Host

Philippa Lamb

Guests

• Graeme Nuttall OBE, International Ambassador, Employee Ownership Association
• Simon Blake, Head of Strategic Corporate Finance, Price Bailey
• Peter Hollis, Principal, Hollis & Co

Philippa Lamb: Welcome to Behind the Numbers. I’m Philippa Lamb and in this episode we’re going to be talking about succession planning, and specifically the pros and cons of employee ownership trusts as a solution.

Seventy per cent of mid-tier accountancy and audit firms are still structured as limited liability partnerships, but with 45% of firms citing succession planning as a critical talent challenge, and private equity investors taking more interest in the sector, some firms are now looking at other options.

Peter Hollis: You get to a point where you think, if I don’t give this some direction, then we may lose staff and we may lose clients.

Graeme Nuttall: The management style is participative. They listen to ideas from employees, individually, collectively, and all of this helps – research shows this – generate extra profits for the business.

PL: Peter Hollis is one of them. He’s transferred his own practice, Hollis & Co, to an employee ownership trust, and he’s going to talk us through the how and the why, and the challenges along the way. We’re also joined by Graeme Nuttall OBE, author of The Nuttall Review of Employee Ownership and International Ambassador for the Employee Ownership Association. And here to share his experience of advising clients about the pros and cons of EOT, Simon Blake, partner in Price Bailey’s Corporate Finance team is our third guest.

Hello, everyone. Simon, shall we start with a bit of scene setting? Why is succession planning feeling as if it’s become a bit of a bigger issue lately?

Simon Blake: I guess succession planning has always been an issue, but right now, with a huge amount of activity around the sector for accountants and auditors, it has really become a very live topic. Private equity and other trade buyers are rapidly consolidating the accounting industry, and at the same time there’s increasing pressures coming on the smaller practices, which is making it harder to attract people that want to stay in small practice environments.

On top of that, we’ve got perhaps a bit of confusion created currently over ownership of accounting and audit firms – audit particularly, but accounting firms perhaps as well – where the Institute of Chartered Accountants is trying to work out exactly what the new world really means when it comes to independence, and the historic desire, at least of the Institute, to ensure that audit firms are controlled by auditors. And that’s causing some complications that are moving quicker than the regulator is able to cope with.

PL: Given all that complexity, why would firms want to move away from the limited liability partnership model? I mean, it’s the norm. Everyone knows how it works.

SB: It is the norm, but that’s not to say it’s the right thing. I think there’s increasing recognition that larger practices that are structured as LLPs don’t really operate as partnerships, they operate as corporates. And actually, my own firm would be one of those where the day-to-day decision making running the business is by a six-person management board, which I’m grateful to be part of, because I can’t have 43 separate partners all making decisions at an operational level – it just wouldn’t happen. You don’t make decisions with 43 people in the room. And so, in order to run our business effectively, we have to run as more like a corporate. We still like the partnership approach, from the mentality of it, I guess, and taxation is still preferable, but the decision making, the leadership, the actual governance, is much more like a corporate. So why not be a corporate?

PL: Well, Graeme, conversely you are a great believer in EOTs. I know you’d like to see them more widely adopted. There are various ways of doing this, but can you give us a basic explanation of how they work?

Graeme Nuttall: The employee ownership trust, or EOT, provides for the collective ownership of shares on behalf of current and future employees. A discretionary trust is set up, the beneficiaries of which are all the employees of the business. This provides a profoundly different way of thinking about ownership. Instead of trying to find one or two individuals to buy a business, perhaps through a management buyout, one can look to the employees as a whole to acquire that business, using the EOT as the buyout vehicle.

PL: So essentially the business still runs in the same way. It’s still run by the same people day to day, isn’t it?

GN: This is what’s tremendously attractive about this model, that it provides a really neat business succession solution. It does require a company, it won’t work for an LLP, but once you’ve got a company, essentially the EOT, the trustee, takes over the ownership of that company, allowing the company to continue to be run as a separate company but under the ownership of this vehicle, which is dedicated to long-term employee ownership.

PL: The original owner, of course, they have to wait for their money, don’t they?

GN: Yes. I should say the employee ownership business model has become a mainstream idea over the last 10 years. The main reason for this is the success of the employee ownership trust, or EOT, as a business succession model. It’s financed by using company profits that have paid out over a period of time, which can be, well, on average seven years. So an owner has to be prepared to wait to get paid. That’s probably the main downside. But for most owners, they’re planning ahead for their retirement or stepping back from the business, and this allows them the flexibility to pick the timing as to when that happens.

PL: Well, Peter, as I said, you’ve done this. You’ve gone down this route with your own firm. Why did you choose this route?

PH: As you grow older, you become aware that whilst you’re enjoying work and you don’t really want to stop, other people are looking at you, knowing how old you are and wondering what you’re going to do. And you get to a point where you think, if I don’t give this some direction, then we may lose staff and we may lose clients. So although I don’t really want to stop working at the moment, I did want to give some direction to clients and particularly to the staff. And as we went down this road, looking after the staff, many of whom have worked here a long time, became the paramountly important part of this really.

PL: And the fact, as Graeme’s just described, that you are going to have to wait to be fully recompensed for this – that wasn’t an issue for you?

PH: Well, I’ve never really liked the thought of selling client relationships, so keeping the business intact and run by the same people who’ve worked here for years appealed to me on a different level. These type of arrangements tend to work best when there’s some accumulated cash in the business that can form a down payment, with the rest being generated from future profits and paid out on the drip. Although, you know, being paid on the drip is really a feature of most management buyout type situations.

PL: That brings me to my next question really, which was management buyout. Did you think about that instead?

PH: I did think about it, and I did talk to the staff about management buyouts. There was a split in the staff really. Some were open to the idea of a management buyout and others definitely weren’t. So I felt that if we went down that line, we’d end up with nine employees and a two-tier system. And I didn’t think in the longer run that having two different classes of worker would work terribly well. I thought that we’d end up with friction between them.

PL: Now, EOTs haven’t been widely adopted by accountants. How was the process for you as you found your way through it?

PH: It was difficult at first, because I had to establish the principle that an audit practice could be controlled by a trust. And that took quite some time to negotiate with our institute, but they now accept that you can indeed do that.

PL: So, in terms of the regulatory framework?

PH: Absolutely.

PL: That was the thorniest issue, was it?

PH: It was the most time-consuming issue to resolve. Once that was in place, the whole thing took about four months to finalise.

PL: Okay, so pretty rapid. And are you happy with it? I mean, you’re in the midst of this now… can I ask you, how long do you think you’ll remain involved with the firm? Is there a time frame in your head?

PH: Well, I’m thinking it’s probably going to take about five years for me to get paid off, and I expect to be working here for most of that time.

PL: And the new environment, how does it feel? Does it feel different to the way it was before?

PH: At the moment it feels exactly the same. Things are happening just as they did before, and I’m running the thing in the way I was. That’s got to change, and that’s really the biggest challenge now – to get the thing to a position where it will operate without me.

PL: It’s quite a cultural shift that, isn’t it?

PH: It’s challenging for me.

PL: Yes, that’s what I mean really – a big change.

PH: It’s challenging for me to let go of something that I’ve spent the last 35 years building up.

PL: While still remaining involved with it.

PH: Mmm.

PL: So Graeme, you advise Peter? What are the issues that you’d pick out along the way?

GN: What I want to highlight is that it’s well worth the exercise. This morning I’ve chaired a meeting of the trustee board of a company that embarked on employee ownership in 2016. The founder is completely paid off, one of the founders has retired, others are still involved in the business, and the company is energised as an employee-owned business, with all the employees contributing to how that business is run.

I should emphasise that employee-owned companies still have a board of directors. That is the appropriate body to run that business with the right skill set, the right qualifications. But what happens is the management style is participative, they listen to ideas from employees, individually, collectively, and all of this helps – research shows this – generate extra profits for the business, increased productivity, happier staff, and indeed quite often, benefits to the community, which spill over from companies being very good businesses.

PL: All this sounds really positive and yet EOTs haven’t proliferated quite as much as one might have thought, have they? What’s your feeling about why that would be?

GN: I would say employee ownership trusts are mainstream. They are the second most popular form of business succession after transfer to family. More than one company is converting to employee ownership a day. But there are, as we’ve heard today, there are sectors where the idea has not accelerated. And what I’ve seen is, in some sectors, it takes a pathfinder to accelerate growth in that sector. This is what happened with architects. A large firm of architects converted to employee ownership in 2017; I think, by 2022 there were well over 100 employee-owned architects’ practices. Similar phenomenon with law firms: overcame the regulatory hurdles with the first EOT-owned law firm, 2018; there are now over 30 of them. So the idea can take hold and can take hold quickly.

PL: So that’s what you’re hoping to see with accountancy: a trailblazer?

GN: I am, but also I wanted today to explore perhaps why it might not take off as quickly as it has in some sectors. It comes down to the dynamics of a particular business. Employee ownership has got to be right for a business. And if the nature of a practice is that the work is brought in by two or three individuals who need to be personally rewarded for effectively owning and managing a business, then perhaps employee ownership is not right. But if a business has established a brand, and work is coming in because of that brand, because of the reputation perhaps locally, it’s easier to see that that can convert to employee ownership, where you have collective ownership by the trust of a business, rather than ownership by one or two individuals.

PL: Simon, you’ve got had a lot of experience of EOTs – does that chime with your experience? They work for some but not for everyone?

Simon Blake: Yes and no. I think it’s a real combination of factors that are involved in the EOT decision. And actually, I’d start with a wider employee ownership piece, not necessarily just employee ownership trusts. Price Bailey, all of our employees have some shares in our business as long as they’ve done 12 months’ service, and that means there’s over 400 shareholders in our business as a result.

But I think the point that we have to think about here is employee ownership needs to be an incentivisation for the people that are going to drive the business forward. One of the unique things about the employee ownership trust model is that no individual employee actually has a share certificate with his name on it. The shares are held for the body of employees at any given time, and that, I found, is a barrier for some. It’s also built around the subject of all-employee ownership. That’s the concept under which the original rules were written, and that means that the incentive for everyone is very equal. In a normal trading business, the contribution isn’t equal, and therefore the incentive required perhaps for some is greater than for others, and that’s where the employee ownership as a standalone model doesn’t work so well.

PL: But can you not handle that through a different remuneration structure, bonuses, whatever it might be?

SB: Well, if you do that, then what’s the real advantage to the EOT model in itself? I think this is where, when you are , you do see a few barriers coming up. What we do see is some hybrids, and maybe it’s worth us chatting about the hybrid model.

PL: Yes, absolutely, that was a thing I wanted to ask you, because you can do a bit of a mix and match with EOTs, can’t you?

GN: In terms of the employee ownership model, typically the move is towards 100% employee ownership by an EOT. It’s probably only 10% of the cases where there is a hybrid model, and in some of those cases it’s only temporary – it’s during the deferred consideration period. So most employee owned companies find they are able to incentivise senior executives essentially through cash bonuses, occasionally perhaps through an executive share plan. But when you run the numbers, the rewards from running a share plan over minority shareholdings can be relatively modest, and for many you’re creating a problem that you’ve just overcome – namely how to buy out shareholders and the drain on resources that can provide for a period. So moving towards a hybrid… it’s possible and the EOT model is flexible and can accommodate it, as long as the EOT has a controlling interest, but generally speaking it’s not what’s seen as the usual model.

PL: Simon, do you want to talk us through what a hybrid might look like?

SB: Yes. And just to be controversial, I think what we are seeing is more and more clients that don’t want to do EOT in the traditional route and do want to look at hybrid. And I would say the majority of the EOTs we’re now talking to clients about are hybrid rather than standalone.

PL: And how would that work?

SB: Hybrid will always have, as Graeme quite rightly says, at least 51% controlled by the EOT. But that still leaves a lot of shares available for incentive to the key managers, which is typically a handful of key people for whom in a larger organisation a sub-1% shareholding, if there’s more than 100 people in the organisation and you start with an all-employee perspective, less than 1% isn’t very attractive. But actually, if four or five people could have 10% or 15%, maximum 49% between them, and they are incentivised through that structure of being a real shareholder with a real stake, which is much more akin to a management buyout type scenario, especially a management buyout backed by an investor –that’s the kind of shareholding you would typically end up with in those scenarios – then you get the best of both worlds. You have employee ownership for the wider employee body that wouldn’t typically access ownership of the business through a traditional route, and the management buyout type of incentive that means the key people in the business that are leading and driving it forward have got a significant incentive in there.

Graeme’s right to talk about what happens next, but what happens next is something we haven’t seen very much of in any EOT so far.

PL: If I’m understanding your model correctly, there’s a degree of equality which you wouldn’t have had before, but some people are… well, to quote a phrase, more equal than others. Is that how it works in practice? So you still end up with a hierarchy in that sense?

GN: I think if we go back before the EOT became the predominant model, we are fortunate in the UK that our tax and legal system supports employee ownership models of all sorts: direct ownership through employees owning shares personally, or through share incentive plans, and the collective model. And it may be that we’re returning to a more balanced range of models, rather than the predominant EOT model, which is the current situation.

All I would say, based on a long time advising on employee ownership models, is that I have seen hybrid models close down when it becomes apparent that it’s difficult to manage them. Individuals don’t always buy shares at the right price or sell them at the right price. And I have seen companies move away from these hybrid models to collective employee ownership after several years of trying to make them work as an incentive tool and relying on cash bonuses instead.

PL: Moving to a slightly different question, I’m thinking about size of organisation. Obviously this has worked well for Peter with a relatively small organisation. Is there a limit to the size of organisation that it would be appropriate for?

GN: Let me start with the statistics that large companies do adopt EOT ownership, but it is a small/medium-sized enterprise phenomenon, so between 10 and 250 employees, typically perhaps with an average of 40 to 90, but it can scale up. The John Lewis Partnership is well known as a long-standing exemplar of the employee trust model, and it has tens of thousands of employees.

PL: What do you think, Simon? Does it work for much bigger organisations?

SB: I would share the experience of the majority that under 100 people is where it seems to be served really well. The John Lewis model isn’t a model under the current EOT legislation, but the concept of employee ownership was very much driven by the John Lewis model. So I think that’s right, there are a number of large, particularly surveying firms that are employee owned, but again not using the current model. They didn’t get there through EOT, they were employee owned prior to EOTs existing.

PL: I’d be interested to hear what you all would pull out as the biggest considerations and challenges for organisations that might be considering this option, particularly given it’s a heavily regulated sector.

GN: We’ve already identified the deferred consideration, so sellers need to be patient to be paid. This may make it difficult for some sellers of a certain age or who have a reason to be paid quicker.

PL: Simon, your thoughts on that?

SB: The accounting sector is an odd one, because there are many accounting businesses that actually don’t recognise goodwill, and therefore arguably it could be easier for some businesses to undertake employee ownership, because actually the purchase price of individual shareholders won’t be so significant if goodwill isn’t being recognised. But where it is recognised, it also tends to be recognised in the hands of the individual shareholders as a minority shareholding, ie much lower in itself than a pro rata shareholding as it would have been for somebody in a more standard business scenario away from the partnership model.

In many ways, if it wasn’t for the issues that Peter experienced around the audit question, which I referred to earlier on, that’s one of the biggest confusions that’s going on at the moment over who can own a firm of Chartered Accountants or registered auditors now. Clearly lots of people believe a whole complete variety of people can own that firm, including private equity or including a corporate structure. The question is, is it controlled by registered auditors, and the Institute of Chartered Accountants has not got its own clarity on that, and hence Peter was able to persuade them in his scenario; many private equity have just assumed, I suspect, that it doesn’t matter. And yet, others who are working through the technical rules carefully are going, well, it doesn’t actually say what happens if a business is not owned by a majority of registered auditors as individuals or as Chartered Accountants, and that’s a big debate going on within the Institute right now.

PH: I think the strong point in my case, Simon, was that every person involved in this had the audit qualification or an appropriate qualification. And I deliberately engineered it like that, because I thought that took away any objection.

Just turning to other issues, I think one of the major issues a small firm like mine faces in the longer term is that most of the people who work here are in the age band, perhaps 45 to 55. We’ve just got someone started at 30, and I think the challenge is going to be for the people I leave behind here finding their replacements, so that they don’t end up in a position where they actually need to look at selling the business.

PL: Right. Have you given some thought to how they might manage that?

PH: No. I think there’s lots of things you need to consider when you go down this line, and if you try and answer all the questions before you press the button, you end up going on forever and never doing it. So I took the view that this is what I wanted to do, the staff were on board, they were happy with it, and I know there’s some loose ends, and I thought I could sort them out in the longer term.

PL: Graeme?

GN: One of the advantages, in particular of the 100% EOT model, is that you can promote individuals without asking them to invest in the business, and that is seen as a significant advantage. You get promoted based on merit, not on your ability or willingness to invest in a business.

PL: And obviously an outright advantage for younger people in that regard, who might struggle with that.

GN: It’s worth noting that if you have a large LLP, then… and particularly one that works on the so-called ‘naked in, naked out’ basis, then there is actually less need for a business succession solution. This is why law firms have existed since Victorian times, because partners can retire without getting paid out an equity valuation at the time of retirement. For a business like that, you could look at creating a stake in your business, in effect bringing your employees in as a partner in the business so that they’re entitled to a profit share. And there is a precedent for this amongst the law firms. So you don’t necessarily have to go to EOT ownership to bring in, as we’ve heard, an all-employee stake. There are other alternatives, which is again one of the benefits of the UK legal and tax system: there’s some flexibility to adapt the employee ownership model to fit your business.

PL: Does that chime with your thinking, Simon?

SB: Well, I think, as I said earlier on… there’s plenty of businesses that still do operate that ‘naked in naked out’ in the accounting sector as well. But there’s also now increasing numbers that do recognise that there is goodwill value that is created, particularly in the larger practices, where it’s not about individuals so much, it is about the team, about the wider group of people that you’re… And actually, if you’re then asked to pay for goodwill on the way in, you’re certainly going to want it on the way out.

Private equity coming into the market is all about equity. Private equity is dominating the conversations at the moment, and how does private equity get in? Well, they pay big money to typically senior, exiting or near-retiring partners to sell and persuade them to give up the income rights that, in the future, the investors behind the private equity house are going to receive. So I think the idea that we’re in a direction of travel towards the past rather than towards the future is probably unlikely. That’s not to say the private equity model itself is proven in the long term. In fact, if anything, consolidation has proved to not work in the long term, as we’ve seen from previous situations of Vantis and Tenon and a number of others that we have all experienced in the sector over… certainly my working career.

PL: Yes. Peter is nodding vigorously, yes?

GN: That leads, yes, naturally to considering something like the employee ownership trust as an alternative. It’s a method of realising value to sellers, and research suggests that maintaining independence of a business, rewarding those who work in it, are strong motivations for sellers. Peter is not alone in this. These are the number one results when you ask, why have sellers sold to an EOT rather than a trade sale or private equity?

PL: An evolving story. Thank you all very much indeed.

Thank you all for being with us today. Behind the Numbers will be back in March. Before then, the next episode of Accountancy Insights will cover the first 20 years of HMRC, the 10 biggest tax changes taking effect in April, and how to get smaller firms to take on more audits.

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