Own goals

Employee ownership is a rapidly developing area of business ownership and one that is now being tentatively adopted by law firms.

Following the 2012 Nuttall Review of Employee Ownership, tax incentives were introduced, under the Finance Act 2014, that encouraged the growth of employee-owned businesses. Since then, the UK has seen a rise in the number of businesses owned by employee ownership trusts (EOTs), to the point where there are currently more than 1,650 employee-owned companies.

Tax incentivisation of employee ownership emerged at the same time as the legal profession was starting to think about non-solicitor ownership. However, the development of non-solicitor ownership was not without concern. The fears expressed at the time were that, despite the potential opportunities alternative business structures (ABSs) offered, the persons most likely to benefit would inevitably be venture capitalists, supermarkets and stock markets, as the traditional partner-centric model of ownership succumbed to the scions of the capitalist market.

The introduction of the EOT legislation and interest in ABSs gave rise to the potential for an employee-owned law firm. The EOT tax incentives created benefits for employee ownership, while the introduction of ABSs enabled law firms to be owned by EOTs.

Position today

There are now around 20–30 employee-owned law firms in the UK. The exact numbers are not known, but against a backdrop of over 9,500 legal practices, it is a tiny fraction.

What is holding law firms back? Most likely, it is the distraction of events that prevents partners from considering the future. Back in 2020, the issue of ageing partners and worries about succession were of critical concern. Matters did not improve as the pandemic struck, followed by war in Europe, the cost-of-living crisis and disruptive mini-budgets, all of which were set against the background turmoil of Brexit. Given these challenges, it became exceedingly difficult, if not impossible, to prioritise addressing succession.

Indeed, succession planning is often what leads most companies in the direction of the EOT, because it provides the existing owners with a way to move the business into the hands of new owners and future leaders. However, while the succession aspect is important, it is not the only reason for considering the option. EOTs can be highly beneficial in creating more employee-invested business and/or ethically motivated organisations.

Traditional succession routes

If partners have considered succession, they will be familiar with the traditional options:

• introduction of new partners to buy out retiring partners
• sale of the business or merger with another firm
• closing down and liquidating.

However, the current business environment appears to be challenging – of the 523 law firm closures in the 12-month period from May 2023 to April 2024, over 50% ceased trading, while only 22% merged. The data does not detail the myriad number of damaging consequences that invariably arise when a business ceases to trade.

Likewise, finding new partners to buy in and pay off an outgoing partner has become more challenging. A combination of rising house prices, substantial student loans and the rollercoaster ride of law firm fortunes does not encourage an appetite for more debt in the next generation.

Accordingly, there has never been a more important time to find new succession options for law firms.

A new alternative

The inception of the EOT brought forth a new alternative to succession. Rather than needing to find a buyer, the company owners could now sell the business to a trust that would hold the benefit of the shares for the employees of the company. The EOT would be created by the company and would purchase the shares for a sum at, or close to, market value, with implementation being carried out at a time of the owner’s choosing.

The absence of an incoming owner with visions of a radical new direction or potential ‘restructuring’ (that is, laying off employees) allows the owners to fix in place values and culture that might not survive a takeover. If those benefits alone were not enough, there are also tax incentives; the sale of shares would be subject to zero capital gains tax (CGT), with no limit, and EOTs introduce a tax-free profit share to all employees of up to £3,600 per person.

EOT legislation

To obtain the benefit of zero CGT, the EOT must meet the provisions set out in sections 236H–U of the Taxation of Chargeable Gains Act 1992 (TCGA).

Simplified, the TCGA requires the following criteria to be met:

• The shares disposed of to the EOT must be made by a person (accordingly, not a subsidiary of another company).
• The company (the subject of the share transfer) must meet the trading requirement (most companies comply with no issues, but there are traps for the unwary).
• The EOT must meet the all-employee benefit requirement (all employees must be beneficiaries of the EOT and treated on equal terms).
• The EOT must meet the controlling interest requirement (hold a majority of shares and not be subject to any provision in an agreement that confers rights over the EOT in favour of the sellers).
• The limited participation requirement is met. (This is a convoluted test relating to the number of employed shareholders compared to the number of employees, which must not exceed 40%; for any company going into EOT, this will need to be thoroughly analysed.)

Compliance with the rules is generally readily determined, though care must be taken in connection with the limited participation test. Furthermore, the EOT deed will either contain the necessary clauses, or the EOT will fail the criteria and the sale will not have the benefit of zero CGT. Be warned – there are still templates made available on government employee ownership websites that are not compliant!

Selling to an EOT

One of the advantages for owners moving to an EOT is that the sale process is neither combative nor draining, by virtue of an absence of endless due diligence and other advisers choosing to negotiate tedious minutiae. Any solicitors reading this article who deal with commercial transactions will know that the mergers and acquisitions sector now regularly fields an army of lawyers on even the most modest of deals – all very well when you are earning fees that way, but somewhat less appealing when you are the seller.

An EOT transaction has far fewer complications in terms of the process. It is not combative; in fact, it is more a process of creating the most appropriate structure for the business going forward. While this may take time and thought, it is not a design that is forced upon the sellers; rather, it is one they craft.

Ultimately, the sellers, rather than the EOT, are the persons at risk – they only get paid if the EOT, and the company it owns, thrives. Therefore, it is imperative that the sellers balance the terms of the sale with particular regard to the repayment of the sale price against the need to ensure that the business grows, reinvests and shares some profits with employees. There is much to be said in ensuring that the implementation of the EOT is beneficial for the current owners, the company itself and, ultimately, the employee-owners.

Valuation versus consideration

While a valuation is certainly necessary to ensure that the price reflects the market value of the company, the acid test is checking that the proposed purchase price can be met through the likely post-tax profits of the company in future years, as, for most EOTs, the purchase price is paid through the future post-tax profits of the company (the same pot from which dividends are declared). Failing to properly scrutinise the affordability of the repayment terms is probably the greatest risk for the business and the sellers.

EOT bonus

Having implemented the EOT, the company owned by the EOT (or indeed all the companies owned by the EOT) can then distribute a tax-incentivised bonus of up to £3,600 per employee per year, under sections 312A–I of the Income Tax (Earnings and Pensions) Act 2003. To do so, the company must meet the following rules (again simplified):

• The bonus must not be regular salary or wages.
• The bonus must be awarded under a scheme that meets the participation and equality requirements (all employees to benefit on equal terms).
• The company must meet the trading requirement.
• The company must meet the indirect employee ownership requirement (the company is majority or fully owned by an EOT).
• The office holder rule must be met (directors and other office holders must not make up more than 40% of the total number of employees).

From an employee perspective, the profit share bonus may be the first tangible benefit of being employee-owned. How the bonus amount is determined and how it is shared will be an important development. Finding a methodology that matches the values of the business is key. A firm that has a strong sense of equality may choose an equal sum for all, whereas a firm that has a more commercial ethos might choose to share based on hours worked or percentage of salary (the latter being the classic John Lewis model).

Leadership

An EOT principally deals with ownership of the business, but don’t overlook the need for good leaders, who may take on the responsibility of leading the business in the future. It’s important to ensure that these individuals are properly motivated, retained or recruited; being an employee-owned business can create great resilience, but it does not insulate it from external market pressures.

Tools for incentivisation range from providing a direct shareholding for key individuals in the firm to share options (based on setting strategic goals) and simply providing a performance-based individual or leadership bonus.

One of the benefits of the EOT model is that it can remove the problems associated with equity ownership. Having paid for their capital stake, equity partners may (quite reasonably) expect to control the business decisions and firm’s direction. However, not all partners are suited to business leadership, and the intrinsic tie of ownership and leadership may well be damaging to some firms. Furthermore, this can also lead to the exclusion of those who may be better suited to leadership but are unable or unwilling to pay the equity price tag.

Once the equity element is removed, individuals can be freed up to focus on developing and using their talents and potential, regardless of whether that is taking up the role of managing partner / director, leading a growing team, opening a new office or immersing themselves in a niche specialism.

The SRA

The Solicitors Regulation Authority (SRA) has now approved multiple firms becoming employee-owned. If the firm is not already a licensed body, then an application will be required, as the ownership by an EOT will mean that the firm is not owned exclusively by solicitors. The management of the firm is still keenly scrutinised by the SRA, but this is no different to the existing requirements for all firms. Ultimately, there is no objection to employee-owned law firms from the legal regulator.

EOT challenges

For any partner warming to the idea of an EOT as the potential future for the firm, there are practical issues to consider:

Too many partners

Choosing to sell to an EOT requires a high degree of alignment between the current shareholders. As any partner of a larger organisation will know, finding agreement on major developments for the firm can be tricky. Choosing to sell to an EOT may be a challenge on a greater scale.

Aspiring partners

As previously mentioned, ensuring leaders are incentivised is an important element of a successful EOT, but so too is ensuring that the key individuals in the firm support the concept of becoming employee-owned, and see that their future is not compromised by it.

EOT exits

To date, there are few examples of EOT-owned businesses being sold out of the EOT. In principle, a successful business, regardless of its ownership status, may be subject to unsolicited offers. The EOT may determine that a sale is in the best interest of the employees. But note that the EOT will likely pay CGT on the whole of the sale price (not just the uplift against the original sale price) and any proceeds to employees will likely be subject to income tax.

Governance

In place of shareholders, the directors are accountable to the trustees of the EOT (which is, of course, the shareholder). The EOT does not run the business but it should expect to have oversight of business plans and major decisions. It takes time to become accustomed to this development, but this can create stronger decision-making processes and more employee-conscious decisions.

Conclusion

The employee-owned law firm may still feel like a radical concept in legal circles, but the model is already making waves. It provides an alternative succession route for partners, brings together employees as co-owners and distributes wealth to those who contribute to the fortunes of the business. In the words of Lord Denning: “If we never do anything which has not been done before, we shall never get anywhere. The law will stand still whilst the rest of the world goes on; and that will be bad for both.”