Proposed Employee Ownership Trusts gives owners a new way to exit their business: Stikeman lawyer

Canadian business owners may soon have a new framework for selling their companies should the federal government follow through in next Tuesday’s budget on its interest in employee ownership trusts, which allow leveraged buyouts by employees that come with tax benefits.

Employee ownership trusts “may soon become an additional avenue for Canadian business owners looking to sell their enterprises,” says Michael Decicco, a mergers and acquisitions lawyer in Stikeman Elliott LLP’s Toronto office.

He adds that many founders of a business don’t necessarily want to sell to a competitor or private equity and think that having the option to sell to employees would preserve the company’s legacy and better ensure that jobs aren’t lost.

Often, these employees have been loyal to the employer and the business for years, so selling the company to staff is a way to transfer ownership and preserve the status quo, Decicco says. Giving employees this empowerment “is appealing to lots of people who have spent a lot of their lives building a business.” 

An independent appraiser is retained in these transactions to establish a fair market value for the sold business.

The benefits of employee ownership trusts

A recent Stikeman blog post suggests that 500 to 700 small to medium-sized businesses could be sold using an EOT structure in the first eight years. That could create up to $9 billion in wealth for up to 114,000 Canadian workers.

The federal government initially expressed interest in exploring EOTs in its 2021 budget and, the following year, committed to finalizing the development of rules regulating their creation.

More recently, the Canadian Employee Ownership Coalition, a non-partisan group of leaders in Canada’s academic, banking, business, and non-profit sectors, called on the federal government to create a tax-advantageous framework for EOTs in its 2023 budget expected on March 28, 2023.

EOTs exist in the United States and the United Kingdom. The framework south of the border has enabled 14 million participants across 6,000-plus businesses to hold a combined US$1.6 trillion in wealth. In the UK, over 730 companies employing over 90,000 have used an EOT structure.

For employees, EOTs can lead to more wealth. Studies have shown employee-owners have nine percent more wealth and 33 percent higher median wage income than their counterparts at non-employee-owned enterprises. EOTs can also improve job stability during a crisis and provide insulation from economic cycles. Studies show that employee-owned businesses retain jobs at a 4 to 1 rate compared to non-employee-owned businesses.

There are also benefits to lenders, Decicco says, as EOTs can provide lenders with solid returns on their capital with attractive debt coverage. In addition, EOTs can improve environmental, social, and corporate governance (ESG) metrics for those investors who want to invest responsibly.

He points to organizations such as the Healthcare of Ontario Pension Plan and Canadian non-profit Social Capital Partners. They helped finance an EOT structure that enabled staff of U.S.-based Taylor Guitars to buy the company founded by Bob Taylor and Kurt Listug 48 years ago. The employees borrowed money from HOOP, Social Capital Partners and the owners, which they used to buy the company. The company profits are then used to repay the loan.

The social good of employee ownership trusts

Decicco points out that, in many cases, businesses owned through an EOT structure have significantly outperformed their counterparts in employee retention. Such resilient companies and high-quality jobs attributed to EOTs can positively affect the “social” criterion in ESG, which measures a business’s relationship with various stakeholders, including its employees.

The lack of a dedicated trust vehicle under the current tax regime in Canada is the primary obstacle to creating EOTs, Decicco says. But the government’s interest in EOTs has grown over the last several years, even if it loses some of the tax revenue.

Decicco says that while it is true that the government may lose business tax revenue, an EOT can not only keep well-paying jobs in Canada, but it can also regain revenue from the personal taxes of employees. They’ll not only have wages but dividends from the business’s earnings. And the tax rate on personal taxes is higher than the taxes on businesses. 

“The government might not make it all back in one shot, but they’ll make it over time.”

How EOTs work

Typically, the creation of EOTs in jurisdictions which have them involves four steps: 

• A trust is formed, and the employees of the target business are made beneficiaries of the trust; 
• Debt financing is arranged to finance the purchase of shares of the target business by the trust; 
• The trustees of the trust negotiate the terms and conditions relating to the purchase of the shares of the target business; and
• The trust repays the debt over time using the earnings from the business.

In the U.S., to create an employee stock ownership plan, or ESOP, a company establishes a trust fund to finance a sale in one of two ways.

In non-leveraged situations, the company will contribute newly issued shares or cash to the trust to purchase existing company shares at no more than fair market value. In leveraged U.S. ESOPs, the trust will take out a loan to buy new or existing company shares while the company makes annual contributions to the trust to repay the loan. 

U.S. ESOPs come with various tax advantages. In the case of non-leveraged trusts, a company’s contribution of shares to the trust is tax-deductible. For leveraged transactions, a company can make tax-deductible contributions to enable the trust to repay the loan. 

In the case of UK EOTs, employees do not directly own shares of their employer firms but rather are beneficiaries of a trust that holds a controlling interest in their employer. The company can then provide annual distributions to participating employees from profits.

Business owners in the United Kingdom can benefit from significant tax breaks through UK EOTs. For example, founding sellers will be exempt from capital gains tax on selling qualifying shares to the trust. Sellers and their heirs will also be exempt from inheritance tax on this transfer of shares. For employees, UK’s EOT rules allow qualifying companies to pay each employee an annual tax-free distribution of £3,600.

Decicco says he is not sure what details will be released on EOTs on Tuesday and, if they are, whether it will follow the U.S. model or the one in the UK.