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Considerations for Succession Using an EOT

Employee Ownership Trusts (EOTs) have recently burst into the business succession scene in Canada and are consuming a lot of owner’s thoughts, providing another option for those business owners who hope to transition out of their business.

While new to Canada, they were initially conceived over fifty years ago and have been used successfully in the United States and other countries as a mechanism for owners to transition their business to their employees in a tax efficient and cost-effective manner. Owners considering using an (EOT) as the mechanism to exit their business will need to understand how they work, as well as the advantages and disadvantages of using an EOT for succession and exit from their business. Here are several key considerations an owners will need to assess should they wish to use an EOT as a succession mechanism:

1.      Financial Readiness: Assess the financial health and stability of the business to determine if it can support the implementation of an EOT. Consider factors such as cash flow, profitability, debt levels, and access to financing. Companies with good fiscal governance and disciplined financial processes, which have more predictable cashflows, an established and loyal customer base with long-term contracts may be better candidates for an EOT succession.

2.      Valuation: An independent professional valuation of the company to determine the company’s fair market value will be required. This valuation will serve as the basis for the EOT transaction and ensure that both the selling owner(s) and the employees receive a fair deal. As well this independent valuation will be needed to support the transaction in order to satisfy any regulatory and taxation considerations.

3.      Employee Engagement and Culture: Evaluate the company's culture and assess whether employees are ready and willing to become owners. Communication and education are crucial to ensure that employees understand the benefits and responsibilities of EOT ownership. Not all company cultures can support an employee ownership model so serious consideration must be given as to whether employees are capable and ready for such a change.

4.      Management Succession: Develop a plan for leadership transition and ensure that the company has capable management in place to oversee the EOT and drive continued growth and success. Companies with long term employees who have demonstrated competency, loyalty and an ability and willingness to adapt may be better suited for an employee ownership transition model.

5.      Tax Implications: Understand the tax advantages and implications of selling to an EOT, including potential capital gains tax deferral for selling owners and tax deductions for the company's contributions to the EOT. Both company and personal financial and tax planning.

6.      Legal and Regulatory Compliance: Ensure compliance with all legal and regulatory requirements governing EOTs can be met. As of this writing there are some rules in place, but regulatory conditions and requirements have not been fully clarified for an EOT in Canada. The cost for maintaining a compliant EOT structure is uncertain at this point, as are the implications of failing to comply with the necessary regulatory and legal requirements.

7.      Fiduciary Responsibility: Recognize the fiduciary duties that come with managing an EOT and ensure that trustees and other fiduciaries act in the best interests of the participants, which will require a higher level of responsibility and accountability for management and the governance team than for a private, owner owned business.

8.      Liquidity and Diversification: Consider the liquidity needs of selling owners and develop a plan to provide them with an exit strategy or options for diversifying their investments outside of the company.

9.      Employee Education and Communication: Implement a comprehensive education and communication strategy to educate employees about what an EOT is, the transition process, its benefits, advantages and disadvantages, and help them to learn about and understand their roles as owners as well as how the company will be governed and managed on their behalf.

10.  Long-Term Sustainability: Evaluate the long-term sustainability of the EOT structure and its ability to continue providing benefits to employees and supporting the growth and success of the company.

The EOT structure offers an exciting new path for owners in Canada to transition out of their business and to provide employees with a path to ownership without incurring significant personal costs, but it must be considered with caution. When considering an EOT as an exit or transition mechanism, owners must carefully consider the above noted key factors in order to assess if an EOT is the right exit strategy for their business, or even for their employees.

If this option is the selected path forward for an owner, it will become imperative that they undertake the necessary planning and preparation to ensure a successful transition of ownership to employees. For some companies this may be relatively easy, but for others the preparation process to make an EOT a succession mechanism for exit may take longer and could end up being a costly experiment. Understanding the requisite conditions for a successful transition using an EOT will be critical for an owner who wishes to avail themselves of this option.

Please Note: the rules surrounding EOTs in Canada are evolving and if you are considering this option for an exit from your business it is imperative that you consult appropriate legal and tax professionals.

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