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

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

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NCEO – US ESOP Info and cultural testimonials

https://www.esopinfo.org/

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