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Legal Insight: The pros and cons of the employee share ownership model

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4th May 2012
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On the last day of April, the government agency that administers the pensions of 1.5 million former and current civil servants became the first ‘mutual’ organisation in Whitehall.

MyCSP Ltd will take over the operation of the state-run pension scheme, but will also be able to expand and bid for new business under the shared-ownership model that it has adopted.   Its 500 staff will own a joint 25% of the organisation, while taxpayers will keep a 35% stake and a private business services company will own the remaining 40%.   The coalition government is keen to push the operating model, despite union disapproval, as it believes that it will help boost productivity, contribute to economic output in being a taxable business and save taxpayers 50% on the cost of administering civil service pensions by 2022.   Elsewhere however, John Lewis is perhaps the best and most well-known example of a successful employee-owned business. But while taking such an approach may sound like a great idea in theory, there are issues that organisations need to consider before going down this route.   Most large businesses recognise the value of providing staff with incentives and more and more company directors are seeing the value of doing so through shared ownership. But whether you decide to go for such a scheme or not may depend on how the organisation is set up.   First of all, it is worth noting the distinction between partnerships (or firms) and limited companies as, while these terms are often used interchangeably, they are fundamentally different structures.  Responsible capitalism?  In brief, partnerships (and since 2001, limited liability partnerships or LLPs), which are the most common operating model for solicitors, accountants and other professional practices, are owned and managed by their equity, or profit-sharing, partners.   Companies, on the other hand, are run and managed by their directors, but owned by their shareholders.   At one end of the spectrum, directors and shareholders are one and the same (‘owner-managed businesses’) while, at the other, there are companies such as Tesco plc, where the vast majority of shares are held by unconnected individuals and institutions, even though the directors are also likely to have considerable shareholdings and/or share options as well.   The private limited company is the most common form of business ownership in the UK, with currently around two million in existence. As an aside, the John Lewis Partnership plc is a public limited company and not a partnership in legal terms.   But in a belief that it will cut red tape, the government is now encouraging organisations to adopt the John Lewis share ownership model and is reforming the tax system to make it easier to do so.   The aim is to create a more “responsible capitalism”, in which staff engagement, loyalty and commitment – particularly within small- and medium-business enterprises – plays an important part in driving the economy through current and future troubled waters.   But take-up will depend on a number of factors, including the finer details of the government’s formal proposals. Whatever the outcome, however, what is certain is that employee share plans are very effective in helping to recruit, retain and motivate the workforce.   In addition, they can also be good for the bottom line. Depending on the type of scheme employed, tax and national insurance contributions savings can be realised for both employer and employee – savings that are particularly attractive where enterprise management incentive options are used.  Attractive proposition  In these difficult times when companies are under far less pressure to offer salary increases, ownership schemes can become an even more attractive proposition. This is because they can provide a low-cost option for companies and would-be option holders, who do not have to pay for option shares up front in the same way that they would if they become shareholders.   In many ways, it could be said that minority shareholdings in private companies have limited value – there is no immediate market in which to sell them (although a market can be created) and unless the directors decide to declare dividends, shareholders will derive no income from the shares they own either.   But it is the intangible, psychological feeling of being part of something that motivates businesses to choose this model and employees to embrace it.   Individuals have the option to exercise their share options, buy shares and immediately sell them on to the buyer of their company and, in most cases, they will never have to use their own funds. The purchase price is simply offset against the sale proceeds.   The same kind of idea is true of business partnership models, where most professional employees wish to become part-owners in the business for which they work at some point – thereby becoming self-employed and ‘working for themselves.   While in practice, management structures within both companies and firms tend to result in some individuals being more equal than others, a number of the best-performing businesses do operate day-to-day working practices that are genuinely based on collaboration, in a consistent fashion with their shared legal ownership structures.   If considering whether to adopt this approach, however, it is also important that businesses consider the potential downsides. For example, disagreements can arise if employees leave the business, with potential disputes including issues around ‘good and bad leaver’ provisions.  The downsides  Similarly, while it is common for share options to vest over time (which generally means they become the option holder’s permanent right), unvested options at the time of leaving the company usually lapse.   The rationale behind this situation is that people are provided with incentives right up until the point of a sale or flotation, with a loss of financial return ensuing for those who do not stay the course. There are also various ways in which share options can best be granted, for example over time or based on performance, in order to try and maximise employees’ efforts.   Some other important matters should also be considered, however. For instance, it is sensible to consider the effects of giving employees possible disproportionate influence and veto rights.   As a result, documenting shareholder agreements is paramount because the inconvenience, management time and legal cost of dealing with a departing employee who may be fixated on retaining a minority shareholding should not be underestimated. From the outset, all stakeholders should agree and sign up to clearly delineated provisions.   It should likewise be borne in mind that, while improved employee retention can result in organisational stability, longer service can also lead to higher costs. Severance negotiations, for instance, may become more difficult if an employee is also facing the prospect of losing the value embedded in his or her share options.   Therefore, while it may seem outwardly attractive, the co-ownership business model will not suit all businesses and so advice should be sought if this approach is being considered. If it does suit your business model, however, the benefits can be simply immeasurable.  Shelley North is a legal executive at law firm, Taylor Vintners. If you've enjoyed this story, you might also like to read Accord Energy Solutions: Becoming an employee-owned company.

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