Employee buy-outs can offer a welcome exit route for owners

This article by Andrew Bibby, in a slightly different form, was first published in the Financial Times, 2004

Derek Morgan admits he is “pleased” at the way the business he works for has been developing. The word seems a trifle modest. As managing director of E.O.M. Electrical Contractors, based in the mid-Wales town of Newtown, he can report a growth in turnover from £450,000 to £2m in the nine years since the company was established in 1995 whilst the number of staff has more than tripled, from 12 to 39. Last year [2003] E.O.M. celebrated a big step forward when they moved into a modern 10,000 sq foot factory unit in the town.

But E.O.M.'s growth is not Derek Morgan's achievement alone. The company is structured as an employee-owned venture, having been set up to take over the business of an existing family-run concern, Evan Morgan Ltd, at the time when Evan Morgan and his family had decided to withdraw. Derek Morgan (no relation) at that time was the contracts manager.

“We all knew that the alternative was that we would all go our separate ways, which would probably have meant up to twelve more self-employed electricians competing for the same work in the Newtown area. We felt that if we could stay together and form our own company, maybe we could tender for the larger, and more profitable, electrical jobs,” he says.

The new business raised capital from a bank loan and the twelve original members of staff contributed up to £5,000 apiece in share capital. Since then employee-ownership has been maintained, with the vast majority of new staff also becoming shareholders, albeit often with smaller holdings. Shareholders meetings are held at least twice a year and there are informal staff meetings more frequently, though Derek Morgan says that there is no attempt at interference in day-to-day management. “We run the business as any other,” he says.

E.O.M.'s successful route towards saving a business which would otherwise have been liquidated was highlighted when Derek Morgan was one of the speakers at the Westminster launch of Succession London, an advisory service set up in conjunction with Business Link for London. According to Gregory Cohn, coordinator of Tower Hamlets Co-operative Development Agency and a founder of Succession London, the aim is both to find solutions for business owners wanting to retire or move on whilst at the same time helping existing employees keep their jobs. “Everyone can end up a winner this way,” he says. He argues that up to now business advice culture has paid insufficient attention to issues of small business succession, which he says can lead to unnecessary business liquidations.

His comments are echoed by David Daws, a partner in London solicitors Ingram Winter Green and a member of the Succession London team. Having worked for more than ten years in the field (he has helped advise both E.O.M and the high-profile worker-run Tower Colliery in south Wales), he is enthusiastic about the benefits of employee buyouts. “When people have a stake in the business for which they work, they knuckle down – in accountancy speak, productivity goes up. And wealth is kept local,” he says. All too often, he claims, the alternatives for business owners who don't have family members waiting in the wings are either a voluntary liquidation or a sale to a competitor whose only interest is in capturing the order book.

He makes it clear that successful employee buyouts do not depend on owner philanthropy. “Most of the owners we deal with are trying to provide for their retirement, and they do have to be hard headed about the deal. However, most of them also have a degree of emotional involvement in their company - they've built it up, they know the people who work there,” he says. This can mean, in some situations, that existing owners are prepared to accept a staggered sale. Although not the route followed by E.O.M., some employee buyouts can be structured over a period as long as five years, with the final 20% of shares only changing hands at the end of this time.

According to Derek Morgan, one early challenge facing E.O.M. was to find a bank which would work with the firm's would-be new owners. But business advisers say that finding the finance for an employee buyout is not normally a major issue. Regional loan funds for SMEs and specialist institutions such as Industrial Common Ownership Finance can be brought in to play a complementary role to banks when finance packages are assembled. What can be more problematic, however, is the valuation price. Some owners, it seems, have a rather optimistic idea of what their business is really worth. In at least one case – according to Norman Watson, business adviser at the Wales Co-op Centre - the owner was happy to agree to an employee buyout only after he had realised that there were no buyers elsewhere waiting with open chequebooks.

The exact structure of an employee buyout varies between companies and can be complex, particularly if tax-efficient share incentive plans and share option schemes approved by the Revenue are to be utilised to the full. One model is to create an employee benefit trust which can hold the company shares, allocate them gradually to employees under an all-employee share incentive plan, and also buy them back when employees leave their jobs or come to retire. Derek Morgan, in his mid-forties, already sees E.O.M.'s employee benefit trust as providing a further succession route for the firm when in due course he and other colleagues of his generation reach retirement.

But employee buyouts in the future may not have quite the same flexibility here. The concession which allowed firms to make contributions to employee trusts from pre-tax profits was withdrawn in last year's Finance Act, a move aimed at blocking tax evasion being used by some companies for senior staff but which, as David Daws explains, also prevents employee buyouts from using this route to build up their own employee benefit trusts. Whilst there remain other ways of structuring employee buyouts, he is disappointed that his attempts to persuade the Treasury to think again were unsuccessful. “Employee buyouts should be supported. It should really be the big idea for a government interested in improving productivity and in creating work,” he says.

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