Employee Ownership Trusts: What They Mean for Canadian Business Owners
Jon Shell is Chair of Social Capital Partners (SCP) and has been advocating to bring Employee Ownership Trusts to Canada since the release of SCP’s report Building an Employee Ownership Economy in 2020. He’s a former small business owner and co-founder of the Canadian Employee Ownership Coalition.
Employee Ownership Trusts (EOTs) are coming to Canada. This note is intended to give business owners and their advisors a simple (albeit not short) explanation about what they are, and why they should care. I’m not a lawyer or an accountant, so I’ll try to use language that I understand (and that may in some cases not be technically perfect). So, don’t take this as legal advice, but as someone trying to explain this in a way I think I would understand.
A quick point up-front: EOTs are intended for succession — a way to sell a majority of a business to a company’s employees. They don’t help with selling a minority stake in the company — there are other approaches for that, like stock option plans and share purchase programs. So, unless you’re looking to sell your business, the EOT likely isn’t for you.
However, if you are considering selling your business in the next few years, you should be aware of the EOT. Employee ownership has a long track record of being good for employees, companies and communities, and as a result the UK and US provide significant tax incentives for business owners who sell to the workers. Canada is now following suit, exempting the first $10M of capital gains from income tax for sales to EOTs. This exemption is only available until the end of 2026, so there’s good reason to look seriously at the option.
EOT-like structures are quite popular in other countries, and tax incentives are only part of the story. I’ll get into more detail about the legacy and resiliency benefits later, but here are a few stories featuring owners who have sold to their employees through this structure in the US and UK: Taylor Guitars (US), Emsworth Yacht Harbour (UK) and Craggs Energy (UK). In the US about 250 companies a year are sold to their version of the EOT, and in the UK over 300 companies have sold to their version in each of the last two years.
If you’re looking for more technical detail, I’ve added links at the end, including to the government’s own EOT explainer. If you scroll down and say to yourself “man, this is too long” feel free to skip to the end and click on one of those other links instead.
If you’re still with me, you likely have dozens of questions, so I’ll try to anticipate some of them in a Q&A format.
Why do we need this trust? Can’t I just sell my company to my employees if I want?
Yes, you can! But you’re probably not going to. There are very few companies in Canada where employees hold a majority stake. The new EOT is designed to solve the two biggest barriers to these sales: funding the transaction, and decision-making after you sell.
The first question that normally comes up when talking about employee ownership is: how are my employees going to come up with the money?
The answer, in the case of EOTs, is they don’t have to. Like the structures in the US and the UK, the purchase is funded by future company cash flow. In the simplest case, a business owner will transfer their shares to the EOT in exchange for fair market value. Instead of getting paid up front, the company agrees to pay the purchase price to the business owner over time.
For example, let’s take a company that produces $1,000,000 in after-tax cash every year, and the fair market value is $4,000,000. If the owner sells 100% of the company to the EOT, it will take four years to pay the owner back. At that point, the EOT will own the company debt-free on behalf of its employees. This is obviously a very simple example, but hopefully illustrates the point.¹ A business owner could also approach a bank to lend some of the money to pay for the shares, so they get some cash up front. For example, it’s common in the US for a bank to lend up to 50% of the transaction to the company to fund the purchase, meaning in this case the owner would get $2,000,000 up front, and an additional $2,000,000 over time, once the bank is paid off. (In this UK example, HSBC participated in the financing of a company sale to an EOT).
A trust helps by holding the shares on behalf of employees, and committing to pay the owner the purchase price over time. For a bunch of tax reasons we won’t get into here, the trusts that were available in Canada prior to the EOT don’t work well for this kind of transaction. In contrast, the EOT has been designed for this express purpose.
The trust owning the shares is also helpful for the second common barrier to selling to employees: decision making. How does it work once I sell? Do all the employees get to vote on every decision after the sale?
If you sell to an EOT, they do not. The reason why these trust models have been so popular in the US and the UK is they allow for companies to be managed the same way they’ve always been, and help with a seamless transition. EOTs are often referred to as “indirect ownership” because employees benefit from the financial success of the company without owning the shares directly. The EOT will have a Trustee Board, who will make a limited set of decisions on behalf of the employees, and the company will have a Board and a management team that will make the decisions required to run the company.
For example, if you’ve been running your businesses with a traditional structure for decades (i.e. with a President or CEO, and with different layers of management), and you’ve already identified a new management team to take over for you (or you intend to stay and keep running the company yourself), that works perfectly well with an EOT.
So, the EOT gives business owners a new alternative for selling their business, financed by the future cash flows, and in a way that limits disruption at the company as much as possible. Using a trust is helpful to make all this work, and the EOT is a new trust that’s set up specifically for this purpose.
How much of my company do I need to sell to use an EOT?
In order to qualify as an EOT, at least 51% of the company needs to be sold to it in the initial transaction. An EOT needs to be the majority shareholder of the company. In the UK, the most common percentage to sell is 100% — more than 50% of companies who have sold to an EOT in the UK have sold 100% in the initial transaction. One reason for that is that the tax incentive available to owners who sell their companies to EOTs in the UK are only available on the first transaction. So, if an owner sells 51% to an EOT up front, and then the rest over time, they won’t be eligible for the tax incentive on the remaining 49%. That will also be true in Canada — the tax incentive will only apply on the initial transactions.
As I said, if you’re looking to sell a minority of your company to your employees, the EOT is not for you.
Who am I selling to, exactly, when I sell to an EOT? My management team? Some of my employees? All of my employees?
In an EOT, you are required to sell to a trust that will hold shares on behalf of all your employees (both current and future). Today, many sales to employees in Canada are management buy-outs, where a management team will take some of their own money and buy out an owner, often with a promise to pay over time. That’s of course a perfectly legitimate succession plan, but the EOT is designed to be more inclusive.
Many owners in the US and UK have described this as one of the most attractive features of this structure: that all employees benefit, even if they don’t have the money to pay for shares. EOTs are often described as broad-based employee ownership plans, because of how widespread the benefits are for employees. Owners see this as a legacy for all the current and future employees that have contributed to their success.
This broad-based approach is also important for governments, and the reason why selling to an EOT will qualify for tax incentives. It’s been proven that these structures lead to great outcomes for employees, and keep jobs in local communities. That’s a great result for the economy and society, and as a result governments want more of them to happen. We’ll get to these incentives in more depth a bit later on.
In the Canadian EOT, once employees have fulfilled their probationary period, which can be up to one year, they will qualify as beneficiaries of the trust. Now, this doesn’t mean that everyone gets equal benefit, which we’ll get to now.
So, what rights and benefits do the employees have with the EOT?
First, benefits:
The employees are the beneficiaries of the EOT, which means if the company has enough cash to pay dividends, or if it is sold to a third party, the money goes to the employees (according to the percentage owned by an EOT. If the EOT owns 100%, they get all the money and if they own 51% they get about half, etc.).
How it gets divided between the employees is determined by a formula that is set up in the initial EOT document. Business owners and the initial trustee board will decide on this together. The formula can allocate benefits based on three different criteria, alone or in combination: wages, hours worked and the number of years worked at the company. There can also be different formulas for different events, like an annual dividend payment or a sale of the company.
For example, a common approach might be to divide dividends based on employees’ wages, and proceeds from a sale of the company based on a combination of wages and years worked for the company. So, if someone makes $50K a year, they’d get half the annual profit share of someone who makes $100K a year. But, if the company is sold and that person making $50K a year has been with the company for 30 years, they may get a lot more than someone who makes $100K but just started.
There’s any number of ways to set up these formulas — I’ve only scratched the surface here. The Canadian EOT is very flexible in terms of allocating benefits to employees, which is a great thing.
A Canadian EOT is also flexible in providing benefits as additional income (dividends) or assets (shares)⁵. This blends the UK approach, which focuses on dividends with the US approach which focuses on shares. The right answer will depend on the company and the objectives of the seller and the trustee.
You’ll want a good discussion with your accountant to work out what’s best for you and your company.
Second, rights:
While they don’t vote on every decision, employees do have important rights in an EOT.
They have representation on the Trustee Board, which has to be at least one-third employees. So, a Trustee Board of three needs at least one employee, and Board of five at least two.
The employees, through the EOT, are also the majority shareholder in the company. That means both the Trustee Board and the Company Board have a responsibility to do what’s in the best interest of the employee beneficiaries of the Trust.
While the Trustee Board and Company Board are the entities making most of the strategic and oversight decisions, employees get to decide directly on whether the business can get sold to a third party, or can sell a large division of the company to someone else. At least 50% of all employees would need to approve a transaction like this, so the company can’t be sold out from under them without their explicit permission.
In summary, the company can continue to be managed the same as it was before, but the employees now have a voice, have to be consulted if the business is going to be sold, and get to split the proceeds of any cash distributed by the company.
What about my rights as the previous owner? Can I continue to run the company if I want to?
After a sale to an EOT, the previous ownership is able to have up to 40% of the Trustee and Company Board seats of the company. So, you can’t control the Boards, but you can have a voice in decisions.
If you provided some of the funds to buy your shares by offering to get paid over time (which is considered a loan), you can get some rights related to that loan to make sure you do eventually get paid. That’s a topic you should discuss thoroughly with your accountant or lawyer.
And yes, if you’re not ready to retire, you can continue to run the company. And hopefully do a great job for your shareholder employees! You now need to report to a Board that will have employee representation, and that you won’t control. But many owners in the US continue to run their companies after selling them to employees, and are able to plan for a smooth transition over time.
How does selling to an EOT compare to selling to someone else?
For you, the business owner, there are some real legacy benefits to selling to an EOT. You’ve likely built up your company over years or even decades, and you care about the people it serves: clients, your community, your suppliers and your employees. Selling to an EOT gives you a great chance to protect your legacy by selling it to people you know and who know the mission, while increasing the chances your company stays rooted in its local community.
There is a cost, though. Instead of getting paid most of the proceeds up front, you’ll get paid out over time out of company cash flow. Because you’ll likely be providing a lot of the loan to your company to buy out your shares, you’ll want to stay connected to the company for at least as long as the loan is outstanding (generally 4–8 years, but really depends on the transaction structure); it’s not a clean break. While you’ll be selling for fair market value, you won’t be able to have a “bidding war” for your company which might have otherwise inflated the price you get. And you’ll need to engage in the complexity of designing the EOT so it works for your company.
So, there are a lot of considerations to weigh when thinking this through. But as I said earlier, it’s quite a popular option in the US and UK for owners who care deeply about their company, their community, and the legacy they leave behind.
This brings us to two key questions: what type of company works best in an EOT, and what incentives are available to help me get over some of the negatives listed here?
What companies and industries are normally appropriate for EOTs?
In the US and UK, companies from all industries and of all sizes have sold to their employees through their respective trust models. However, there are industries and sizes where it tends to be more popular. Common industries are construction, wholesale distribution, light manufacturing, retail, finance and IT consulting and professional services.
The vast majority of companies are between 25 and 250 employees when they sell, with a tiny minority larger than 1,000. At the smallest end, companies just don’t have the administrative capacity to manage an EOT structure, and there just aren’t too many privately-held companies that are bigger than a few hundred employees. This still leaves a lot of companies! There are about 150,000 companies in Canada between 25 and 250 employees, employing about five million people.
Not to discourage anyone else, but I normally say that the best candidates for EOTs are companies with strong and consistent cash flows in mature industries with a thoughtful management transition either in place, or in progress. These things lower the risk of the transaction, and help ensure that there’s sufficient cash to pay the purchase price of the company, leaving a lot of future benefit left over for a company’s employees.
Finally, it’s often less about the company, or the industry, but about the owner themselves. Business owners who sell to EOTs are generally very passionate about their companies, and very much against the idea of selling to the most common buyers, like competitors in their industry or private equity companies. They worry about losing the culture they’ve worked years to build. A lot of Canadian business owners feel this way, as shown in this survey of business owners by the Canadian Federation of Independent Business.
Here’s Nigel Schroder, CEO of Herd Group, explaining what drove their decision to sell to an EOT:
“Within our industry sector we see so many businesses being swallowed up by larger competitors or taken over by outside investors when they reach a certain size…Invariably, the original business and the culture of that business are destroyed, broken up, diluted…The people that built the original business become a number and the culture that created the success is forgotten.”
This video, by the previous owners of Taylor Guitars in the US, is representative. If these folks sound like you, this is a path worth looking into.
We’re 2,000+ words in and you haven’t discussed these incentives yet. What gives?
Milk is at the back of the store for a reason — I wanted you to read the whole article. I hope you’re not lactose-intolerant because it’s time to talk about incentives.
In both the US and the UK, governments provide a tax incentive to owners for selling to employees in the form of a reduction in capital gains taxes. They do this because they know that selling to employees is riskier, more complicated and potentially (but not always) less lucrative than selling to someone else, and they really like the social outcomes of employee ownership. For them, it’s a good trade-off.
That will be true in Canada as well. The government has announced that the first $10M in capital gains in a sale to an EOT would be tax free. So, if your sale to employees netted you a capital gain of $20M, you would only pay tax on $10M, and if your sale netted a $5M capital gain, that gain would be tax free. Assuming you’re paying the highest tax rate when you sell your company, that means you could save up to about $2.6M in taxes ($10M gain, times the highest rate (about 50%), times the inclusion rate for capital gains (50%)). ²
This incentive is less generous than the UK, where the entire capital gain from a sale to an EOT is tax free, and the US, where an owner can eventually eliminate their capital gains tax (it’s the US, so it’s complicated). But, it is still attractive, and will hopefully encourage many Canadian business owners to overcome the challenges of an EOT transaction.
Importantly, the tax incentive is only available for sales to EOTs that happen before December 31, 2026. We hope this deadline will be extended, but if you’re interested in this and the tax incentive is important to you, my advice is to move as quickly as you can.³⁴
In addition, if you sell to an EOT you will be able to take your capital gain over a 10 year period, as long as it matches when your loan to the company is repaid, and as long as it’s at least 10% a year. (For example, if you sell for $10M, and are repaid $1M a year, you can claim only $1M each year). The business advisors we’ve talked to do not see this as a very meaningful benefit, but for some it might be helpful.
You haven’t talked about other kinds of employee ownership, like co-ops or employee holding companies? How does the EOT compare?
A worker co-op can be a great answer for an owner looking to sell to their employees, and there are about 500 of them in Canada today, employing about 6,000 people, according to Statistics Canada. The decision here is really about what works for your specific company. Most worker co-ops operate democratically, giving employees a lot of say on how the company is run. That works for some, but doesn’t work for everyone. The EOT is designed to provide an option for business owners who don’t think a co-op is best for them, but you should explore all your options. You can find out more at the Canadian Worker Co-Operative Federation website. The tax incentive for EOTs will also be available for sales to worker co-ops.
Employee holding companies can actually do a lot of what I described in this article. They can take on the loan from the business owner in exchange for the shares, and they can house the shares for employees. They’re also more flexible in some ways — you can sell less than 51% to an employee hold company.
There are a couple main reasons to choose an EOT over an employee holding company. The first is the capital gains tax incentive. With the holding company, there are no rules around a broad distribution of shares, or required employee voice, so the government won’t provide incentives for selling that way. The EOT’s incentive would not be applied to a sale to a holding company.
The second is that there can be a lot more decisions involve in a holding company. How will employees get shares? How will they vote those shares? What happens if and when a small number of employees gain the majority of shares, and have control? The trust model, through an EOT, limits these decisions to a more manageable number, and protects against any small group of employees from exercising too much control.
There’s nothing wrong with either a co-op or an employee holding company, but there are differences that you should go through in detail with your advisor.
OK — I’m still with you and I like it. What do I do now?
In the UK, sales to EOTs are often completed with the help of a company’s accountants and tax lawyers. Some firms have developed specific expertise. We’re seeing new advisors in Canada start to organize around serving this market: consultants, financial advisors, lawyers and accountants. If you write to me, I can give you some names, and I’ve included below a number of links to articles written by people who are becoming experts in this space.
I’m sure I’ve left a lot of questions unanswered, but hopefully some of the links below get into the details you need, and if not feel free to write me (I’m accessible, if not speedy, on LinkedIn). We don’t do any advisory work in this space, so any advice we give is both free and also non-expert. We can probably direct you to the right place.
Bringing EOTs to Canada has been a labour of love for a lot of people over the last few years. We’re deeply grateful to the government for establishing the policies we need for employee ownership to flourish here. Now that it’s real we can’t wait to see the community pick the idea up and run with it. It’s going to be an exciting few years. Let’s go!
¹ There are lots of complexities that make it unlikely for things to work out this smoothly, like the terms of the loan from the seller, potential investment needs of the company, etc. You’ll want to model the payback thoroughly with your advisors in a way that balances paying back the loan with the resiliency of the company.
² If the capital gains tax inclusion rate increases to 67%, the potential savings increases to $3.3M
³ The legislation establishing the incentive has been introduced in the House of Commons, and will likely to pass prior to the end of June. We’ve discussed with many political and tax experts, and all agree that there’s a very negligible risk that it won’t pass, as it would mean the government would fall, and it’s OK to start planning now. As with all things in this article, discuss with your advisor first.
⁴ There are restrictions to the tax incentive that you will want to discuss with your advisor. Companies are not eligible for the incentive — i.e. a company divesting a division to an EOT will not be eligible. The incentive is available on a per-transaction basis, and not an individual shareholder basis, so shareholders will need to split the incentive. Certain professional corporations are not eligible (complete list from Income Tax Act: accountant, dentist, lawyer, medical doctor, veterinarian, chiropractor). There are other elements too detailed for this post (or beyond my understanding).
⁵ This is very deep in the weeds, but the Canadian EOT allows for something called “internal capital accounts” within the trust, where employees can be allocated a specific number of shares every year that accumulate over time. This process has led to tremendous outcomes in the US, like the millionaire grocery clerks at Winco Foods. Work needs to be done on how this will actually work in Canada, but the fact that it’s possible increases the potential of the Canadian EOT (it is not possible in a UK EOT).
Helpful Links
Government of Canada Explainer on Employee Ownership Trusts
Employee Ownership Canada’s Webinar on EOTs by Rewrite Capital Advisors (Video)
National Centre for Employee Ownership (US — useful resource)
