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EOT Announcement in Budget and why it probably doesn’t mean much for Employee Ownership
EOTs: Are Employee Ownership Trusts right for Canada?
Originally published Jan 2023. Updated March 31, 2023
Employee Ownership Design Models in Canada
Overall, there are a couple of ways to achieve “Employee Ownership” in Canada. EOTs could be an added design parameter to achieve Employee Ownership depending on the goals the owner would like the plan to achieve.
- Employee Share Ownership Plan (ESOP)
- Worker Co-op
The main difference between these two is that votes are equal in a co-op whereas in an ESOP votes are dependent on the shareholders’ type of share (voting or non-voting) and how many shares they own.
In Canada, we consider an ESOP the umbrella term, but there are different types of plans under an ESOP that achieve slightly different goals.
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Employees become shareholders through share purchase | An option is granted to employees to purchase shares in the future at a pre-set price | No ownership is transferred. Employees become unitholders. It’s like a “super bonus program” |
1. Equity Plan
The owner or company sells shares to employees. This could be set up as a purchase plan using cash, payroll deductions, bonuses, loans, dividend reinvestment to name a few. The Canadian federal government has announced an Employee Ownership Trust (EOT) coming to Canada (see our special bulletin). This could be another way business owners can design an employee share ownership plan to help facilitate succession and exit planning. The two most quoted models using EOTs are in the US and the UK, the US also has specific ESOP legislation. The recommendations for Canadian EOTs was to model components of structures in these two countries. A purchase plan is the most common plan design that our clients implement for the reasons below. If you are considering implementing some form of employee ownership, identifying your goals is the first step. All of the ESOPs we have helped design and implement have not been created with EOTs (since there is no legislation for it) and have had success especially for Small and Medium Sized Enterprises (SMEs), which are privately owned.
Pros:
- Creates the maximum ownership mentality when employees purchase shares. This doesn’t have to be a high financial commitment. Most clients have a minimum purchase requirement of $1,000 to $2,000 per year if the employee chooses to participate (this could be as low as $20 per pay cheque).
- Employees understand how the company’s value increases and have more visibility on the relationship between their individual day-to-day responsibilities and the bottom line.
- It is fairly straightforward administratively
- Can be broad-based for all employees and new ones
- Provides cash liquidity to founders/owners or keeps cash in the company for operational use
- Employees may be able to use the lifetime capital gains exemption (LCGE) which is about $971,000 in 2023 and is an excellent long-term wealth creator
- If legislation is created for an EOT that is similar to US and UK, potential for the owner to transition a significant portion of ownership through a trust to employees with tax benefits
Cons
- Need for annual valuation (a formula can be used for up to 3 years, then the valuator should review and complete a new valuation)
- Continuing communication and disclosure is needed to support the ownership culture created
- In a purchase plan, perhaps not all employees are financially able to participate to the same extent as other. In the US and UK the EOT owns the shares on behalf of the employees and the employees don’t pay anything for the shares.
- A certain level of financial disclosure is needed and not every owner is comfortable with that. The level of disclosure can be minimized in certain circumstances.
- Unmanaged expectations from employees can impact the success of the plan
- If legislation is created for an EOT that is similar to US and UK, it could be very costly and could restrict flexibility to design a plan that meets the owner’s goals
2. Stock Option Plan
Employees receive options to purchase shares at some future date at a set price. This is typically used to incentivize and motivate senior management and executives to create greater company value or in a start-up to attract employees to work in a high growth company with the expectation that there will be a sale or IPO in the future.
Pros
- No risk to the employees, they don’t own the shares until the future. If the value has increased they would buy the shares at the pre-set lower price, and if the value hasn’t increased they don’t have to purchase the shares.
- Focuses employees motivation on the growth of company value
- Is fairly straightforward administratively
- Can be used to attract and retain employees
- No financial disclosure is required to option holders
- No loss of control until the shares are purchased which might not be for up to 10 years
Cons
- Need annual valuation of options as Generally Accepted Accounting principles (GAAP) require annual expensing of share options
- Less able to achieve an ownership mentality because employees have not made a financial investment, no skin in the game.
- Employees cannot access the LCGE until they trigger their options and have owned shares for 2 years
- Provides no cash to the Owners
3. Phantom Plan
We call these Equity Value Ownership Plans (EVOP™️) since trying to communicate a phantom is…tricky…These create more of a “super bonus plan” since employees don’t become shareholders, but unitholders. It is more than a bonus or profit-sharing program because the units can go up and down in value as the value of the company increases or decreases (like a share would).
Pros
- No financial disclosure
- No loss of control of the company
- Can be broad based to all employees
- Can be converted to actual share equity in the future
- Can be used to repay owner’s shareholder loan to the company, potential tax-free
Cons
- When units are “redeemed”, employee must take value as income and pay the appropriate taxes
- Employee cannot access the capital gains exemption, nor any capital gains treatment
- Need for annual valuation (a formula can be used for up to 3 years, then the valuator should review and complete a new valuation)
- An owner cannot use proceeds as a capital gain
- Doesn’t actively create an ownership mentality
Employee Ownership Trusts
It is important to understand how the EOTs are structured in the US and UK to help determine if it might be the right design for your company if implemented in Canada.
For example, in the UK, the owner must sell a controlling stake to the EOT. The trust then owes that owner the value of the shares and over time, profits pay down the debt and payouts to employees (new owners).
With ESOPs in the US, a trust is established to purchase the shares from a founder (see this NCEO article describing how ESOPs work in the US). The company contributes funds to the trust or a loan can be acquired from a financial institution to buy the equity. The trust owns the shares and over time profits pay the loan (principal and interest) and allocate equity to the employees via the trust.
In the US and UK, legislated structures provide substantial tax benefits to the exiting owner and can create great ownership mentality. They are quite complex and costly to set up, and can be restrictive. Because of this, many small to mid-sized companies find that other models align better with their goals.
We can see some useful data from the NCEO here.
Unfortunately, while this could provide an additional mechanism for how to structure a Plan in certain limited circumstances, the proposed EOT has really missed the mark and the government does not seem to have listened to the recommendations given to create more Employee Ownership. These limited circumstances for its use would be a business that is steady, has stable cash available, not growing much, and the owner has no other exit options. As it is described now, there doesn’t seem to be much incentive, tax or otherwise, to create the Plan through the EOT. In the end, the employees do not actually own the shares, employees become beneficiaries of the EOT which owns the shares. The employees are only entitled to dividends while they are employed. It is perhaps more like an employee benefit trust rather than an EOT.
Our advice to the government would be:
- Ensure that the legislation does not benefit the founder/selling owner at the expense of the employees
- Allow the founder/selling owner to designate the percentage ownership to be transferred
- Incentivize owners to sell to employees rather than an international competitor or PE
- Allow employees to access preferred tax treatment
- Make it as simple as possible to structure
- Avoid restricting the design parameters too much
So, are EOTs right for Canada? In the right circumstances some owners could see a use for them. As we’ve said, the owner should first define the goals they want an ESOP to achieve and then strategically design the parameters using the options above based on those goals.
Resources for interested parties:
ESOP Association Canada
2023 Employee Ownership Conference – May 11-12 in Edmonton AB
Roundtable Session (for members only) – meet and openly discuss with reps from ESOP
companies, ESOP experts, lawyers, business valuators, ESOP tax experts, etc.
ESOP Design, Communication, Education and Implementation
Complete the Feasibility Study to see if an ESOP can be right for your company now
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NCEO – US ESOP Info and cultural testimonials
By Joanna Phillips, CHRL, CVB, Vice President, ESOP Builders
5 questions business owners ask about ESOPs in Canada
What are the tax benefits to owners and employees?
When setting up an ESOP in Canada it is important to know there are no federal laws that govern ESOPs specifically. ESOPs are set up following securities legislation and The Income Tax Act of Canada. However, a major consideration to designing a plan is the tax treatment to employee shareholders. Plans can be designed so that employees of a Canadian Controlled Private Corporation (CCPC) who become shareholders would not be subject to tax when getting the shares and can access capital gains tax treatment when the shares are sold (50% of the gain is taken into income and taxed at an individual’s marginal tax rate, the rest is not taxed). They would potentially also be able to access the Lifetime Capital Gains Exemption or LCGE, which is over $900,000 in 2022. This would mean all gains made on sale would be tax free.
Does it have to be offered to everyone in the company?
Eligibility can generally be categorized as a broad-based plan or strategic-person plan (a.k.a. key-person plan). The intent of a broad-based plan is to allow the majority of employees to be eligible, however there is a qualifying or waiting period that the employee has to be employed for before becoming eligible. That period can range from 3 months to 5 years, but usually is 1 or 2 years. A strategic person plan is meant only for specified employees or those in a certain position and above. A company with a hierarchical structure may indicate that only those in a manager position, or above are eligible, while smaller companies with less hierarchy, might have the owner identify individuals who they feel contribute most directly to the success of the company. The latter example is less common as it is difficult to communicate eligibility in a fair manner since it is very subject to the owner’s thought process.
How do I make sure it is fair?
There are many considerations when it comes to perceived fairness. Generally, they all boil down to one thing; communication. Designing a plan in a participatory way has been shown to lead to greater success (the ESOP achieves its goals). A participatory approach just means that you are not only considering the technical requirements (legal and tax) but also the cultural elements. It is important to think about what questions employees are going to have; how does it benefit them as individuals and what are the risks. Defining all the design parameters, including ones that won’t be in a shareholder’s agreement, like eligibility, share allocation, and purchase methodology, clearly with input from potential participants creates the conditions for a successful launch and sustainable ESOP. Many people are unsure and concerned that employees with more money than others will be able to own more of the company. Having a specific and transparent allocation methodology addresses the issue of fairness because it is easy to communicate, and everyone knows what criteria is considered and to what extent. When designing the plan, companies will usually come up with a formula that includes 1 to 4 criteria, such as tenure, position, salary and/or performance. Many companies prefer to make sure that the number of shares an employee owns is related to level of responsibility and impact they have on success of the company, rather than how much money someone has.
Can it be offered to non-employees such as independent contractors?
Independent contractors can participate in an ESOP. However, according to securities legislation, there is a rule that non-employees are considered investors and if the company has more than 50 non-employee shareholders, it may need to meet additional requirements such as issuing a financial prospectus. Employees are exempt form this rule. Out of ESOP Builders clients, owners who desired to include independent contractors are in the minority.
How do I get my money out?
Owners typically want their ESOP to achieve multiple goals. One of those goals is often an exit plan. Owners should, but don’t always, think of 3 things when it comes to planning for their exit. How to get their money out, how the company will run without them (or succession planning), and how to maintain their legacy. An exit doesn’t necessarily mean selling 100% of the company. A recent client of ESOP Builders set it up to achieve his exit and sell 50% of the company (his shares) in 10 years. When one of the goals is to exit, the owner should define their timeframe. The most convenient way to get their money out is to sell their shares directly to the employees rather than issuing new shares and diluting the owner’s ownership. Many companies might start off with a five-year time frame and plan to sell 10 to 20 percent in that timeframe, however consideration needs to be given to what employees can realistically acquire. This is why defining the exit timeframe is important and having multiple financing methodologies (cash, payroll deduction, loans, use of bonuses, etc.) can help.
By Joanna Phillips, CHRL, CVB, Vice President
Employee ownership interest is surging
July 18, 2022: FriesenPress announces ESOPs in Canada now a bestseller as many search for employee ownership information in Canada.
More and more business owners are reading about Employee Share Ownership Plans or ESOPs. ESOPs can be a smart way to sell your company and a great way to attract the best employees. Owners and professional advisers are turning to the practical guide, ESOPs in Canada, to learn more about how to sell to employees successfully and employee ownership in general.
Interest in employee ownership got a boost in February when Budget 2022 stated that the federal government plans, “to create the Employee Ownership Trust—a new, dedicated type of trust under the Income Tax Act to support employee ownership.” Back in 2021, the federal government began engaging stakeholders about barriers to creating these trusts. The government now needs to finalize the new tax rules.
Perry Phillips, co-author of ESOPs in Canada: How to Implement an Employee Share Ownership Plan to Grow and Exit Your Business with Your Legacy Intact, says,
“Employee ownership is a solution to some of the biggest challenges facing the Canadian economy. Baby boomers are exiting their businesses. Companies need to attract talented people who can help them become innovative and productive. ESOPs make that possible.”
Learn more about ESOPs in Canada or Buy Now
CONTACT Joanna Phillips, Vice President, ESOP Builders Inc.
PHONE 647.881.8532
EMAIL joanna@esopbuilders.com
Canadian ESOP design and implementation in the works
What an interesting spring it has been, we’ve seen Employee Ownership Trusts (EOTs) development proposals in the budget, in the news, and have been very busy in our offices. In June’s newsletter, we thought we’d share with you a current clients’ Canadian ESOP design and implementation.
ESOP Client in the works: We currently have a client in the construction industry with about 100 employees in stage two of our two-stage participatory design and implementation process. This client came to us last year and filled out our feasibility survey online. Upon completing the feasibility review and initial meetings with the client we were able to begin the stage one process to assess if an ESOP would be feasible at this point in time. The goals of this ESOP are very straightforward and were articulated by the Owner in our stage 1 review:
Engage employees across the organization to be more consciously aware of the “Big Picture” at the Company.
Enhance the commitment and motivation of the team.
Create a long-term, flexible exit and succession plan for the current Owners.
Retain the people who drive the success of the company.
Attract qualified and entrepreneurial talent.
During stage one, we performed a total of 10 owner/employee interviews and 51 employee questionnaires. These interviews and questionnaires allowed us to gain insight into both the employees’ and owners’ understanding of ESOPs and what participation would look like for this potential ESOP. Our client provided us with all requested documentation regarding the company’s structure and current financial situation and our analysis began. Utilizing the information, we then prepared a Feasibility and Recommendations Report that outlined the unique plan design for this company. We met with the client to review any questions they had regarding the report and our general conclusion. Finding that an ESOP was feasible and after reviewing the recommendations with the client, we were then headed into Stage two of our design and implementation model based on our recommendations – a broad-based equity plan.
Stage two began with an owner survey to gather data on how the owner was leaning on certain decisions such as launch date, financial disclosure, eligibility, purchase methods, etc. These responses were used to prepare the preliminary ESOP design documents, the ESOP Blueprint. Next was the formation of the client’s ESOP team. We like to start these team sessions with an Ownership Thinking exercise to get everyone in the mentality of what it means to be an owner within the ESOP. The purpose of the ESOP Team is to create the conditions for a participatory design approach. Our meeting progressed with a full review of the ESOP Blueprint which is the document from which the Employee Shareholder Agreement will be based on.
Some of the design elements in the ESOP Blueprint that the ESOP Team provides input on before it is finalized are:
Eligibility (broad-based or key-person plan, what is the waiting period)
Allocation (how shares are allocated to eligible employees)
Purchase methods (payroll deduction, shares as part of a bonus, loans, etc.)
Minimarket (participants can sell or buy during a brief internal market)
Buy-out (what happens to shares when someone leaves)
Tax implications (using a trust to buy shares of departing employees so that employees of a CCPC can access the capital gains exemption)
Risks (liquidity, market, tax, etc.)
Currently, there is a general ESOP info session being scheduled, a valuation is being conducted, tax reviews are underway, legal documents are being drafted, and communicated materials are being created. The final launch is scheduled for October 2022 where employees will receive an information package containing an intro letter from the President, the ESOP Blueprint, all legal documents, tax summary, share allocation letter, and FAQs. They will then have about a month to review the information and make their decision to participate. Finally, we would run the CORE4ESOP survey, which is a performance analysis tool to help support the success of the ESOP.
In 2023, we will provide a client update to hear how their ESOP launch went.
Learn more about Canadian ESOP design by completing the feasibility survey, joining our newsletter, attending one of our events, and following us on social media (ESOP Builders on LinkedIn, Twitter, Facebook, and YouTube).
By Joanna Phillips, CHRL, CVB, Vice President & Colleen Johe, Employee Ownership Specialist
ESOP Town Halls go virtual
At ESOP Builders, we know there is value in doing things face to face, however certain circumstances require conducting business virtually. And why not conduct more and more business virtually? It’s almost more challenging to not conduct work virtually since there is motivation to do so in the form of COVID restricting in person contact, and ease or convenience to do it in the form of user-friendly technology.
As our previous ESOP clients will know, a key step in our implementation process is to have a Town Hall with employees to describe and explain the program, as well as educate and answer questions. Recently, however clients in the middle of the implementation process in March 2020 were suddenly thrown a completely unexpected curve-ball. One client moved forward with their ESOP, although delayed, and conducted our first ever virtual Town Hall. This client had moved all company meetings to virtual and said that overall it went well, but they found the need to significantly reduce meeting durations because people just can’t pay attention on a screen for that long. We worked with them to cut down the content from a 1-2 hour session to 30 minutes (including time for questions). However, the management team also did informal communication to ensure everyone understood the program, pushing to get everyone to ask questions, which was key when having such a short minute meeting for something that does require more. Also a key part of the Town Hall was having a detailed and straight forward employee info package for employees to review and contemplate 
after hearing about the plan during the Town Hall. This is something we always provide, but it is particularly useful when dealing in a virtual environment.
This particular client experienced a 60% and 70% participation rate (they implemented ESOPs in two different companies) which is excellent given the norm is 60-75%. Under the circumstances we revised our expectations to around 50% participation, therefore we are very pleased with the result and commend the company for making it happen!
Fortunately, technology made it easy to adapt and work through a different way of doing things.
By Joanna Phillips, CHRL, CVB, Vice President
An economic crisis could be the right time to start an ESOP
While many businesses deferred thinking about implementing a shared ownership plan back in April, now may just be the right time to start taking action. Businesses have adapted and started to see the beginning signs of operations picking up again.
There are around 7,000 ESOPs in the US according to Mary Joseph’s article in Forbes (2020). A Deloitte (2018) found that about three quarters of publicly traded companies offer ESPPs (Employee Stock Purchase Plan). However, we want to see Canadian plans continue to rise. A plan can be set up many ways driven by the goals of the owner, the company, and the participants.
Joseph outlined some reasons why an ESOP should be implemented. In this blog we will use her concepts to similarly highlight some reasons but from a Canadian perspective.
- Company Performance – The most compelling purpose for a time like this is that ESOPs outperform non esop companies during tough times. This is seen in studies comparing companies’ sales, profits, hiring activities, etc. For example, the researchers at the Institute for the Study of Employee Ownership and Profit Sharing at Rutgers University found that ESOP companies grew sales during 2008-09 11.1% while non-employee-owned companies grew by just 0.61%.
- An Ownership Mindset – Employees are also owners and they have a different mindset toward their company and how it works compared to non-employee owners. Think about a renter of a building versus an owner. Employees think about things like their paycheck, Fridays, time off, or the “me mentality”. Owners think of things like sales, profit, expenses, clients, company projects, cash flow, etc. or the “us mentality”. Employee owners understand the bigger picture and are likely to find ways to boost sales and/or cut costs more so than if they were not an owner. When the company does well, everyone individually does well too. As a customer would you prefer to deal with the owner or someone who doesn’t have that level of stake in the company’s success? Usually the owner will be the one giving the best service. When all your employees are also owners client satisfaction soars. Research from the NCEO shows that employees at ESOP companies are less likely to be laid off. Recent research from Rutgers University (2018) also indicates that retirement accounts of employees at ESOP companies are significantly greater than those at non-ESOP companies.
- Successful Exit for the Founding Owner – It makes sense for the founding owner because sale to a third party is only successful about 50% of the time. Selling to your employees on the other hand has an 80% success rate. Why is this you may wonder? For a small or medium sized private Canadian company, third party offers may be hard to come by, and when they do they may not meet the expectations of the owner in terms of what the company is worth and what will happen to the company once the deal is done. Many of our clients want to share the success that their employees have helped create and continue the legacy of their business. The employees are already invested by way of the time and effort they have committed over the years, they are more likely to want to see the business succeed. Not to mention they already know their jobs, know how the company works, and know the clients. Additionally, the owner doesn’t have to share extensive financial and confidential information with a third party. The fact that it is also a lucrative and effective way for an owner to exit is an added bonus.
- Flexible Transition – Control can still rest with the founding owner until such time that they are ready to fully transition controlling ownership. Employee owners are not typically provided a seat on the board until they hold a significant ownership percentage. See our last blog post which talks about participation and what that can look like.
Overall, it is a win for all, the founding owners, the employees, and the economy. An added bonus is that it can support democracy by strengthening the wealth of the middle class without government intervention.
By Joanna Phillips, CHRL, CVB, Vice President, and Perry Phillips CPA, CA, CBV, President
The magic ingredient for creating a successful ESOP
Employee ownership works. It makes companies, on average, better, faster, and stronger. The typical employee-owner stays with his or her company longer, and many of them come up with the kinds of creative ideas that can push expenses lower than managers thought possible, or that open up new lines of business. Overall, the statistics show that, on average, everyone comes out ahead with employee ownership.
Not surprisingly, some companies do far better than their peers, and some employee-owned businesses do not get any performance benefit at all, or may even do worse.
What separates the companies that outperform from the ones that underperform?
A successful ESOP requires open communication. The Plan itself creates the conditions for company success, however strong communication and participation make the plan successful long-term in order to experience the benefits everyone expects.
Studies have shown that participative ESOPs that are fully and clearly communicated enhance employee engagement (rather than their desire to control the company) leading to high productivity, increased profits, and increased wealth for all.
If people are going to think and act like owners, they need a basic level of understanding of the plan through which they have that ownership. Here are some of the methods our clients have used to communicate an understanding of their ESOP to their employee-owners.
Hold meetings: Bring everyone together in large groups to announce the ESOP and to cover some of the most common questions about the plan. Do not go into great detail just yet.
Set up a peer-to-peer training group to further communicate the ESOP in small groups. People can be elected or invited to join a training group and given the time and resources to create a training program. The most successful groups have the active support of the CFO, who can make sure that they have accurate information and can answer all of the group’s questions. These communication groups may even talk with similar committees at other companies so they can share PowerPoint slides, handouts, and agenda items.
Have written materials: Provide information about the ESOP in written format for the people who need to see things in black and white. Employees’ spouses can read them as well.
Let the ESOP sell itself: Most employee ownership plans are good deals for the employees. If they trust the information they receive, rather than suspecting it of being sugar-coating or emphasizing only the positive, they will likely come to their own conclusion that the plan is a good thing.
Target “just in time” information: People learn best when the learning is digestible and repeated. Young employees who have just joined the company do not need to know all the details about the timeline on which they will be paid out when they leave the company, but they probably do want to know the eligibility rules.
Share stories: Not much is as persuasive to human beings as stories. Talk about people who have retired from your company with substantial value in their ESOP accounts, or, if your plan is newer, use examples from other employee-owned companies. Tell the story of why your company became employee-owned. What were the other options? Why did the company choose employee-ownership over those other options?
Use statistics: Some people prefer to see the numbers, so don’t hesitate to show them research—but only the highlights– on the implications of employee ownership for employee-owners, your company and ultimately the community. Good sources of data, even though most are from American companies, are the National Center for Employee Ownership (NCEO), the ESOP Association (US) and the ESOP Association Canada.