Wednesday, 23 July 2014
Since the explosion in the number of provincial brokers from the early 70s, the end-game has focused – with few exceptions – either on sale or inheritance as the only two exit strategies for the founders. Happily, there is now another way, an alternative that captures the zeitgeist of the times into which we have been delivered. Employee Ownership.
Before going any further, one should make the distinction between Employee Ownership and employee *Share Schemes *by pointing out that these two similar concepts do not necessarily amount to the same thing.
Share schemes took a bit of a reputational knock recently following the Giles sale, when it turned out that those shares held by employed individuals were worth nothing at all. It is difficult to justify ‘nothing’ as a motivational benefit, unless, somehow, employees somehow believe that their shares will be worth rather more than they turn out to be. Some Share Schemes also bring with them - in the small print - additional and onerous restrictive covenants over employee, which are not entirely cricket.
Therefore, in all conscience, before involving staff in any form of equity participation, there has to be an honest independent valuation of the business and a formula derived, which can be applied annually in order that said valuation is kept up to date. A legitimate price per share can then be maintained and a universal dividend policy introduced. It is also worth having the valuation and the formula refreshed every 3 years to ensure they remain current and tweak them within limited bands if they are not.
There are various ways of structuring Employee Ownership, one being an Employee Benefits Trust (EOT). An EOT is how The John Lewis Partnership is formulated and this model could legitimately be described as ‘pure socialism’; no individual owns anything, everything is held by a Trust and the Trust represents the interests of all employees collectively. A SIP, on the other hand, allows individuals to buy shares up to a value of £150 pm each, deducted from salary before Tax & NI; which shares can then be sold after three years with no Capital Gains Tax (CGT).
In recent months TEn has made no secret of its intention to work towards Employee Ownership. It joined the Employee Ownership Association last year and is actively now putting steps in place to make this a reality for its staff and ultimately, being a network committed to remaining independent, for its members as well. We have therefore investigated all the various options and for us at least an EOT suited us for a simple majority of the shares, with a Shareholder Incentive Plan (SIP) taking up some of the balance.
Within the rules of a SIP it can also be possible to ‘give away’ shares in lieu of bonuses, or to mark a number of years’ service with shares etc. Certainly for TEn Insurance, a hybrid arrangement combining elements of EOT and SIP seems a good combination of features and benefits; with a minimum of 51% going to the EOT, but backing-off a bit from the ‘pure socialism’ idea!
Included in the 2014 Finance Bill - currently going through parliament - is a provision for the sale of shares to an EOT, if the Trust holds more than 51% of the company’s equity, then there will be no CGT. For most people this means a saving of 10% in tax compared to a trade sale, although, in TEn’s case, the Directors have all agreed that their shares will first be discounted by about 40% off the notional full market price. This discount is because we are all minority shareholders, but there are good arguments why some level of discount should apply, even if this were not the case for other brokers.
In addition to lower than expected multiples and difficult access to funding right now, brokers considering a sale exit strategy should also be aware of the hazards of earn-out periods. Often when brokers are sold there is an earn-out period, during which the 5% to 10% of business naturally lost every year counts against the seller’s final pay-out, whereas the compensating 5% to 10% of new business gained does not count the other way. Obviously this equation gets much worse if any Account Execs quickly decide to go elsewhere after they’ve been sold and, even after 12 months covenant period, begin to take business away.
Not to put too fine a point on it, this means that since networks started to offer these disenchanted ‘sold-out’ Account Execs the opportunity to leave and become start-up brokers themselves, there have been a number sellers who have not realised their full expectations in terms of the headline price. Selling has become a lot more hazardous over the years, because it’s not just a tricksy buyer that you need to worry about.
Instead, why not do what TEn intends to do this summer and in one grand gesture, get 51% of your shares into an EOT. But, how do you afford it and who pays?
Well, to get 51% into the EOT you first need to establish the EOT, which seems to require about £20,000 in solicitors and accountants fees. You then simply sell 51% to the EOT. If it’s £1m for 51% and you don’t happen to have the odd £1m knocking around, then that’s ok, the recipients of the £1m can immediately loan back to the EOT the same £1m. Don’t worry about FCA Solvency, because an EOT is not the regulated entity.
Obviously, the EOT will have to pay a commercial rate of interest for any monies loaned to it by the shareholders who have chosen not to take their money yet. However, most banks seems to believe that 0.5% is a commercial rate for £1m on deposit, so there does not have to be a noticeable cost involved in this part of the transaction, although HMRC guidelines of up to 3.25% may be alternatively applied.
The EOT now owns 51% of the business and entitled to 51% of dividends, with which to buy the shares of the original owners over time. This process does take time and a willingness on the part of the founding shareholders to dispose of their shares gradually leading up to their retirement and, perhaps, even a few years afterwards, if they stay on as non-exec directors.
We shall never get back to the number of brokers that existed 20 years ago and the remaining 2,500 will probably shrink still further. But, the Employee Ownership route should work for organisations above 25-50 staff, which is, realistically, the minimum size of directly regulated broker, outside of a network, that the future will support and exactly the right size in terms of best customer service.
Smaller brokers will still continue to exist of course, but probably only within the context of AR networks, which should themselves convert to ethical and sustainable ownership. Consolidation as a phenomena will end – if it has not already - and broking must be seen once again as a professional living that can provide a comfortable; not as a fast-track to £millions.