The route to Employee Ownership is a single-track road
Every business can chart the journey it has taken to its success. Of course, that path is also not always smooth. In this insight I want to share with you my experience of transitioning Business Computer Solutions Limited (BCS) to being an employee owned business.
It is critical thinking that allows us to understand the importance of the decisions we make when we choose to handover our businesses to the employees.
Typically business owners consider their business exit to be the destination or end game, but I believe that Employee Ownership (EO) will only be successful if you consider it to be a step along the way towards a future destination. I would like you to consider transition to be more like a road trip on a single-track road. You may not always be the driver, but you will still be invested in the success of the journey.
Although ‘exit plans’ had been discussed in casual terms, the decision to transition BCS to EO was properly given consideration in 2015 when we joined a peer group and understood we had built a business of real tangible value. It was June 2018 we handed over the reins, so the timing of writing this article is just after the company completed its second whole trading year without the founder’s regular input. This feels like the right time to share with you the thought process and considerations we undertook.
At the end of this insight I will leave you an exercise to undertake should you be considering this type of future for your business.
So here is the nine to five of employee ownership.
Nine reasons why Employee Ownership is the best way to exit your business.
- Your timing – With a regular trade sale of a business you may need to be ‘for sale’ for many months or even years before you find a suitable buyer who is willing to offer you the sum you require. With EO, you are in control. Therefore, it is typically referred to as transitioning to EO rather than selling to EO.
- Your price – When you are preparing for a trade sale, you invest efforts into polishing your business so it looks pretty for any prospective buyer. This allows you to market the business at an inflated price in readiness for any prospective buyer to try and knock the price down. That dance doesn’t exist with EO as you can sell at any price up to the professional valuation you will need to commission. We used Kreston Reeves for this service as they have a forensic accounting and valuation department to provide us a valuation. They arrived at the valuation by taking an average of 5.5x the EBITDA (earnings before interest, taxation, depreciation and amortisation) and 60% of the revenue. To this they added the balance sheet value. One word of warning on valuations, a telecoms company may be willing to pay over the odds to buy an IT company because it’s a sector they want to get into. This type of strategic value to the trade buyer won’t be factored into your current business valuation.
- Your legacy – I was chatting to a long-term business acquaintance of mine about EO and he said he favoured this exit because it has the ‘warm and fuzzy feeling’ and I fully understand what he meant. You worked hard to create your business and everything it stands for. It’s great to know that your company can continue for future generations.
- Preservation of company culture – You have worked hard to ensure that your whole team have shared values, goals, attitudes and practices. It is what has brought your business success. With a trade sale, your team will be absorbed into the buyer’s company culture. It could look on paper to be similar, but until the companies are one organisation you won’t really see how aligned the buyer and your business is. With EO there is no need to adjust as your culture will remain ‘business as usual’.
- Preservation of customer and supplier relationships – Over time you build positive emotional equity within the relationships you have with both customers and suppliers. They know and like to work with you. Obviously if you are still as principal in operational roles you may need to gently handover these relationships to your team. That was part of what I needed to do in the 3-year run up to our transition to EO. With enough planning, during the transition to EO there are no bumps in the road to impact these relationships.
- Tax advantage – This is typically a headline for most people considering EO. A man called Graeme Nuttall of Field Fisher conducted an independent review of employee ownership for the UK government in 2012 which produced an informative report called Sharing success: the Nuttall review of employee ownership that detailed the advantages of Employee Ownership over its traditional principal owned alternative. The government in support of Graeme’s recommendations now allows full tax relief to businesses transitioning control of their companies to their employees via an approved EO scheme.
- EO companies perform – The report from Graeme Nuttall that I mentioned above also summarises that EO companies typically outperform their traditional principal owned businesses. By outperforming, we are talking about their new authority leading to increased profitability, increased revenue growth and more dynamic decision making.
- Reward long term staff – Your business has a value today and that is likely to be not only down to your blood, sweat and tears, but also from your loyal employees. This type of exit allows you to reward those with the gift of ownership without them needing to mortgage their homes to buy you out. This also ensures that your business remains a place in which the employees feel their continued commitment is valued thus reducing the interruption of staff churn. There is a tax advantage for the employees too as since 2014, they can each earn up to £3,600 per annum of dividends tax free.
- Smooth transition for all – In summary, EO transition isn’t full of scary unknowns for your employees, customers and suppliers. In fact, it isn’t scary for your new business prospects either so all that work you have put into your marketing will still bring value to your sales efforts.
Five reasons why Employee Ownership may be the worst thing you can do.
- Your risk – There are finance sources to support EO transitions, but typically they will lend no more than about 2x the EBITDA as ‘Senior Lending’. As such, this could give you a lump of money to leave with but also leaves your company with a finance agreement to service that they didn’t have before you left. Plus of course, there will still be the balance of the value to settle as non-preferential ‘Junior Lending’. For our exit we chose to lend the trust all the money they needed to buy out the founders and provide them with operational cashflow. As such, on day one it was all our risk. Two years in, the trust has repaid about 25% of the debt.
- Delayed access to your proceeds – Friends who having sold their businesses via traditional trade sales have wanted to draw out the money to look at it as one pile. This type of exit won’t provide an answer for that desire. In the case of the founders of BCS, we see a monthly pulse of money coming in and it may take up to 8 years to conclude. Fortunately, we are good at investing so will put the money to good use as it arrives to our bank, but we will never be able to go and buy a Ferrari from our current account balance.
- Weak processes will hurt – If the service you deliver to your customers today is inconsistent, it will typically be down to a lack of formal process or worse, good process that is not being followed. When you transition to employee ownership, what will be left behind. If you don’t have processes, you need to create them with your teams and ensure everyone knows why they should be followed. In fact, this is best practice for any business even if you are not considering transition to EO.
- Weak leadership will lead to failure – Businesses thrive when they have all the right people in the right roles doing the right jobs to the right standard. Anything less will deliver a suboptimal outcome. So, the leadership at the top. The managing director and their direct top level leadership will be the foundation of this type of business transition succeeding. I often talk about there being four key roles in any business. One person has responsibility for getting work (marketing, sales, customer journey), one person looking after doing work (delivery of your service) and one person ensuing that you are getting paid for what you deliver. Sales, Service and Finance. The final person in this top-level team is the Managing Director who is there to provide and maintain the vision of the company. In essence the glue that holds the rest of the leadership team together. It is not a deal breaker, but if today as the business owner you are in one or more of these roles, part of an essential plan would be to replace yourself building out the skills in those that you will leave behind.
- Can you let go? – This is the toughest one. For most business owners it has been their life for many years. For you to transition your business to the employees means understanding how ‘they’ do it may be different to how you would have done it. It’s hard to let the employees make mistakes that you once made without stepping in.
So now having listed nine reasons why employee ownership is brilliant and five reasons it may not be right for you, the next section details my learning during the three years leading to and the two years since we transitioned BCS to employee ownership. These all feature as considerations, with some more important than others but all things I would have been better off for knowing they were hurdles I needed to jump or walls I needed to scale.
Things to consider when transitioning to Employee Ownership
- Valuation – You can’t just make up a number for the value you wish to sell your business to the employees for. Well, I say that but it’s not strictly true. You can make up a number, but it can’t exceed the value of your business in a normal trade sale. It is better to use an independent valuation agent rather than a business sale agent for this process because you are not looking to sell the business. I was quoted between £3K and £5K to value a business of our size. I needed to do an amount of work to round up all the details they needed for their due diligence, but this is much less arduous than a regular trade sale. They are working to get to the right number, where in a trade sale, the buyer’s due diligence is just looking to reduce the number hence why a business sale agent will always come up with a larger sales price knowing there will be negotiation. As mentioned earlier, your business valuation will be made up of the future trade opportunity (normally as a multiplier of your EBITDA) and the value on the balance sheet from what you have retained from previous trade.
- Tax office approval – You will need a letter from HMRC to say that they approve of your employee ownership scheme. We are still quite early in this type of business transition and HMRC will reject schemes that are not in the spirit of the Employee Ownership. Our accountant, Mark Batchelor of Batchelor Coop in Eastry, sent copies of our trust documentation to the tax office to ask for approval and we were rewarded with the letter that proves that we were then entitled to 100% capital gain relief on the sale proceeds. This process took forever to complete, partially due to the HMRC workload with limited staff resources but also because we couldn’t make the application until we were a long way towards having everything lined up.
- Trust company – BCS used the vehicle of an indirect trust which means that the shares for the company are not directly owned by the employees, but by the nature of them being employed by the company and past their initial probation period means they become ‘owners’ within the trust company. As such, you may need to set-up a trust company to manage the ownership. Again, your accountant will be the best person to help you with this step.
- Managing director and the leadership team – Employee owner businesses are not actually run by the employees. The business decisions will continue to be made by the leadership team working with the Managing Director. The team will need to understand this responsibility. As I mentioned earlier, the Managing Director is there to provide the vision and hold the team to account to delivered against that vision. During our planning for transition we started by trying to build a ‘committee’ based structure to run the business by consensus but quickly learned that would be fraught with a new tension that was not needed in the mix. Finding a replacement Managing Director was achieved from within leadership, but if you don’t have someone in mind you may need to recruit and this could form the timeline for your transition. The other important consideration is your need to become more intentional in your training and development of the leadership team.
- EO council – I just mentioned that decisions are made by the leadership team, but to ensure the employees have a voice you will need to create one or more employee council positions depending on the size of your employee group. The usual process is that some employees will volunteer to stand for an election and the balance of the staff will vote for their favourite. Their role is to ensure that the voice of the employees is heard at the leadership level. In the case of BCS’s model, the employee council meets with the staff throughout the quarter and then attends the quarterly strategy setting meetings. Their involvement is essential to taking everyone along on the same journey.
- The need for a chairman – Both your leadership team and the employee trust will need a chairman. I fill both these roles for BCS. So, the question here is could you put aside your personal views from when you were the owner and be a non-executive director? I have taken to this very easily because I was already heading into my new existence as an executive coach anyway and BCS are just one of my customers, but I could see this being a massive problem for owners who can’t create the demarcation.
- Replacing you and transitioning customer and supplier relationships – So far, I have written a lot about employees, but a massive consideration is also how your customers and suppliers will receive the news that the employees are taking over. Again, don’t go into this lightly but deliberately with positive intention. I spent a few months having lunches with our long-term customers and suppliers explaining what we were planning and why they didn’t need to worry. The void you would create by not being intentional will be filled with their worries and you don’t want or need that. Make sure you include your business professionals in this process such as your accountant, solicitor and bank manager.
- Play book – Think of this as a ‘user manual’. You need to define the areas of responsibility and accountability for all employees, the leadership team and the board of trustees. For example, during the period of your ‘earn out’ you probably don’t want the staff to award themselves 200% pay rises or excessive bonuses. This is the type of content you want to record in an easy to consume handbook.
- Financing exit options – As I mentioned previously about risk, it is possible for your company to borrow money to pay you some of what you value the business at. Typically, not much more than 2x the company EBITDA. Our valuation was about 5x the EBITDA and the three founders of BCS decided to lend the trust all the money rather than push them into taking third party finance. Third party finance can also be hard to obtain especially without expecting employees to give personal guarantees. Of course, that means the ex-founders still carry all the risk, but it also gave a clear message to the team that we believe in this way of protecting our legacy too. Our loan to the trustees of BCS was interest free for the first 4 years too, but you can if you prefer apply a reasonable interest value from day one.
- Stamp duty – This was one that surprised me, but the transition to employee ownership is still considered to be a sale and as such will attract a stamp duty, but fortunately it’s only 0.5%. The company as the ‘buyer’ can, like all the rest of the accountancy, valuation and legal costs, pay this stamp duty too. It doesn’t need to come from your agreed transition or sale value.
- EO association resources – It pleases me to be able to share in this document a link to the Employee Ownership Association. When I set out on this journey, I didn’t even know these people existed and they were ever so helpful in introducing us to companies in the same sector as us who had already made the leap. Through attending their annual conference and regional meetings I was also able to cover some of the gaps in my knowledge in the run up to the exit. Additionally, this bodies use doesn’t stop at the transition. BCS continues to be a member and the Employee Ownership council representatives now get involved in the events and training that the association provides.
- Bank account and available funds – Your business needs cashflow so don’t assume that everything that’s in the bank account today can be yours tomorrow as you transition. You will need to work out how much money the business needs to be able to trade both today and for at least the next 12 months or normal operation. For example, if BCS grows it’s revenue by 10% per annum, we know it will need 1/12 of that for monthly cash flow. So, looking for 10% growth on £1.5M means an extra £150,000 of revenue, which requires an extra £12,500 of monthly cashflow. Your sums will be based on your own business debtor days and if it is your assumption that you intend to get more customers like the ones you already serve. Through the success of Employee Ownership, BCS has grown it’s revenue by about a third since it was valued and every year, additional headroom is added to the cashflow before making payments to the trust’s loans. As a founder I was always ready to lend the company additional cashflow when needed so you need to factor that your employees are unlikely to have the capital reserve or be willing to act as the banker.
- What if they fail? – I outlined this earlier as a risk and it is the biggest one. If your business fails once it’s handed over to the employees will it be catastrophic for your own legacy plan? If so, my advice would be don’t do it. Continue working on reducing your risks or if you want to get out of your business now, take the smaller amount of cash from a trade sale and run. With that said, it was still right for us, so we transitioned our business to employee ownership taking several safety measures. Firstly, in the run up to exiting the business we increased our salaries and privately invested that money wisely. For us, that was rental property but others may prefer higher risk options such as stocks and shares. Then secondly, we put a mortgage charge on the main asset of BCS, the office building. This charge will only be released when the employee trust finish paying the loan that we provided to them but this only secures 30% of the loan. It is therefore the last 30% that is secured. If BCS fails, our legacy will of course be different but it won’t be catastrophic. We will still be able to eat.
- Solicitor will have to be a specialist – Don’t assume that your local small-town solicitor will be able to advise you on your transition. This is a specialist field at this time, so consider using someone who has done this before. For us, we used our accountant as the ‘Project Manager’ of this process and he hired in the solicitor for the few specialist bits that he couldn’t do. We just used a local solicitor when it came to getting someone to watch us sign paperwork.
- Direct v Indirect – There are different models of employee ownership, but in all cases for them to be seen by HMRC as employee ownership, control needs to be passed into the hands of the employees. Well, greater than 50% of the ownership of the company. With a direct model you would allocate the shares out to individual members of staff much like a traditional company. With direct shareholding you can choose to create larger share holdings for significant members of the team you wish to retain. This is not without its risk because leavers of your company still own the shares and you would need to value them and buy back. We chose the indirect model because of its ease of administration for new starters and leavers who automatically lose their shares (following a reducing legacy interest over time). The trust company I mentioned previously is designed to act as the vehicle to look after the needs and rights of the staff. One last point under this, we could have given 51% of the shares to the staff and retained 49% as the founders. This would have still qualified as employee owned and been tax advantageous but it has a few disadvantages.
- You will have lost control of your business and would need to understand how limited your power to veto decisions is once that has taken place. Would you be able to resit the urge to meddle?
- You only get tax relief on your first tranche of shares being sold. The rest, when you are ready to part with more of your interest in the company would, I believe, be at regular capital gain rates as you may not qualify for entrepreneur’s relief.
- The employees may not ‘feel’ their ownership when 49p from every £1 of profit is still going in your pocket. As such, all of the positivity that should build in the team may be hampered by an understanding that you are still taking a very large slice of the pie.
- Staff understanding – You will need to put the work in to get your employees to understand what this is all about and not be either confused or frightened by the future you are laying out in front of them. I recommend you conduct both formal training and invest your time heavily into your employee ownership council members so they can do some of the legwork on this for you. If you don’t do well at this your employees will make up their own mind about how this will impact them and that could result in people leaving that you really value as part of the ongoing business. If they have nothing to be worried about, tell them.
- Open finances – Every company owner not only has a right to see the finances of their company but should be encouraged to see them. That said, at BCS we made it a condition that before they would gain access to financial data, they would also attend a training session to help them understand what they were looking at. The level of training needs to be tailored to the existing level of understanding, but it opens the doors to some great conversations and helps everyone understand why control of finances is critical to business success. Just telling employees not to leave the lights on is not as powerful as showing them how much we pay for electric and its impact on their bottom-line profitability and annual dividends.
- Open pay structures – It’s not unusual for small businesses to have no formal pay structure. Employers ‘get away’ with paying as little as they can and pay rises are driven by the employee arriving with their cap in their hand asking for some more. Because of the open finances it also means that pay needs to be structured too. I don’t mean that everyone should be paid the same. I mean that everyone should be paid what they are worth. This may take you a few years to create a system and bring everyone into alignment. I do quite a lot of work with my coaching clients around separating the salary for the job role and the employee’s performance in their role. This is the fairest way in an employee ownership setting too.
- What do you do next? – This one is massive so I left it to last in this list but it needs to go at the top of your list. If you are like me, building your business was a massive part of your life. You really do need to have a plan of what you will fill your time with. We have not called our exit ‘retirement’ but instead told our friends we are on holiday. A kind of gap year for grown-ups. In the future you could start another business else schools and charities are always grateful for the input of successful business owners. What’s important is that you give some thought to your purpose before you close the door on this chapter of your life. For me, I now fill my time and my mind with coaching work, helping to guide others through challenges in their businesses.
Exercise – So now it’s your turn to do some thinking. Are you ready to consider a commitment to transition to employee ownership? Here are the questions you need to find answers for.
- Consider your leadership team. Are they ready to step up to this responsibility?
- Are you ready to step out and what will you do once you have left your business?
- If your exit is to leave you financially independent, do you know how much money you need between now and when you expect to leave this life? And how much of that you already have amassed in your savings and investments?
- Find out the EBITDA multiplier for your sector and size. What is your business worth today? Does this exceed what you need to exit from step 3? If not, work towards building value in both your personal investments and your business.
This insight has given me chance to show you a photo Samantha took whilst we were recently on a motorhome tour of the North Coast 500 in the Highlands of Scotland. Stopping to take this photograph was also not the end of the journey, but just a step along the way. Think like that about your transition to Employee Ownership and that it is not the end of the road. Handled well, nobody needs to leave the tour. I remain passionate about the immense value of Employee Ownership and would be pleased to help and advise anyone who is considering starting out on their journey.