A deal to buy in to

Something for cranks and idealists, or the business model that could help pull us out of recession? Employee ownership (EO) may not generally feature highly on the radar of those looking to sell their business, yet it offers a compelling exit strategy using a business model that is known to reduce risk, enhance productivity and release wider social and economic benefits.

EO businesses are like conventional companies, but with much greater employee involvement. Often adopted when retiring owners decide to sell their company to the staff, the EO option allows the owner to leave a legacy and ensure that employment is maintained in the local community.

EO, its proponents assert, offers several key advantages over traditional business models. Greater employee involvement generally results in increased productivity and innovation. Employees are able to take a longer-term perspective than would be the case if they were driven by the short-term demands of external shareholders. These factors result in EO businesses having higher rates of survival.

Evidencing the performance benefits, the Employee Ownership Index, compiled by law firm Fisher Field Waterhouse, shows that EO companies have outperformed the FTSE All-Share index by an average of 11% a year over the past 17 years. A recent report by London’s Cass Business School also found that EO businesses are often more profitable than conventional businesses and create jobs more quickly – even in difficult economic times.

Research like this clearly shows there is considerable scope for Scotland to generate sustainable economic development by embracing EO.

One business leader with a mission to increase awareness and takeup of this business model across Scotland is Sarah Deas, Chief Executive of Co-operative Development Scotland (CDS), the Scottish Enterprise subsidiary tasked with increasing the contribution of co-operative and EO businesses to Scotland’s economy (www.cdscotland.co.uk). Last month Deas hosted and chaired a round table discussion in association with the Journal in order to raise awareness among Scotland’s legal community of EO and its potential.

A natural fit?

There are believed to be only about 50 EO businesses across Scotland. Yet the model has particular potential given our geography, and our national characteristics. So claimed Carole Leslie of the Baxi Partnership, specialist funders and advisers to the sector.

“Scotland is very much an SME and family business economy,” she said. “Selling to employees is often seen as a way to anchor the company in the local community when a trade sale often means relocation.”

One example she cites is West Highland Free Press: “If it hadn’t gone for EO the likelihood is that the company would have relocated to the central belt or down south. That’s 12 quality jobs in Broadford in Skye anchored in the local area hopefully for ever.”

“I think there’s quite an interest among young people as well in going to work in an organisation that’s owned in this more fair-seeming way,” added Brodies’ Isobel d’Inverno. “That’s perhaps another driver because there are some start-ups that were established as EO from the beginning and that might be something that is attractive to the younger generation.”

Alastair Dunn of bto added: “There is a particular mindset in Scotland for a politically acceptable way of doing business. I think we’re going to see that increasingly as the public sector is cut back, and I think there’s scope for a number of models, including EO.”

Solving the succession issue

So who should consider it? For many businesses, the option has been taken up as the way to secure a succession plan as owners near retirement or seek an exit.

According to Leslie, it’s nearly always owner driven. “We’ve been approached by employees who want to do this, and unless the owner’s onside it doesn’t work,” she said. The exception that proved the rule was a small company that ended up as part of a multinational. When it refused to allow a buyout, the employees walked out and started their own business – “and now they’re an incredibly successful company in the oil industry”.

Grigor Milne (Dundas & Wilson) asked: “So you’ve got them securing the legacy effectively, in family businesses, and it’s a bulwark against a takeover?”

Sarah Deas: “We’ve got a number of clients who are looking at restructuring. Perhaps an inward investor has withdrawn. They’re not trying to take the plant to another part of the world, but are happy to see it continue and survive under a different ownership model.”

Semple Fraser’s Scott Kerr wondered if there were opportunities in insolvency situations. Deas responded: “We would always position EO as being an option for profitable, successful businesses. It’s usually the future profits that are paying back the loan capital.”

She added: “Discovery Packaging in Dundee, which was in the headlines earlier this year, was a rescue. They did find a benefactor who was willing to make an investment.”

Ewan Hall, Wright Johnston Mackenzie, noted: “Loch Fyne Oysters was done quite quickly because of the owner’s illness, but they were fortunate enough to have funders available who were able to finance the purchase at fairly short notice.”

Deas: “That is an important message, it can be done quite quickly.”

Dunn: “That is the magic word though, funders. In the current market that is incredibly difficult, so if the initiative is now, where’s the money going to come from until the banks get back on the game properly?”

Leslie: “We do quite a lot of buyouts with vendor finance – the vendor may want to stay in the business and is happy to wait for their cash, in some cases up to 15 years.”

Christopher Kerr, Harper Macleod, commented: “There was one case we were involved in recently, I was amazed at the amount of money that the employees came up with in a short space of time.”

He added: “Historically EO wasn’t the number one option, whereas now it’s come up the agenda. It does require the vision of the vendor and a willing employee team, but it’s gradually risen up the list of options.”

Hall joined in: “Also for some founder/vendors, the fact that you can control the timescale quite appeals to them: they can hand over gradually in a much more controlled manner. You’re not bringing in an outsider who just wants to kick you out; you hold all the cards. That’s quite appealing for some people. They want to take time because they may not be quite ready to retire yet but they can see it on the horizon.”

Stewart Whyte, McClure Naismith, agreed: “You see that a lot. A majority shareholder who owns and runs the business and has done so for years often finds it quite difficult to let go. I think the EO model is a good way of giving up control gradually for a shareholder in that position.”

Deas: “We saw in the press last week that Blackwells, the bookstore, is looking to transfer ownership to the employees. There you have an 81-year-old who’s made that decision having sat next to the chief executive of Unipart, which is an employee-owned business, and being enthused by the model. What was interesting was the lack of knowledge of the option – followed by recognition that this was the right thing for him.”

Workers unite

What about the employee perspective? As Whyte commented: “This is a vendor-driven process, but it depends on buy-in from the employees... How does it work when you have to accommodate the interests of two parties at the same time?”

Hall: “It’s important to have cheerleaders; you need to have people who actually believe in the process. That doesn’t mean everybody has to buy in from day one… Some people never buy into it in that transition period, because they just want to get their pay cheque and that’s it. And that’s where it’s more than just drafting bits of paper, setting up trusts and so on; it’s about a process which involves engaging the employees, managing communication between the employees and regular communication between management and all staff, and that’s something that takes a while to build up so it becomes second nature.”

As Leslie noted, it’s always good to involve employees in the buyout process. Often a “buyout team” is put together, led by a senior manager, who will work with professional advisers to ensure there is a broad understanding of what is happening. The legal documentation can be weighty, and a key role for the lawyer involved is to spend time translating this into layman’s terms for the team.

She also emphasised the need to make information accessible and not just provide copies of the accounts. “But once you do find the right channels and format for information sharing, you see the success of it. There is a broad spectrum of EO, but it’s important to bear in mind that usually in this model the managers will still run the company, although the employees own it.”

Tailored to fit

EO can work for startups too: Kerr suggested that the recession could increase its appeal, linked to a drive for entrepreneurship especially for young people looking to set up. If they can convince their backers, that is – Adrian Bell of Morton Fraser recounted a case “where all the employees and a number of consultants took shares and then went and raised angel money. The first question they were asked was: why have all these people got shares? They were very uncomfortable with it, and my guys said, ‘Well we’d always intended to have significant EO and, if you’re interested, you have to invest on that basis.’ And they were reasonably enlightened investors and did.”

Another recurring point was that there is no “one size fits all” model. There are hybrids where the shares are split between the employee benefit trust (EBT) and a family trust, or external shareholders. Carole Leslie said: “There are many ways to design an EO structure. We recommend that you have at least 50% of the shares in an EBT because that gives the stability, that ensures the employees reap the benefits. We’re currently talking to a multinational looking to divest a business unit which will only have a 10-20% employee ownership stake; they believe they need to keep equity available to attract institutional investments. We’ll work with that company in the hope that the EO will eventually grow and develop. But you do lose some of the benefit unless you’ve got significant EO.”

Scott Kerr wondered if the trust was the only structure, not being something that commercial lawyers generally were familiar with. Isobel d’Inverno thought so, because of difficulties with the tax rules on disposals if operating through, say, an LLP. Ewan Hall pointed out that the role of the EBT had changed over the past 10 years and it is often a crucial component of the governance structure in an EO business. This means that the commercial lawyers working on this structure do need to understand both the trust deed and the company documentation.

Again, some businesses say there should be no free shares, and there is a view that unless employees invest at least something of their own money, they don’t properly appreciate the value in being shareholders. While a trust is generally recommended, a hybrid model that also allows employees to hold shares directly can enable employees to have a strong feeling of ownership.

On the menu?

Raising awareness of EO remains the biggest challenge, whether in getting business owners to start thinking about succession far enough ahead, or on the part of the professional adviser consulted about a disposal, or the bank or other funder approached for finance.

Christopher Kerr regretted that clients often consult their accountant before their lawyer, who may only be asked for the documents to carry through a decision. But he thought there was a “massive opportunity” in the present financial climate, “because if the banks are not giving out as much as they previously were, people are more willing to look at other alternatives than they were two and a half years ago”.

Whyte agreed: “While there may be a perception that owners will have to accept a lower price to facilitate an EO structure, owners are having to accept lower prices anyway at the moment. It may be not that difficult to encourage business owners to consider another option [the EO route] which may not be a significantly worse deal financially but may be a much better long-term option for their employees and the business. So in terms of retirement planning, it’s a good option to be thinking about at an early stage.”

Dunn said: “I think by working collaboratively with people we’ll probably find opportunities and get an audience more easily than by doing it on our own. I don’t think, unfortunately, we’re front line as often as we’d like to be in terms of the opportunity generation. It’s generally the accountants who are in there before us – they’ve got more client contact by dint of audit. It doesn’t mean we can’t do it, but it’s more challenging.”

Sarah Deas concluded with a challenge: What else can the legal profession do to help? Lorna Jack was quick to see the CPD possibilities, and also the potential for firms to spread the word through their own client seminars and other forms of contact.

“It’s exciting that there’s a cross-section of the profession that’s involved in this,” she added. “I thought we might have more conversation about the dearth of advisory ability. That’s encouraging. But it’s not a specialism, it’s not a listed area of work, it will probably just come under general corporate. So it depends on what scale it grows to.”

Bruce Davidson pointed out the possible role of external chair of the employee benefit trust, a “significant and powerful role” and “a great reassurance to the succeeding business if it’s filled by someone who’s familiar with the business”.

Hall: “Particularly in the early days when people are still trying to work out their roles, having someone there to gently nudge at the right time.”

d’Inverno: “We’ve mentioned that accountants are often involved at an earlier stage, but there’s no reason why lawyers can’t be if we sharpen our pencils and make sure we get involved.”

What did those not already active in the field take away from the evening?

Bell: “I like the idea that EO can operate for the good for the economy generally; sellers that like the idea of EO having a ready market and being prepared to support that. Couple that with vendor debt and it’s a relatively gentle way to take a company from my ownership into new ownership releasing my value to me. And I suppose if you’re showing somebody like that a model where the company’s likely to succeed because there are examples that show it working, then he’s got more comfort on the vendor debt. It’s quite healthy for the economy in that it’s relieving pressure on those businesses at that point and thereby giving them the best chance of succeeding. I find that quite appealing and I think to not suggest it when the possibility arises is to miss out on a potential opportunity – even if there’s still a hurdle to get over with many sellers.”

Milne: “I think it’s something that’s good to have in your toolkit; it’s got the advantage of deliverability. And deliverability in current markets is probably important.”

Scott Kerr: “I think one of the difficulties we have is that while we might know the directors, it also helps in this sense to actually know the employees you expect to come through… you’ve got to know that the employees are of the type, and the business is of the type that could actually take it forward. Because the worst thing you could do is decide we’re really going to push this and find that with a particular client it doesn’t work. That’s a client which isn’t happy and is automatically going to tell everyone not to go near that structure again.”

On similar comments Hall observed: “Ultimately it’s about enabling your clients to take decisions about what they want and implementing those decisions. You give them all the options, you talk about their particular circumstances and, if that’s the option they want to go down, you want to be able to implement that for them. That’s really what all advisers want to be able to do.”

In fact, it’s not so difficult to see the concept in action, as many companies in the sector, Loch Fyne Oysters included, welcome interested visitors. Deas said: “I’ve been absolutely amazed how open people are to sharing their experiences. We take our clients to see other businesses; it’s most valuable.”

Whyte: “If you can chip away at the negative perceptions, then I think business owners will be much more open to the idea when their adviser presents EO as one of the options. You’re appealing to people’s better nature sometimes, by emphasising the community benefit angle, the ability to build a sustainable business for employees and so on, but people also need to see and understand that an EO business is not the same thing as a co-operative; it’s a distinct and dynamic business model. That’s the perception shift which is required.”

We should let Bruce Davidson have the final word: “I think there are lots of opportunities, and I do think for a business that wants to take a long-term view it’s not only a credible option, it’s the preferred option.”

FOOTNOTE

Since the event, some of those present have already met with the Society to plan CPD for the profession. Any others interested please contact neilstevenson@lawscot.org.uk

RECIPE FOR SUCCESS: LOCH FYNE OYSTERS

One of the Scottish role models in the employee ownership world is seafood company Loch Fyne Oysters, and managing director Bruce Davidson was on hand to share something of their experience.

The EO conversion was a succession strategy by one of Loch Fyne’s founders, Andy Lane. He wanted to protect what he had built up and avoid the risk that, if sold on the open market, the business and its 120 jobs would disappear from the local area. There was no obvious succession within the business, or resources among the management team for a buyout, but a chance meeting revealed the EO option.

From there, the search became one for funding to facilitate the employees becoming shareholders. The whole process took a matter of weeks, unusually short but necessitated by the seller’s illness.

An employee benefit trust was created through loans from Baxi Partnership Ltd and Royal Bank of Scotland, repayable from company profits over time, and money put in by the workforce – with the vendors receiving full market value. Any employee who has been with Loch Fyne for more than six months qualifies for an annual issue of free shares, depending on profits; shares can also be bought through a savings scheme or by conversion of dividends. Shares have to be sold on leaving the company; and there is an annual “dealing day” when anyone can buy and sell shares at the assessed value.

“How it works in practice is something that definitely evolves over time,” Davidson said. “There’s no magic switch or different atmosphere overnight. There was a fair degree of scepticism at the beginning; it helps when you have tangible benefits like dividends in the good years, and it helps when people can see that the share price is rising. And the other big thing is that when people retire they sell their shares. We only have an internal market, obviously, but they can walk out with quite a substantial cheque which is extremely useful in seeing the tangible benefits.”

Two employees are elected directors, retiring by rotation every two years. Davidson reckons it’s a particularly difficult role: “There are certain things on the board that are by nature confidential, and they have performed that part of it very well and with a lot of delicacy as we discuss things and various decisions are made.” They are also part of the communication process, running the employee communications group and reporting from that meeting back to the board. In addition, there are quarterly company meetings to share results and other relevant matters.

As for intangible benefits, “we have some successes in terms of more engagement in the business, and more participation in decision making,” said Davidson. “We also have some fairly horrific miscommunications, like in all businesses, and a fair degree of animosity between different departments. So it’s not all sweetness and light and normal business issues don’t disappear by any means, but it’s an evolution. People become more comfortable over time with the structure and hopefully feel very engaged. Almost two years ago now we could see that trading was going to be tough, cash was very difficult, and everyone in the company agreed to take a pay cut because we had stated that our aim was to have no forced redundancies at all as we felt that would be inconsistent with what we stood for.

“That was a very positive process. We proposed one solution that was discussed, and the vote was that they wanted to go away and come back with a different solution, which in the end was much better than ours. The directors took a bigger share of the pain but there was a greater degree of fairness in what they had worked out should be done.”

Davidson himself only came to the company after the transition was complete, having previously worked in plcs – “wondering every six months what we were going to be reporting in the next six months, because that’s as far as we ever looked”. Having been attracted to Loch Fyne “because it’s a great business and a great brand with lots of potential”, rather than any commitment to EO, he found the model took some months to get used to, especially the employee-elected directors.

“From my perspective, the biggest advantage is you don’t have an opportunistic external shareholder base that’s driven more by short-term considerations. So for managing the future of the business there are significant benefits from a much longer-term view. An example is where we bought a company down in England, and that had short-term painful repercussions. But there was a unanimous vote in favour because they could see it was a very positive move for the business, that would pay long-term benefits.”