Description
Employee ownership trusts (EOTs) are an increasingly common way for sellers of closely held companies to transition out of ownership. In an EOT, the company sets up a special-purpose trust to own shares that the company (not employees) buys from the seller using their future profits to repay a note, often from the seller or a combination of the seller and a bank. The trust is designed to hold the shares in perpetuity. The employees are generally not owners but have a claim on company profits through dividends or conventional profit shares. EOTs are often chosen instead of an employee stock ownership plan (ESOP), which offers tax benefits but is much more costly and complex than an EOT. This book helps decision-makers decide whether an EOT is the right approach for their company. Chapter 1 introduces EOTs and compares them with ESOPs. Chapter 2 elaborates on how EOTs work, and chapter 3 delves into structuring them. Chapter 4 explores EOT financing, while chapter 5 discusses EOT governance. Chapter 6 discusses how EOTs can share equity rights with employees. Finally, chapter 7 provides EOT company case studies.
Product Details
Table of Contents
Preface
1. How ESOPs Compare to EOTs
2. A Simpler Path Toward Employee Ownership: Key EOT Benefits
3. Setting Up the Trust
4. EOT Financing
5. Governance and Ownership Culture in EOTs
6. Putting the Ownership Back in Employee Ownership Trusts
7. EOT Case Studies
About the Authors
About the NCEO
Excerpts
From Chapter 2, "A Simpler Path Toward Employee Ownership"
An EOT differs from an ESOP in one primary way: an EOT is not a retirement plan. While ESOP participants enjoy the benefit of seeing their accounts grow over the time they work for their employer, they won’t fully realize the fruits of their labor until some time after they leave their jobs or retire due to legal rules. However, in EOTs, employees receive financial rewards, typically through a profit-sharing plan, while working at the company. At the same time, nothing prevents an EOT company’s board of directors from using a portion of the surplus available to the company in any given year for additional employer contributions to an ERISA-based plan, such as a 401(k) plan.
An EOT conveys ownership in the company to employees, just as an ESOP does. However, there is typically no equity component (no individual employee share accounts) with an EOT. The standard practice is that when employees leave the company, they do not receive any compensation relative to the value of the company. As is said in the United Kingdom, participants in an EOT are “naked in, naked out.” This means that employees do not buy into the plan when they enter the company and are not bought out when they leave. This is just the same as in any professional partnership, like a law firm, architectural firm, or medical practice. In some cases, a nominal buy-in and fixed buyout might be involved in such a firm. But the main benefit of participating in such a professional partnership is to participate in the profits, not the equity growth of the firm.
In a broader sense, EOTs offer five significant advantages for any entrepreneur looking to streamline the transition to an employee-owned company: privacy, flexibility, low cost, simplicity, and sustainability.
From Chapter 3, "Setting Up the Trust"
Business owners may use a grantor trust to establish and make contributions in the name of employee beneficiaries to create a source of funding for the EOT transfer. The grantor trust is often useful when the business owner is financing the transition to the EOT. However, federal tax law conditions the beneficial tax treatment of a grantor trust on the requirement that the trust fund remains subject to the claims of the employer’s creditors as if the assets were the general assets of the employer. Trustees are bound to act in the highest good faith toward their beneficiaries. This means that fiduciaries must discharge their duties solely in the interest of, and for the exclusive purposes of providing benefits to, participants and their beneficiaries, minimizing employer contributions thereto, and defraying reasonable expenses of administering the system.
From Chapter 4, "EOT Financing"
As an important form of broad-based employee ownership, an EOT can qualify for traditional employee ownership financing similar to financing tapped by employee stock ownership plans (ESOPs) or worker cooperatives. As long as the characteristics of the EOT include conveying some governance functions and financial benefit to the employees, lenders with experience lending to worker cooperatives or ESOPs—CDFIs, impact lenders, and some banks—will look to provide debt to finance the sale to the EOT.
Once an EOT has been designed and a deal has been finalized, the new employee-owned business takes on the loan or loans to purchase the company from the selling owner. These loans are paid off over time from the future operating profits of the company. The selling owner receives an upfront payment for any portion of the sale price financed by the outside lenders, and they receive payments over time for the remainder of the sale price financed by the seller.
Exact requirements vary from lender to lender, but a hallmark of employee ownership financing is that personal guarantees may not be required of employees or selling owners for employee ownership transition loans. Interest rates also tend to be favorable when financing comes from CDFIs or impact-focused loan funds. For example, during the period of higher interest rates in 2023, of the CDFIs that finance employee ownership on an ongoing basis, interest rates did not move with Fed rate increases. Some states have guarantee programs to help underwrite risk. State and federal policy changes are also in play to incentivize employee ownership. These include making financing more accessible and broadening tax benefits to selling owners. The Small Business Administration (SBA) recently updated its guidelines for its 7a loan guarantee program to help ESOPs access transition loans, but it will require federal legislation to remove the personal guarantee requirement for all SBA-backed loans for employee ownership transition financing.
From Chapter 5, "Governance and Ownership Culture at EOTs"
The “three-legged stool” of EOT governance can be burdensome if not approached with the right mindset. Although we have outlined the main EOT governing groups as distinct entities, many small businesses do not have enough employees to build governing bodies in which each person serves in only one role. For example, at some EOT companies, the CEO serves on the board, on the TSC, or as the trust enforcer. In others, one employee may serve on both the board and the TSC. All employees serving on a governing body will also continue their day-to-day operational work unrelated to governing tasks. In all of these cases, employees within the EOT will need to learn how to juggle multiple hats as part of the transition to employee ownership, switching between their operational and governance roles as required. It can take some practice to master this mindset shift, but over time, employees learn how to assess each topic through the lens of the hat they are wearing at that time. Ultimately, this can build the capacity of employees to address important issues as they arise and drive company performance over time.