EOT companies – planning for profit share after financial freedom day

It’s more than ten years since Employee Ownership Trusts (EOT) were introduced in the UK, and for many of the businesses who’ve transitioned to Employee Ownership (EO) in that time, the debt has been repaid and “Financial Freedom Day” has already arrived, or is getting closer.

As debt repayments to former owners come to an end, businesses can find themselves with a significant increase in available post-tax profits. The question then becomes how best to deploy that “spare” capital to benefit both the company and its employee owners.  For many EOT companies, that means that the employee owners can really start to see some long-promised financial returns.

Naturally this takes some thought and planning – as well as the need to be able to flex your arrangements to take into account future changes in the business.  Here are some key pointers before you proceed with your formal profit share arrangements.

What cash is “spare” for bonus payments in my employee owned company?

Remember an EOT business is still a business – and the majority shareholder, the EOT, must make sure that decisions taken by the company’s directors are made in the best interests of the employees.  While employee bonuses can provide an immediate and tangible benefit, financial freedom also presents an opportunity to invest for future growth. Striking the right balance between reward and reinvestment is often the key to maximising long-term value for employee owners.

The most sensible approach is to set aside a pool of distributable profits that can be used for employee reward.  This ensures that everyone gets a level of financial reward, while still allowing reinvestment in the business to drive growth.   The size of the pool will vary business by business (and you may want to allow some flexibility year on year, depending on your business’s financial performance and external factors).

Can I pay Income tax free bonuses (EOT Bonus)?

Your business may already have been making the most of paying all its eligible employees an EOT Bonus.  These can be paid equally or on the basis of length of service, hours worked, or salary – or a combination of the differentiators.   Every employee can receive up to £3,600 each year without income tax applying (although NICs still applies to the payments).

There are some tricky aspects to EOT Bonuses that can sometimes trip companies up.   For example, it’s essential that if you pay an EOT Bonus, all eligible employees get paid something.  So, if you’re using hours worked as a basis, and you have any zero hours workers, take care that they’re not excluded.  You also need to be sure that your EOT Bonus isn’t structured so that it inadvertently provides disproportionate levels of reward to particular groups of people (including higher paid employees).

HMRC recommends that your EOT Bonus is awarded under a “scheme”.  Ideally you should have something in writing so that you can demonstrate to HMRC – should they enquire – that your EOT Bonus arrangements meet all the legislative requirements.

Can I pay discretionary bonuses?

For higher paid employees and directors, the EOT Bonus may be a nice-to-have but it’s unlikely to be sufficient reward in comparison to salary.  Like any company, EOT owned businesses need to consider how best to reward key staff appropriately to keep them properly motivated.

This is likely to mean a significant differentiation in remuneration and reward between employees and may seem, on the face of it, uncomfortable for a business owned (indirectly) by all of its employees.

This is not, however, a question of “some animals are more equal than others”.  As noted above, an EOT business remains first and foremost a business: it must operate efficiently and profitably for its shareholders.

An effective reward framework recognises that retaining key leaders and high performers is often essential to protecting and enhancing value for the wider employee group.  And without a successful business, the employee owners end up with nothing.

So it’s perfectly acceptable to create a separate bonus structure to reward those big hitters, provided that you have stretching and relevant targets in place to ensure that payouts are delivered in return for excellent performance.

Can I use an employee share scheme to deliver reward?

While EOTs hold shares on behalf of employees, this does not deliver the concept of “direct” share ownership.  It is, however, possible to put in place employee share plans running alongside an EOT to create individual shareholders.

This can deliver the financial rewards of dividend payments, as well as the potential of a capital return for shareholders if shares are sold.  In the case of an EOT (or indeed any privately owned company), an internal market will need to be put in place.   This could be by way of company buyback, purchase by other shareholders, or via an Employee Benefit Trust.

Of course, direct shareholdings can also deliver reward for direct shareholders if the company is sold at some point in the future.

The most common share plan used by EOT owned companies is the Enterprise Management Incentive (EMI) option plan.  Typically, EMI options are granted to employees and are then exercised subject to certain conditions – which might be, for example, the repayment of the debt to the original sellers.  In practice, EMI options are frequently used to incentivise the next generation of leadership, particularly where those individuals will assume greater responsibility as the original owners reduce their involvement in the business.

Direct share ownership can also be delivered for the many as well as the few.  The Share Incentive Plan (SIP) is a very tax efficient plan that must be offered to all employees, thus mirroring the all employee ownership concept created by the EOT.  The SIP involves a separate trust that creates an internal market place automatically and can be used to buy shares back from employees (including from leavers).  Under SIP, employees can be given shares (free of tax) or can purchase shares (out of pre-tax salary), so they allow you to create a share plan that is either super-generous, or one that requires a bit of “skin in the game”.

Using share plans in EOT businesses can be an excellent way of delivering long term retention with reward linked closely to increase in company value.  EMI options in particular can be tied to specific performance targets, whether corporate or individual.

There are a number of technical issues associated with putting in place share plans – whether or not an EOT company – so appropriate professional advice should be taken.

Who decides on an EOT’s bonus arrangements?

In private companies, although some shareholder approvals will be required,  employee remuneration, bonuses and share plan arrangements are typically the remit of the board of directors of a company.

In an EOT company, the position is a little different, and the directors are ultimately answerable to the employees, by way of the EOT Trustees. EOT Trustees will typically expect to have appropriate oversight of bonus and share plan arrangements, particularly where the benefits are concentrated among a relatively small group of employees, rather than across the whole company.  This is to ensure that they are meeting their key areas of responsibility as trustees, acting in the interests of the body of employees as a whole.

Many EOT companies will have detailed constitutional documentation that may set out additional requirements that need to be met before any such decisions are taken.

Directors considering discretionary bonuses or share plans should therefore be prepared to articulate the commercial rationale for any proposed arrangements, demonstrating how they support the long-term success of the business and, ultimately, the interests of employee owners as a whole..  They should also expect the EOT Trustees to review any EOT Bonus arrangements, including in particular amounts paid to the directors or higher earners.

Care should be taken to record the Trustees’ approval to any arrangements (in addition to any formal shareholder resolutions that may be required).

How RM2 can help with EOT Bonus and Profit Share Arrangements

Financial Freedom Day represents a significant milestone in the employee ownership journey, but deciding how to balance reward, reinvestment and retention requires careful consideration.

RM2 advises employee-owned businesses on the design and implementation of EOT bonus arrangements, profit-sharing policies and employee share plans, including EMI and SIP structures. We also help companies review existing arrangements to ensure they remain compliant, commercially effective and aligned with the long-term objectives of employee ownership.

If your business is approaching financial freedom day, now is the ideal time to start planning for the next phase of value creation and employee reward.  Contact us at enquiries@rm2.co.uk to arrange a call with one of our specialist advisers.