EOTs: Are Employee Ownership Trusts right for Canada?

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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.

  1. Employee Share Ownership Plan (ESOP)
  2. 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. 

  1. Equity Plan
  1. Stock Option Plan
  1. EVOP™️ (Phantom)

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

Learn more

Roundtable Session (for members only) – meet and openly discuss with reps from ESOP 

companies, ESOP experts, lawyers, business valuators, ESOP tax experts, etc.

Register

ESOP Design, Communication, Education and Implementation

Complete the Feasibility Study to see if an ESOP can be right for your company now

Follow us: LinkedIn Twitter Facebook Instagram YouTube

NCEO – US ESOP Info and cultural testimonials

https://www.esopinfo.org/

 

 

 

 

 

 

By Joanna Phillips, CHRL, CVB, Vice President, ESOP Builders

5 questions business owners ask about ESOPs in Canada

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  1. 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.

  2. 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.

  3. 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.

  4. 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.

  5.  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

ESOP Owners

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Over 20 years we have had the honour of meeting many business owners who wanted to implement an ESOP for their company.  We have also interviewed thousands of employees of these companies on their desire to become owners.

In our opinion there are two types of owners.  The first we call Founding Owners.  These are people who start a business where none existed before.  They have an idea, a passion, and a skill which they believe will be wanted by clients and customers.  Then they risk everything to start the business.  Many go without salary, raising funds from family and friends and putting up their own assets as collateral for bank funds.  The highest risk for a business is the first 5 years as most start ups fail during this period.  But this risk does not deter Founding Owners.  

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