The recently announced Employee Ownership Trusts (EOT) structure which is now available in Canada may provide an opportunity for owners of small and mediums sized privately owned corporations to transition for their business by selling to their employees without the employees having to provide the capital to purchase the company. While brand new to Canada, these trust ownership structures have been used in the United States for over fifty (50) years and more recently in the UK (2014). As a result of the experience seen in these jurisdictions the EOT framers and advocates in Canada were able to secure an EOT structure in Canada that borrowed the “best” parts from the US and the UK to produce a very unique opportunity for Canadian business owners to exit successfully.
As I have spoken in my previous articles, EOTs can be a very successful mechanism for an owner to transition out successfully, and they have some distinct advantages over other exit options, with most successful ESOP/EOT transitions resulting in companies that perform better than their non-ESOP/EOT peers, and which have provided long-term wealth growth to the employees.
While the EOT does offer a significant opportunity for owners to continue their legacy through their employees, it may not be suitable for all sizes and types of companies. Historical perspectives on the success and characteristics of companies that are both suitable and who have been successful can provide some guidance on the types and sizes of companies that may benefit best from this transition option.
In order for a company to implement an EOT transition (in any jurisdiction) there are a number of regulatory hurdles that must be met (I will leave those to the tax and EOT implementation specialists to discuss Canadian requirements in detail) as well as several operational, financial and structural conditions must be met in order for a company to be successful in an EOT implementation.
Historically, companies that have been successful in implementing an EOT have had the following characteristics that have led to their successful implementation.
1. Strong Financial Health
Stable Revenue and Profitability: Companies with consistent and stable revenue streams and profitability are better positioned to transition to employee ownership. This financial stability ensures the company can meet any debt obligations incurred during the buyout process and provides reassurance to employees about the security of their new ownership stakes.
Healthy Cash Flow: Consistent, positive cash flow is critical as it allows the company to fund the purchase of shares from existing owners and cover ongoing operational expenses. Companies with strong cash flow can more easily manage the financial commitments involved in an employee ownership transition.
2. Robust Organizational Structure
Clear Leadership and Governance: A well-defined leadership structure is crucial. Companies with experienced management teams. That have well defined operational and disciplines decision making disciplines can better navigate the complexities of transitioning to an EOT. Additionally, strong governance frameworks help ensure that the interests of all stakeholders, including employees, are represented, and protected.
Employee Readiness and Engagement: Employee ownership works best when employees are prepared and engaged. Companies with a culture of transparency, participation, and communication are more likely to succeed in the transition. Educating employees about the benefits and responsibilities of ownership can foster a supportive environment for the change.
3. Favorable Market Conditions
Industry Stability: Operating in a stable or growing industry can provide a favorable backdrop for transitioning to employee ownership. Stability in the broader market environment can mitigate risks and support the company’s long-term success under the new ownership model.
Access to Financing: Favorable conditions in credit markets can make it easier for companies to secure the necessary financing for an EOT transition. Low-interest rates and readily available credit can reduce the cost of borrowing and make the transition more financially viable. Access to funding will be critical for an EOT to be successful. Having financial institutions that are willing to fund the EOT share purchase is essential for this structure to be successful.
4. Regulatory and Tax Considerations
Tax Incentives: Governments often provide tax incentives to encourage employee ownership. In Canada there are significant potential tax advantages to an owner who wishes to use an EOT for their transition, however there are conditions around these advantages that must be considered when assessing this option.
Regulatory Support: A supportive regulatory environment that facilitates the creation and operation of EOTs is also beneficial. Clear and favorable regulations can reduce legal complexities and costs associated with the transition process.
Share ownership Structure: Given the significant tax savings opportunity available through using an EOT as an exit strategy (up to $10 million dollar capital gains exemption on the sale of qualifying shares), there could be a significant benefit for owners who sell to an EOT. It will therefore be imperative for private company owners to seek both legal and tax advice on whether they qualify, and should they not qualify, what they would have to do in order rearrange their structure to qualify (if even at all possible).
5. Succession Planning
Owner’s Retirement Plans: Business owners looking to retire or exit the business can find and EOT to be attractive succession planning tools. These structures provide a way to sell the business to trusted employees, ensuring continuity, and preserving the company’s legacy.
Desire for Employee Welfare: Owners who prioritize the welfare of their employees may prefer transitioning to an EOT as it can offer greater job security and potential financial rewards for the workforce, aligning with the owner’s values and long-term vision for the company.
6. Professional Guidance and Expertise
Access to Advisors: Transitioning to employee ownership is complex and requires specialized knowledge. Companies that have access to experienced legal, financial, and organizational advisors are better equipped to navigate the process successfully. These experts can provide critical insights and guidance on structuring the deal, complying with regulations, and managing the transition.
Comprehensive Feasibility Studies: Conducting thorough feasibility studies can help determine the best approach and identify potential challenges. Companies that invest in detailed planning and due diligence are more likely to experience a smooth and successful transition.
History has also provided context on the size and financial wherewithal criteria that have led to successful EOT implementations. While there is no absolute minimum size, historical evidence and case studies suggest certain benchmarks that can help guide companies considering this path. For example, in the USA and the UK we have seen the following:
Minimum Number of Employees:
10-15 Employees: Companies with at least 10-15 employees are generally considered the minimum size for an ESOP to be viable. This size ensures there is a sufficient base of employees to spread out the administrative costs and responsibilities of the ESOP.
20-50 Employees: Companies with 20-50 employees often find it easier to manage the costs and complexities associated with setting up and maintaining an ESOP. This size allows for better economies of scale in terms of administrative expenses and benefits distribution.
Revenue, Profitability & Costs:
Consistent Profitability: Companies that have shown consistent profitability over several years are better positioned for an EOT transition. This financial health indicates the company can manage the debt often associated with buying out the current owners' shares.
Median Profitability: Research suggests that companies with median revenues between $10 million and $50 million (US) with EBITDA between $1 million and $5 million (US) and between £5 million and £20 million (UK) with median EBITDA between £500,000 and £3 million (UK) tend to be the most successful. Companies that have lower revenues can effectively use the OET structure for a successful transition however, the ability to service the EOT costs (debt servicing, operating and EOT compliance) will be crucial to ensure ongoing success for the company.
Setup Costs: The initial setup costs for an ESOP can range from $50,000 to $100,000 in the US and between £15,000 and £40,000 in the UK. Companies need to be able to afford these initial costs without jeopardizing their financial stability. The costs for setting up and maintaining an EOT I Canada are expected to be similar.
Ongoing Costs: Annual administrative and compliance costs have ranged from $20,000 to $50,000 in the US with expectedly similar costs in the UK. Companies need to ensure they can cover these ongoing expenses to maintain the EOT effectively.
While there is no definitive minimum size for a company to be successful under an EOT transition in Canada, historical evidence that suggests that in order to be successful, in the long-term companies must have predicable sustainable revenue, a minimum profitability that can support continued profitability, the initial EOT feasibility and set-up costs, the ongoing maintenance costs for administering the EOT as well as supporting the debt costs associated with the buyout.
Before a company can transition using an EOT a feasibility study must be conducted to determine whether they are even a candidate for an EOT transition. Understanding the risks as well as the benefits will be critical to any successful EOT implementation.
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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