Should I sell my business to an employee ownership trust (EOT)?
Traditional retirement routes may not be the optimal choice for every business owner. Passing the reins to a family member is not always appropriate, and selling to an external buyer can jeopardize the future of the business and its employees. Fortunately, a new avenue has recently become available in Canada that could provide a welcome alternative: employee ownership trusts.
EOTs are gaining traction as a viable exit strategy for business owners in Canada. Modelled after similar frameworks in the U.S. and the U.K., EOTs allow owners to sell their businesses to their employees without the employees having to pay out of pocket. This unique mechanism facilitates succession while benefiting employees and preserving the company’s legacy.
If you’re thinking of stepping away from your business in the near future, transitioning ownership to an employee ownership trust might be the solution you’ve been waiting for. To help determine whether EOTs are right for your business, we need to look at the eligibility requirements, the feasibility of implementation and how EOTs compare to more traditional exit strategies.
What Is an Employee Ownership Trust?
An Employee Ownership Trust is a special type of trust set up to hold a controlling stake in a company on behalf of its employees. Unlike traditional employee share ownership plans, where employees hold shares directly, an EOT holds the shares collectively for the benefit of all employees. This means employees become beneficiaries of the trust, sharing in the profits and success of the company without having to pay out of pocket or deal with the complexities of individual share ownership.
Rules and Requirements for Establishing an EOT
The first step in determining whether an EOT is a viable exit strategy for your company is understanding the eligibility requirements. Certain conditions must be met to transfer business ownership to an EOT. These criteria are designed to ensure that the trust operates in the employees’ best interests and maintains the integrity of the employee ownership structure.
BUSINESS:
• The business must be a Canadian-controlled private corporation (CCPC), where all or substantially all of its fair market value (FMV) is derived from assets used in active businesses conducted in Canada
• The business cannot operate as a partner in a partnership
• No more than 40% of the company’s directors can own 50% or more of the company’s debt or FMV of any class of shares before the trust gains control
BUSINESS TRANSFER:
• The EOT must acquire a controlling interest – more than 50% – in one or more qualifying businesses
• Throughout the 24 months prior to the transfer, the shares must have been owned exclusively by the seller or related persons
• The seller (or their spouse/common-law partner) must have been actively engaged in the business on a regular and continuous basis for at least 24 months before the transfer
• After the EOT assumes control, the business must deal at arm’s length with any previous majority owners, meaning there should be no significant ongoing influence or control by former owners
TRUST:
• The EOT must be an irrevocable trust resident in Canada
• It must be exclusively for the benefit of the employees of the business
• Substantially all (90% or more) of the FMV of the EOT’s property must be attributable to shares of qualifying businesses that the trust directly or indirectly controls
• Certain transactions, such as changes to the EOT’s property, must be approved by more than 50% of current beneficiaries
• Distributions to beneficiaries can only be determined using a reasonable and equitable method based only on factors such as length of service, remuneration, and hours worked
• The EOT is prohibited from distributing shares of the qualifying business directly to individual beneficiaries
TRUSTEES:
• Must be Canadian residents
• Trustees must have equal voting rights
• Individuals who held a significant economic interest in the business prior to its sale to the EOT are subject to limitations regarding their involvement as trustees
• At least one-third of the trustees must be beneficiaries who are current employees
BENEFICIARIES:
• Must be current employees, or certain former employees, of the qualifying business
• Should not own 10% or more of any class of shares directly or indirectly, nor should they, together with related persons, own 50% or more
• All qualifying employees must be beneficiaries of the EOT
EXCLUDED BENEFICIARIES:
• Employees under the age of 18
• Probationary Employees – Employees who have not yet completed a reasonable probationary period, not exceeding 12 months
• Significant Owners – Employees who directly or indirectly hold 10% or more of any class of shares of the company
• Major Shareholders – Employees who, alone or with related persons or partnerships, own 50% or more of any class of shares
• Vendor Group Members – Individuals who owned 50% or more of the FMV of all shares or debts of the qualifying business before its sale to the EOT
These requirements ensure that EOTs align with their purpose of promoting broad employee ownership while maintaining compliance with tax regulations. To navigate these provisions effectively, it is recommended to consult tax professionals or legal advisors for further details. Understanding the various requirements is vital to structuring the EOT correctly and ensuring compliance with the law.
Advantages of EOTs Over Traditional Sale of Shares
Employee ownership trusts offer several advantages over selling your business to a third party. From tax incentives to enhanced productivity, here are the main benefits of transitioning ownership of your business to an EOT:
Tax Benefits – Selling to an EOT can provide significant tax advantages, including an extension to the capital gains reserve, an exception to the 21-year rule and a greatly increased shareholder loan repayment period. Perhaps most significantly, for qualifying share dispositions between January 1, 2024, and December 31, 2026, the government is offering a temporary tax exemption for the first $10 million in capital gains.
Preservation of Legacy and Vision – A key concern for many business owners is maintaining the company’s culture and values after their departure. Selling to an external party often leads to changes that can disrupt what makes the business successful. With an EOT, the company remains in the hands of those who understand and value its history and ethos, ensuring continuity and preservation of the founder’s vision.
Enhanced Employee Engagement – When employees have a stake in the company’s success, it naturally fosters a greater sense of ownership and responsibility. This can lead to increased motivation, higher productivity, and improved retention rates. Employees are more likely to go the extra mile when they directly benefit from the company’s performance.
Long-Term Sustainability – Employee-owned businesses often take a longer-term view in decision-making. Without external shareholders demanding short-term returns, these businesses can prioritize sustainable growth, employee well-being, and community impact. This approach not only benefits the employees but can also enhance the company’s reputation and relationships with customers and partners.
Smooth Transition – EOTs provide a straightforward and structured approach to succession planning. By transferring ownership to a trust, business owners can avoid the complexities and uncertainties associated with traditional sales. This can make the transition smoother and more predictable.
Drawbacks of Employee Ownership Trusts
EOTs certainly provide some significant benefits, but they are not without their downsides. Here are some considerations for owners choosing between employee ownership and a traditional sale of shares:
Financial Viability – A key consideration for owners looking to sell their business to an EOT is their current and future financial needs. In an arms-length sale, the seller receives an upfront payment at the time of the transaction. When a business is sold to an EOT, however, the proceeds from the sale may be paid to the seller over a period of many years (depending on the financing structure). This creates greater risk, as the company must remain financially healthy to support the repayment obligations and benefit the employees.
Costs and Complexities – Another prohibitive factor is the costs and complexities associated with EOT setup and governance. Smaller businesses (25 employees or less) may struggle with the financial implications of establishing an EOT, with higher upfront costs for legal and financial advice. As EOT transactions are generally paid for through debt, they may also not be suitable for struggling companies or those with weak profit margins. Businesses that lack a healthy, consistent cash flow with strong financial projections may struggle to obtain financing or generate the funds needed to pay back the purchase debt.
Loss of Control – By transferring ownership to an EOT, business owners relinquish control over the company. The trustees of the EOT make decisions on behalf of the employees, which can lead to conflicts of interest or differences in opinion between the former owners and the trustees.
Employee Management – While EOTs can boost employee morale and engagement, they do not necessarily ensure that employees have the expertise or experience to manage the business effectively. This could lead to a decline in performance or failure to meet targets.
Regulatory Compliance – Maintaining compliance with the specific requirements for EOTs can be demanding. Regular reporting and adherence to CRA regulations are necessary to retain the tax-advantaged status of the trust.
Governance – Effective governance is crucial for the success of an EOT. Trustees must act in the best interests of the employee beneficiaries, which can be challenging if there are conflicting interests or a lack of clear governance structures. Ensuring transparency and accountability in decision-making processes is essential to maintaining trust and alignment with the EOT’s objectives.
Valuation Challenges – A certified business valuator must ascertain the FMV when selling a business to an EOT. This means that the value of shares sold to an EOT may be lower than what could be achieved through a traditional sale to a strategic buyer.
Is an EOT Right for Your Business?
Now that you’ve determined your company’s eligibility and understand the pros and cons of EOTs, the final step is to evaluate whether this structure aligns with your business goals, succession planning objectives, and employee interests.
Business Size and Structure – EOTs are well-suited for small-to-medium-sized enterprises with stable financial performance and a committed employee base. Businesses with consistent earnings and sufficient cash flow are better positioned to support the debt financing required for the EOT to purchase shares.
Business Suitability – EOTs may not be suitable for all types of businesses. Companies that rely heavily on the expertise of a single individual or require significant investment for growth may struggle to thrive under an EOT structure.
Succession Goals – If preserving your company’s legacy and ensuring its ongoing success under the stewardship of your employees is a priority, an EOT can be an excellent choice. It allows you to exit the business while leaving it in the hands of those who are invested in its future.
Employee Readiness and Interest – For an EOT to be successful, your employees need to be willing and able to take on the responsibilities of ownership. Assessing their interest and readiness is crucial. Employee engagement initiatives and open communication can help gauge their enthusiasm for such a transition.
Financial Considerations – It’s essential to evaluate the economic implications of an EOT. The funding structure typically involves debt repayment through future profits, which could impact the company’s cash flow. Working with financial advisors to model the impact on the business and ensure sustainability is essential.
To help assess whether an EOT is the right exit strategy for your business, try answering the following critical questions:
• Considering market conditions and business performance, is the timing right for transitioning ownership to an EOT?
• Does the business have sufficient profitability and cash flow to support the financing of an EOT?
• Are you in a financial position to accept deferred payments over time instead of an immediate lump-sum payout?
• Are you ready to relinquish full control of the business?
• Is preserving your company’s culture and legacy a priority?
• Do you want to give your employees a stake in the company’s success?
• Do your employees have the interest, capability, and motivation to take on ownership?
If you can answer ‘Yes’ to these questions, then transitioning your business to an Employee Ownership Trust might be the right exit strategy for you. At this stage, it is critical to engage with legal, financial, and tax professionals who have experience with EOTs. They can help you understand the implications, benefits, and potential challenges specific to your situation.
Final Thoughts
Employee Ownership Trusts present a compelling exit strategy for business owners seeking to preserve their legacy, reward their employees, and ensure the long-term success of their companies. By aligning the interests of employees with the future of the business, EOTs can foster a thriving, sustainable enterprise.
However, implementing an EOT requires careful planning and adherence to specific legal and tax requirements. It’s crucial to consult with legal, financial, and tax professionals to navigate the complexities and tailor the approach to your unique situation.
As you consider your succession options, an EOT might be the right path to achieving your goals and securing your business’s future.
This article was written by the NVS Professional Corporation team, your knowledgeable Barrie and Markham accountants. The content is intended as a general guide for informational purposes only. For specialist advice tailored to your specific situation, please reach out to our expert team.
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