Succession Planning Using Employee Share Ownership

For many Canadian businesses, the topic of succession and retirement is a daunting one given how many are family-run. But it’s not always possible to pass the business on to the next generation. This is where an employee share ownership plan (also employee stock ownership plan or ESOP) may come in.

Succession planning involves many components — tax and legal, culture and communication — that should be detailed in a written plan. However, only one in 10 business owners have a formal business succession plan in place to ensure a smooth transition, according to the Canadian Federation of Independent Business.

Research shows three-quarters of owners will leave their business for retirement, while a smaller share will exit because of stress (22 per cent) or to step back from their responsibilities (21 per cent). To make the process more challenging, there are barriers that keep business owners from planning. Finding a suitable buyer is the most common obstacle to succession planning (54 per cent), followed by business valuation (43 per cent) and the reliance on the owner for day-to-day operations (39 per cent).

The most essential factor for owners when selling their business is protecting current employees, indicated by 56 per cent of owners as very important, more than getting the highest price, ensuring legacy and so on.

ESOPs can be a feasible consideration for many private Canadian businesses because they take care of employees and maintain legacy, the owner doesn’t have to search for a buyer, and employees have great knowledge of the business — they might be the best ones to run it. On a larger scale, they are great for the country, keeping businesses and jobs local and sharing wealth with those who build it.

Research from the National Centre of Employee Ownership shows businesses with successful ESOPs can thrive. They experience faster growth than expected (eight to 11 per cent annually), higher productivity (four to five per cent), leading to higher sales and company value, and longer job tenure (53 per cent). These businesses are also 50 per cent less likely to go out of business and are more resilient through challenging times. Employees in successful ESOP companies generally have higher wages and retirement accounts.

But what exactly are these plans?

Employee share ownership can be structured in a variety of ways, but essentially it is a formal plan that allows employees to acquire and realize results of ownership in the business in which they are employed.

There are five main models of employee ownership: employee ownership trust (EOT), equity share/purchase plan, stock option plan, phantom share plan and employee co-operative.

Employee Ownership Trust
This is a new model, available since January 2024, allowing qualifying businesses and business owners to sell the company to their employees. The selling business owner is able to access up to $10 million of capital gain tax-free until 2026, a significant tax incentive. It allows all eligible employees to be beneficiaries of the trust and allocate profit (annually, for example) and/or equity payout when an employee leaves (retires, for example).

The EOT buys the shares from the owner for the benefit of the employees with funds from a lender and/or the company. Even though the owner is selling a controlling stake, they would likely see their full payout over time through company profits rather than immediately.

An EOT is best used for owners wishing to fully sell their business as the transaction must be a sale of a majority interest; the business owner would no longer control the company from a legal standpoint. If desired, the selling owner can continue as a director of the company and as a trustee (along with employees) in the EOT, but only to a certain degree. The business owner must also be comfortable having their employees essentially own the business without having to pay for any shares and that all employees are eligible (it is not a single person plan). It can be an attraction and retention tool for the company long-term.

Equity Share/Purchase Plan
An equity share/purchase plan is one where employees purchase shares from the owner (or subscribe for shares from the company) with their own funds (lump sum cash, payroll deduction, loans the employee gets on their own). There are other means to help make the program more attractive for employees: give shares as a bonus (annually, for example); offer a payroll deduction program; loan funds to the employee from the company; and propose to match share purchase with ‘free’ shares. Many owners value the concept of financial skin in the game — they believe it maximizes the ownership thinking that would result from having ownership in the company compared to if the shares were given to employees.

There is flexibility in how much ownership is transferred to employees and when it is transferred, so the original owner can exit on their terms. However, there is no special tax incentive to the owner. As the employees are now owners as well, they may be able to access the capital gain taxation and lifetime capital gain exemption when they eventually sell, as long as certain conditions are met.

In addition to succession, this model is great for attracting and retaining employees, engaging everyone in an ownership culture and alignment to the same goal.

Stock Option Plan
This is a common model in start-up companies or companies wanting to encourage key people who have the most direct influence on company value. Employees are offered the ‘option’ to purchase shares at some point in the future at the current price (or less) with the goal of incentivizing them to increase the success of the company. If the company grows in value after five to 10 years, the employee would exercise their stock option, purchase the shares at the previous price and sell (if available).

The model is employed most often when a third-party sale is the desired outcome, but can also be useful as a long-term motivator without the goal of a third-party sale. There is no upfront risk from employees and it may not achieve the ownership culture to the same extent as the other models. There is also certain administration that goes along with a stock option program, such as proper expensing of stock options annually.

Phantom Share Plan
A phantom share plan doesn’t involve sharing legal ownership; rather, it is more like a super-bonus program because it creates an agreement between the company and employee that they will have access to funds based on the success of the company. Typically, the agreement involves the employee ‘acquiring’ units that mirror a share in the company; they can go up and down in value. There can be profit distributions based on the value and/or payouts upon certain exit events like retirement based on the value at the time.

This model is not effective as an exit strategy as no ownership is actually being transferred; however, it can be successful as a bonus plan that aligns employees’ behaviour with increasing the company’s value and does not require any financial disclosure. The owner and employees would not be able to have capital gain tax treatment or access the lifetime capital gain exemption in this model.

Employee Co-operative
Popular in some areas of Canada, a co-operative model involves employees becoming equal owners of the company. It is a slightly different mindset compared to the other models because everyone has an equal say in running the company. Like the other models, it can be a feasible option for increasing ownership culture, keeping business in the community and sharing wealth with those who create it.

The Right Choice
When considering employee ownership, a business owner should connect with a specialist to assess which model, if any, is feasible. No two companies are the same and the specific employee ownership plan chosen is going to depend on the owner and company’s goals, the employee group and technical structure. All models have potential to achieve an ownership culture to varying degrees, the key being how engaged the employee group is. When contemplating these plans, make sure to not only think about the technical components (legal agreements, tax structuring, valuation) but also the cultural elements (communication and education) to ensure employees are engaged and your program is successful.

Joanna Phillips is director of Employee Ownership Canada, a non-profit association that aims to provide information about and increase awareness of employee ownership for Canadians. She is also vice-president of ESOP Builders, a provider of employee stock ownership plans for small and medium-sized businesses in Canada. Joanna has been formally involved in the employee ownership space since 2019.