Employee Ownership Trusts (EOTs) have recently burst into the business succession scene in Canada and are consuming a lot of owner’s thoughts, providing another option for those business owners who hope to transition out of their business.
An Employee Ownership Trust (EOT) is a mechanism for a business owner to sell their companies to their employees when they decide to transition out of the business without the employees having to contribute any monies for that purchase. Owners have used EOTs as an exit mechanism because they offer a unique combination of financial, strategic, and cultural benefits that can support a successful transition of ownership to employees while preserving the company's legacy and creating value for employees and the broader community.
Canada tabled legislation in 2023 that provided a mechanism for employees of a company to become owners of a company through the purchase the shares of the business they work via a mechanism called an Employee Ownership Trust (EOT). The Employee Ownership Trust (EOT) will be similar in nature to the Employee Stock Ownership Plan (ESOP) arrangements that have been used in the United Stated for over fifty years, and which are now being used in the UK, New Zealand and Australia (under various nomenclature) to facilitate an exit for a business owner who prefers to have employees benefit directly from their involvement in helping the owner be successful in their companies.
There are several advantages to owners for using an EOT as a transition and exit mechanism including:
1. Succession Planning: EOTs provide a mechanism for business owners to transition ownership to employees gradually, ensuring continuity and stability for the company. This can be particularly beneficial for owners who wish to retire or exit the business but want to preserve its legacy and continue its operations.
2. Tax Advantages: Selling shares to an EOT can offer tax advantages for both the selling owner and the company. Under the proposed legislation in Canada, the initial $10 million in realized capital gains from the sale to an EOT will be exempt from tax (currently for a specified and limited period of time).
3. Employee Retention and Motivation: Using an EOT can help to attract, retain, and motivate employees by providing them with a direct stake in the company's success. This can lead to increased employee engagement, loyalty, and productivity, which can benefit the company's performance and long-term sustainability.
4. Fair Market Valuation: Selling shares to an EOT involves an independent valuation of the company's stock, ensuring that the transaction is based on a fair market valuation of the business. This can provide owners and employees with confidence in the fairness and transparency of the sale process.
5. Liquidity and Diversification: Selling shares to an EOT provides owners with liquidity, allowing them to monetize their ownership stake in the company. This can be particularly valuable for owners who want to diversify their personal wealth and reduce their concentration of assets in the business.
6. Employee Ownership Culture: EOTs can promote a culture of ownership and shared responsibility among employees, fostering a sense of pride, commitment, and alignment with the company's goals and objectives. This can contribute to a positive work environment and a stronger sense of community within the company.
7. Community Impact: EOTs can have a positive impact on local communities by promoting employee wealth accumulation, job stability, and economic prosperity for the community in which they are located. This can enhance the company's reputation and relationships with customers, suppliers, and other stakeholders. Given the sheer number of expected business owner exits over the next ten years in Canada, EOTs can be a creative mechanism to ensure local economic stability and the maintenance of the local tax base.
While we still do not have a clear path or specific rules in place in Canada, the process of creating and implementing an EOT may be as follows based on what we currently know about similar programs:
· Establishment: The company sets up the EOT in accordance with the associated laws and regulations. While not a lot is currently known there may be some form of pre-approval vetting of companies who wish to set up an EOT.
· Trust Formation: The company establishes a trust to hold the shares on behalf of the employees. The rules, mechanisms for purchase/resale/allocation of shares to employees, eligibility/qualifying criteria and so on, are established, along with the governance structure for trust will be set up. Budget 2023 proposed to exempt EOTs from the 21-year deemed disposition rule, however, should an EOT no longer meet the conditions to be considered an EOT, the 21-year rule would be reinstated as of the date the trust no longer qualified as an EOT until the trust next meets the conditions to be considered an EOT.
· Funding for Share Purchase: We anticipate that the trust will borrow money from a lender, such as a bank or financial institution, to finance the purchase of shares from the company's existing owners. The amount borrowed depends on the value of the shares being acquired and any additional funds needed for transaction costs or working capital.
· Employee Participation: Participation will likely be based on some form of eligibility criteria. Eligible employees are typically enrolled in the EOT automatically, although they may have the ability to opt out. Participation criteria can vary but often include factors such as length of service and hours worked.
· Stock Allocation: The EOT trust acquires shares of the company's stock, either directly from the company or from existing shareholders. These shares are allocated to employees' individual accounts within the EOT based on a formula approved during the set-up process.
· Vesting: Employees gradually become vested in their EOT accounts over time, meaning they gain ownership rights to the shares allocated to them. Vesting schedules can vary but often range from immediate vesting to gradual vesting over several years.
· Company Contributions: The company may make contributions to the EOT over time, either in the form of additional shares or cash to purchase additional shares. These contributions are used to build and diversify the employee's ownership stake in the company.
· Distribution and Retirement: When employees leave the company, typically due to retirement, disability, or termination, they are entitled to receive distributions from their EOT accounts. The distribution can be in the form of company stock, cash, or a combination of both, depending on the plan's terms.
Under Budget 2023, the proposed rules for the formation of an Employee Ownership Trust (EOT) are laid out by The Canada Revenue Agency (CRA) on their website - Link: https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/budget-2023-made-canada-plan-strong-middle-class-affordable-economy-healthy-future/employee-ownership-trusts.html#q6,
In my follow-up articles on EOTs I will look at what factors contribute to the success of an EOT, the risks associated with EOTs to both owners and employees, as well as why owners ultimately decide not to use this mechanism for their exit.
Please Note: the rules surrounding EOTs in Canada are evolving and if you are considering this option for an exit from your business it is imperative that you consult appropriate legal and tax professionals.
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