A Simpler Path Toward Employee Ownership: The Key Benefits of Employee Ownership Trusts

By Christopher Michael

Originally published in Using an Employee Ownership Trust for a Business Transition, a publication of the National Center for Employee Ownership (2024)

Entrepreneurs are artists. They take the raw ingredients of vision and passion and, by investing their blood, sweat, and tears, create a venture that is unique and personal to them. It’s not a surprise that we often hear entrepreneurs refer to their business as their “baby.” Entrepreneurs also worry about what will happen to their creations when they retire or walk away—especially if they don’t have a succession plan in place. If there isn’t a qualified family member ready and able to take over, for instance, an owner faces a tough choice. To sell or not to sell?

Opting to sell a business can be difficult for any entrepreneur. It’s a very personal decision. For older business owners, selling also comes with long-term financial implications. For most entrepreneurs, their business represents the single most valuable asset in their financial portfolio. So, if the time comes to sell the business, it becomes imperative to understand the long-term implications of such a decision.

If the entrepreneur chooses to sell to a private equity firm or a competitor, what will happen to the culture of the business? Will the loyal employees who helped build the business be fairly rewarded for their contributions under new ownership? Will the culture of the business survive? Will the business even be recognizable for what it was? It’s a lot to wrestle with.

That’s why more and more entrepreneurs interested in preserving the legacy and the long-term impact of their businesses—while also making a win-win financial deal—are exploring the growing field of employee ownership as their succession plan. The idea is that by selling the business to its employees, the founder of the company can take some financial chips off the table while preserving everything that makes the business a special place to work for its employees into the future. But how can an owner make this transition as simply, efficiently, and economically as possible?

Employee ownership trusts, or EOTs, have emerged as an increasingly viable option for entrepreneurs to help create and sustain employee-owned businesses into the future without the need to make financial sacrifices or cede control of the company’s legacy.  

Trust Ownership

EOTs use the perpetual purpose trust form of ownership. Such a trust can exist without beneficiaries. Its purpose is specifically to create employee ownership. With an EOT, the company stock is held by a trustee on behalf of most or all of the employees.

While somewhat overlooked, EOTs have been around for some time. A version of EOTs was deployed in the U.S. as early as 1897 in the state of Washington. The Columbia Conserve Company also embraced an early version of an EOT in 1926. But, until recently, EOTs have been much more popular in the United Kingdom—where generations of companies have followed the lead of the John Lewis Partnership, a popular retailer with some 89,000 thousand employees which has had an EOT in place since 1929.

The lack of examples of prominent EOTs in the U.S. helps explain why, when most entrepreneurs begin their research into the field of employee ownership, they first learn about employee stock ownership plans or ESOPs. Championed by Louis Kelso beginning in the 1950s and given preferential tax status in 1974 under the Employee Retirement Income Security Act (ERISA), tens of thousands of companies have given their employees an opportunity for ownership through ESOPs.

An ESOP is a tax-qualified retirement program that acquires shares of a company and then credits those shares to individual employee accounts. ESOPs can be amazing engines for generating retirement wealth for their participants, giving them a stake in helping to grow the value of their company. As the value of the business grows, so, too, does the value of an employee’s share in the ESOP. There are several examples of ESOPs where their employee-owners have retired as millionaires.

However, ESOPs have some barriers to overcome in how they are perceived by business owners. Fairly or not, ESOPs have developed a reputation as complex and expensive to install, manage, and sustain for the long term. Entrepreneurs are often told that their business is too small, or sometimes even too large, to consider embracing an ESOP. There’s also the constant presence of regulatory forces and “red tape” under the Department of Labor and ERISA that keep ESOPs on their toes, including the requirement to conduct an independent valuation of the business every year. And, if long-term employee ownership is the goal, ESOPs may not achieve the intended outcome due to the possibility of a forced sale––even when the founders and employees don’t want it.

This context helps to explain why more and more business owners are rediscovering EOTs as a viable alternative to creating a sustainable employee-owned company.

Streamlining the Transaction

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 working for their employer, they won’t fully realize the fruits of their labor until some time after they leave their job or retire due to ERISA guidelines. However, in EOTs, employees receive financial rewards, typically through a profit-sharing plan, while they're 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. Standard practice is that when employees leave the company, they do not receive any compensation relative to the value of the company. As it’s said in the United Kingdom, participants in an EOT are “naked in, naked out.” This means that employees are not buying into the plan when they enter the company, and they are not being bought out when they leave. This is just the same as 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.

1. Privacy

Many, if not most, entrepreneurs value confidentiality and privacy. They’re not interested in anyone beyond their accountant digging into their company’s books. How much profit the business makes, or what investments the owner makes, is nobody’s business but their own. Businesses are, after all, generally private concerns. Our entire economic and legal system is premised on this notion. Of course, public companies are another beast altogether. But when a private business owner considers employee ownership as a succession plan, they need to think about the repercussions of that decision. If a business owner sells to an ESOP, or even a large private equity firm, they are engaging in a transaction in which a lot of people will see their financials. Due to the transparent nature of the transaction, they’ll need to bring in a host of experts for help and guidance, including investment bankers, lawyers, appraisers, a trustee, and accountants. It’s not an exaggeration to note that an owner might be shocked to find that three dozen people or more are scrutinizing the financials of their company or the details of the transaction.

With an EOT sale, there may be only one outside party involved: the advisor you hire to structure the dealNot only does this help to ensure maximum privacy, but, more important, it also helps to speed up the pace of the transaction—which is often another big plus for business owners. Further, due to the internal and private nature of an EOT sale, the seller may reduce the potential for litigation that might arise over how the business was valued and the final sale price as calculated after earnouts, performance targets, and other variable measures of the firm’s value.

Of course, business owners should rely on the standing counsel of their firm’s accountant and lawyer, just as with any other major transaction. And a business selling to an EOT may choose to seek an outside appraisal. Moreover, if bank financing is sought, then a commercial bank would naturally be involved in the transaction. That said, as with ESOPs and management buyouts, EOT deals are often structured with seller financing. This typically involves the selling owner taking a promissory note with principal and interest payments paid over several years. It may also involve warrants, which function like stock options, allowing a selling owner to take a “second bite at the apple.” Seller financing shortens the time frame for closing the transaction, and helps to further alleviate privacy concerns the seller might have with bringing on additional eyes to vet the company’s financials.

2. Flexibility

An EOT provides owners with a great deal of latitude in the structure of the trust—provided that the business follows international ethical standards for employee ownership. For example, if a business owner is concerned about the business sustaining its environmental or social impact after they are gone, customized rules can be written into the trust as a secondary purpose of the trust. For that matter, the trust may also provide benefits for the seller’s family in perpetuity.

The flexibility of the EOT also comes into play with how the business distributes its profits to employee-owners. A selling owner has a great deal of leeway in setting up the guidelines for how a profit-sharing program operates. However, to comply with international ethical standards, and to be considered a majority employee-owned business, the business should distribute the majority of its surplus profits to all tenured employees based on a neutral formula.

 Moreover, an EOT company may include an equity component for key employees, or senior leaders, using stock or synthetic equity, e.g., a phantom stock or stock appreciation rights plan. An owner can also defer on making decisions regarding how profits are distributed and leave it up to future boards of directors to determine. For example, a future board of directors might decide to leverage the additional cash surplus generated by the business to award a mix of cash bonuses and employer contributions to employee 401(k) plans. The flexibility of the EOT allows the trust to be structured in ways that can best reward a company’s employees.

Consider the example of a boutique business services firm which the author has advised. As spelled out in its trust agreement, the firm reserves a portion of its annual profits for its CEO, and another portion as a bonus for its lowest-paid employees. The trust also specifies that a certain amount of surplus profits must be allocated to cash reserves. The majority of its profits are then shared out to the whole team with the added stipulation that longstanding employees, who have been with the firm for ten or more years, receive twice the bonus amount that new employees receive. By contrast, another EOT company, a large manufacturing firm advised by the author, keeps things simple by sharing a portion of its profits equally among its full-time employees. These examples demonstrate how flexible the EOT can be in meeting the needs of entrepreneurs with personalized and detailed visions for the future of their businesses under employee ownership.

Another area where EOTs offer flexibility is in how the business is governed. A selling business owner may decide on any number of alternatives when it comes to laying out how and who gets appointed to the board of directors of the company, on whether such a board will include employee-owners, and if so, how many. The flexibility of the EOT also offers the seller opportunities to maintain “effective control” of the business even after the transaction closes, e.g., by retaining a power to appoint the company’s board of directors, which I’ll cover in more detail later in this chapter.

3. Lower Cost

EOTs can be created through a highly efficient and low-cost process. Additionally, year-after-year maintenance costs with an EOT can be zero, depending on how the trust’s governance is structured. These low costs can be attractive to entrepreneurs who would rather prioritize that surplus generated by the business be reinvested in the company or its people, rather than paying fees to outside service providers.

4. Simplicity

One of the primary reasons business owners are attracted to EOTs is how simple they are to put in place. With the help of a skilled advisor, an EOT can be put in place in as little as two months. Perhaps just as important, the concept of sharing profits in the business with the people who work in the business is straightforward and easy-to-understand. This can be a real advantage in terms of engaging employee-owners who immediately understand the benefit conferred to them through their company’s EOT profit-sharing plan.

5. Sustainability

One of the least understood or perhaps overlooked potential downsides to ESOPs is that they can be sold to a third party without employee or founder approval..

When an ESOP company receives a legitimate offer that is at a substantial premium over the most recent appraisal, the board must pass the offer on to the trustee. The trustee, in turn, has to assess how employees would fare from the sale as participants in a retirement plan, not as employees. The company can pass the vote on this issue through to employees, but even then the trustee could, in theory, override the employee vote (albeit, this has never happened).

In practice, ESOP companies are often sold when a buyer offers a really attractive price. That is what happened at New Belgium Brewery. New Belgium Brewing was a proud ESOP company for two decades. They included the “Employee-Owned” tag on their product label. New Belgium’s employees were allowed to vote on any offer, and when they got a very attractive one from Kirun Brewing, they voted yes by a large marginThis possibility, even if limited, is enough to convince some business owners that an EOT, which can be structured as a perpetual trust, is a better choice. An EOT provides more assurance that whatever their vision for the business is can be retained for the long term.

At the same time, EOTs don’t have to last forever either. EOTs allow the selling owner to specify the precise conditions under which a sale of the business would be permitted and how the proceeds should be distributed, e.g., to the employee-owners or charity. It’s also possible to combine an EOT with a family trust, if it make sense as a part of a business owner’s estate planning strategy.

In plain terms, with an EOT, a business owner can customize when, how, and under what terms they would want to allow for the company to be sold out from under employee ownership. This means that for any entrepreneur concerned about the long-term sustainability of the business they created, an EOT allows them to install the kinds of defenses that will guarantee that the company will remain employee-owned for the long haul.

Making The Best Deal Possible

A thoughtful and considerate approach to an EOT transaction should help sellers feel safe, comfortable, and protected. When business owners sell to an EOT, they are well-protected on both sides of the transaction: 1) as a seller to the business who is able to maximize financial returns and retain significant enforcement power over the seller note (i.e., the seller becomes “the bank”) and 2) as a fiduciary of the EOT with the opportunity to retain effective control of the business even after the sale.

1. Maximizing Financial Returns

            One of the provisions that was put into place to help encourage business owners to sell to an ESOP is known as the “1042 rollover.” This refers to a provision in the Internal Revenue Code (Section 1042) that allows business owners to defer capital gains tax when selling their closely held C corporation stock to an ESOP. Under the 1042 rules, when a business is sold to an ESOP, the seller can defer the capital gains tax on the proceeds from the sale if certain conditions are met, such as reinvesting the proceeds from the stock sale in qualified replacement property (QRP) within a specific time frame. QRP includes stocks and bonds of U.S. companies.

            As compelling as the 1042 rollover might seem on paper, the option isn’t as helpful as it might seem at first glance. For example, there are many restrictions on where the proceeds from a sale can be invested—real estate is not an option, for example, including investing in real estate investment trusts or REITs. The stocks and bonds of international companies are also excluded. This limits how much a seller can truly diversify their investments. This is to say nothing about the costs of borrowing the cash required for purchasing QRP within a year of the sale to an ESOP.

It’s also critical to recognize that section 1042 enables a deferral of capital gains taxes—not an exemption. A 1042 sale works best if the goal is to pass on the wealth generated from the sale of a business (i.e., the QRP) to the seller’s heirs or the shares are held for a significant period of time after sale to an ESOP. In the former situation, the QRP would pass tax-exempt to the heirs. But this benefit disappears, relative to an EOT, if the sale of a business to an EOT is deferred until after the death of the owner. Under quite ordinary estate tax rules, all property receives a step-up in basis at the time of death. This means that all property receives a capital gains tax exemption if sold after the time of death. This fact effectively erases the major tax difference between ESOPs and EOTs.

In short, depending on how long the assets are held and the tax rate of the state where the owner resides, the ESOP may not offer as much in the way of maximizing after-tax financial returns as it may seem for some owners. In contrast, an EOT involves far less red tape in the process of establishing the selling price of a business. In selling to an ESOP, a business owner must follow strict rules for determining the fair market value of the business. A major part of the process of selling to an ESOP involves negotiating the sale price with a third-party trustee. Failing to follow the letter of the law, or failing to operate honestly and in good faith, can leave the seller and the trustee open to future legal scrutiny and, potentially, litigation.

However, in selling to EOTs, the rules are far simpler––the seller and their company agree internally on the fair market value of the business. Of course, it is advisable to obtain a third-party valuation, but this is not necessary. Also, as should be clear in this comparison, there is no negotiation with a third-party trustee. If the company comprises a single shareholder, who also serves as the sole board director and CEO, there is no negotiation at all. Of course, ordinary IRS rules apply with respect to fair market value, and if a sale to an EOT is audited by the IRS, it is possible for ordinary penalties to be imposed if the sale price significantly varies from fair market value. However, these rules and penalties are not specific to EOTs––they apply to all sales of business interests. Nonetheless, the above considerations certainly warrant care in the selection of an advisor for an EOT transaction.

The above should also help to mitigate some of the concerns that business owners might have when considering whether they are “leaving money on the table” by selling to an EOT, when compared to what a private equity firm might have paid for the business. To begin, if a business owner receives a competitive offer from a private equity buyer, they can use that figure as one important data point in establishing the fair market value of the company for a sale to an EOT. That being said, the closing price on a sale to private equity rarely matches the initial offer. Private equity firms have gained some renown for whittling the price down during the due diligence process and over the course of negotiations. That often puts business owners in a bind when, after months, or even years of negotiating, they are given a take-it-or-leave-it offer that falls short of what they were initially offered. Private equity offers are also often contingent on the seller’s continued employment with the firm, as well as the company’s achievement of certain metrics laid out in the sale agreement. If a business owner chooses to sell to an EOT, on the other hand, there are no such back-and-forth negotiation. And there is no “moving target” in arriving at the final sale price years after actual date of the sale. With an EOT, the sale price is the sale price.

2. Effective Control

A primary concern many entrepreneurs have when they sell their business regards how the business will fare once they leave. Selling to an EOT gives those owners the ability to assert effective control of the business even after the sale. The form and degree of this effective control depends on the design of the trust.

For example, one of the areas in which a seller can assert continued influence on the business is the appointment of the company’s board of directors. It might be desirable, for instance, for the seller to have a seat on the board, at least until the seller’s note is paid in full. By having influence over the board, the seller would then have authority to impact other levers of control within the company, such as who serves as CEO or what policies are enacted. Over time, after the seller note has been paid, the rules of how board members are appointed can change. The EOT could adopt the very same “circular governance” approach used at most ESOP companies, in which the board of directors is essentially self-appointing. Alternatively, and depending on the vision of the seller, the EOT might grant voting rights to employee-owners for one or more seats on the corporate board of directors.

Another area in which the seller might want to have influence over the company’s operations––and one of the more challenging aspects of designing an EOT––is in determining the rules for the profit sharing program. A seller might be concerned that the program could harm the business by not reinvesting profits back into the business to ensure its continued growth and stability. However, the EOT can be designed in such a way as to allow the seller to have effective control over the levels of reinvestment, the manner in which is profits are distributed, and crucially, the aggressiveness of the firm’s repayment of the seller note, at least until the seller note is paid. This type of decision-making power might be especially critical in capital-intensive industries like manufacturing, and less of a concern in more service-heavy sectors.

As noted earlier, when an EOT is seller-financed, the former owner is put in the position of a benevolent banker, who can adjust their expectations and demands to the market conditions that the business is weathering. This power allows the selling owner to help the firm by deferring payments and extending the loan term, and in doing so, ensure the sustainability and growth of the firm. By the same token, if the business is struggling to make good on its obligations to the seller, the seller does have the power to assert direct control over the business, just as any bank would.

With that said, it is advisable for a seller to appoint an independent fiduciary as a part of the trust governance to help legitimize the EOT in the eyes of employee-owners, as well as to help in conferring economic substance on the underlying transaction. But the mandate of the independent fiduciary will be to enforce the trust provisions put into place by the seller—not those legislated by Congress under ERISA. The only enforcement regime that applies is state trust law, where the overwhelming mandate is to enforce the intentions of the person who created the trust in the first place. In the case of an EOT, this means the selling owner.

The Future of Employee Ownership

Entrepreneurs have a bias for action—and results. That drive is what makes them successful. But that same drive can make it difficult to look ahead and envision a future for their business without them. The EOT provides a happy medium. Owners can sell their business, while continuing to have a say in how their business goes forward, as well as who will be making the decisions that will determine the fate of their company and their employees, now and in future generations. And they can accomplish this through a simpler path to employee ownership that maximizes their financials returns. That’s a win-win.