increasingly we’re seeing EO companies, and their leadership team, looking at their longer-term future and including a shareholder exit into the possibilities. It is not that exit is the only plan, but it shouldn’t be off the table in strategic discussions. 

Equally, we are expecting to see mergers of EO companies being more common. Having been assured that a merger of two EO companies would not crystallise the deferred CGT (under current tax rules) shouldn’t this also be on the table for discussion? 

Frequently vendors sell to an EO having heard about the structure and its benefits from contacts in their sector. At what point do those conversations move into the next stage of what next as an EO? Is there an opportunity for us to harness the good of EO, by protecting the future and becoming a larger entity with a broader remit and reach as a merged company?

Anecdotally, we have heard of companies transitioning into EO to crystallise at least some of the value through initial payments to vendors, with a future merger already in the plans. If the CGT is not crystallised, there is no reason to wait for the end of the vendor clawback period at the end of the 4th tax year following transition. 

A pre-planned EO merger does assume that it is in the best interests of the beneficiaries of both companies. And it should be noted that the decision to merge post transition, is no longer a decision by the former owner in isolation of others. 

As trustees we have to encourage discussions on future company sustainability, with nothing off the table. We also have to be open to the potential outcome of those discussions and the impact it may have on the wider business, both positive and negative.

In a word of caution – this is at strategic leadership discussions, not all employee communications or all-staff awaydays. Creating uncertainty by communicating what is an option, but not a decision, may not be in the best interests of the company or its employees.

Equally, a fire sale of a business is in nobody’s best interests, but may be better than a slow decline into closure. At least the former may protect the future for the majority of employees, the latter is less likely to. 

Having a change of ownership through sale or merger should be part of any high level forward thinking strategic discussion, whether driven by desire or need. When to raise the topic with trustees depends on its imminence, and the membership of the trust board. In our experience, it is often a conversation between the leadership team and the independent trustee as a first step to gauge views and discuss options.

We’re not advocating for sales of EO companies to be the norm, or for transitioning companies to have a pre-agreement to merge in the future, but equally the topics shouldn’t be off the table.

The EO sector is evolving, whilst the headwinds affecting companies are growing. We expect to see more EO companies exiting their ownership structure or merging with other EO companies. Our existing experience of exiting an EO ownership structure has been positive, when part of wider strategic discussions and not forced by circumstances or external pressures.

For further reading, our article on selling an EO company can be found here: Selling an Employee Owned Company

We fully expect to be able to share a similar article on merging EO companies in the future.