The use of Teckal company structures in public service delivery: part 2 - mutualisation

Amy Auton-Smith and Simon Thomas look at some of the legal issues arising in relation to using a Teckal company to kick-start a move towards public service mutualisation, with a focus upon private companies limited by shares as the preferred vehicle.

In the first article in this series, we examined the legal requirements for Teckal companies and how they could possibly be used to kick-start a move towards mutualisation.

This note will look in more detail from a legal perspective at how Teckal companies and the contracts that public bodies enter into with them could be structured, in order to ensure Teckal compliance and also to help with any future transition from public to employee mutual ownership in the future.

It is worth being clear at the start that the ‘incubation’ approach explored here has, in general, been viewed with suspicion by the CJEU and therefore a degree of risk will attach. Where broadly similar ideas have gone before the court previously, they have been seen as devices to avoid the application of the public procurement regimes and held to be unlawful [1].

The key will be to ensure, firstly, that the arrangements are a genuine, compliant use of the Teckal approach and not merely a device to avoid the application of the procurement regime and, secondly, to be absolutely clear that all public contracts will be put out to open tender at the point that public sector control is relinquished (if indeed it is relinquished).

In-house versus open market

As a brief re-cap: although most public contracts are subject to a requirement for open competition, the Teckal exemption allows certain third parties to be treated as though they were part of the contracting authority (or authorities) who are letting the contract.

This ‘in-house’ treatment means that the public procurement regime is not triggered and contracts with the Teckal company can be let without a tender process.

The two basic requirements that these third parties must comply with in order to benefit from the Teckal exemption are known as the ‘control’ and ‘function’ tests. These were covered in detail in the first article.

In the context of a desire to facilitate eventual mutualisation this is important because most newly-established public sector employee mutuals will find it very difficult to convince local authority procurement teams that they are a viable alternative to any established operator in open competition. Running the service as a separate business for a period of time will allow the local authority to assess whether it is one that is suitable for eventual mutualisation and/or open market competition.

Public service

The Teckal-to-mutual route is a way for the public sector and its employees to work out whether certain services, for which there may or may not be a wider market, could be run independently from the public sector. The service can continue to be run under local authority control, whilst at the same time enabling employees and service users to take more responsibility and ‘ownership’ of the service.

This clear focus upon the public interest at a micro level is what sets service transfer to Teckal companies apart from the normal run of outsourcing and privatisation. It is also one of the core strengths of this model.

Given the requirements of the Public Service (Social Value) Act 2012, this public service ethos may also provide the company with an advantage in open competition, if it does eventually proceed from Teckal status to become an independent mutual company competing on the open market.

In the words of the DCLG: “The nature of co-operatives and mutuals may even make them better placed to deliver social value, but this must be tested objectively in the procurement process.”

As with all Teckal companies, it is vital to ensure that the constitution and structure of the company safeguard both public sector control and that public interest focus.

Contracts and the requirement to tender

At the point of entering into a contract with a Teckal company where there is the potential for future mutualisation, the public body should have a clear view of when the company might pass over into employee control. The government has indicated that it regards three years as a reasonable period of time to allow a potential mutual to establish itself within the market [2].

This timescale can then be built into any public contracts let to the company right from the start. This will help to ensure that the transition from in-house delivery to bidding for the opportunity in open competition is something that the employees can be fully prepared for, if the local authority owner eventually decides that the public interest is best served by allowing the company to pass over to employee control.

As soon as the local authority (or other contracting authority) steps out of the company, the control test will no longer be fulfilled and the company will no longer enjoy Teckal status. Most, if not all, of the public contracts held by the company (if they have not already been terminated at that point) will be immediately subject to the requirement to tender in the usual way.

When first looking at whether to set up a potential Teckal-to-mutual company there has to be an understanding by all those involved that the new mutual may not win the open competition at the end of their Teckal incubation period. For this reason alone, the Teckal-to-mutual route is not a path to tread lightly.

If certainty is preferred over speed, then it is possible that the forthcoming new procurement directive [3] may provide a safe harbour for public sector mutuals (although this is likely to be time-limited), and/or make clear the position on employee participation in Teckal companies.

State aid and public assets

State aid is something that will need to be dealt with carefully. As long as the company is Teckal compliant, it is reasonable to expect that this exception to the competition requirements will also ensure that the arrangements do not constitute an unlawful state aid, for as long as the Teckal conditions are fulfilled.

The position is different at the point that the company transfers into employee ownership. Any residual value within the company will need to be assessed and those assets might amount to state aid, if they’re then used to support a private business.

The state aid de minimis threshold (200,000 Euros) could be useful. As long as the value of the public sector assets remaining within the company is below that threshold, it will be exempt. The company will need to keep an eye upon their state aid status as the de minimis amount is assessed over a three-year rolling period. Any additional aid it receives from any state resources will count towards that total.

There are other exemptions available from the application of state aid, depending upon the area of operation of the company. State aid is a complex area, so specific advice should always be sought.

Alongside this, the parties could consider whether the use of asset locks could be appropriate as a way of protecting any public assets.

Share structures and legal form

It is possible for Teckal companies to be established in a number of legal formats, most commonly either as private companies limited by shares or limited by guarantee or as community interest companies (“CIC”).

In a nutshell, companies limited by shares are more able to distribute their profits and companies limited by guarantee or CICs are usually more able to demonstrate a public interest focus. The type that is chosen will depend upon the ultimate objectives of the company.

If it is envisaged that employee ownership of the Teckal company is a likely outcome, and that those employees would want to share to some extent in both the management and possibly the profits of the company, then the “private company limited by shares” option is probably best. This allows for the easier distribution of profits generated in the company; something that is more difficult if the company limited by guarantee or a CIC (community interest company) structure is chosen.

Assuming that the preferred structure is a private company limited by shares, then the share structure should be set up from day one so as to enable any eventual transfer to individuals. The method of that hand-over should also be considered at this stage.

There are basically two ways to get the shares into employees’ hands. Firstly, the shares held by the local authority owner(s) could simply be transferred to the employees. In this case, however, the local authority has to hold sufficient shares so that they can be transferred in such numbers and proportions to the employees to achieve the desired ownership proportions going forwards.

By way of example, it is usual for employees to hold different numbers of shares or shares with different rights attached. Those with more responsibility (such as the chief executive) or those with longer service may be given greater incentivisation or participation through a larger shareholding than someone with a lower strategic level of input or someone who has only just joined.

So, it is therefore more complicated to transfer 1 existing share to an employee group of 5 individuals who each want to have different percentages. It is much simpler to establish the company with 100 shares in issue in the first place and then allocate them in the most appropriate way when the local authority steps out.

Secondly, employees can acquire shares by way of “subscription”. This route is more flexible because the new shareholding percentages can be created at the time the local authority steps out. It can be tailored directly to the employees who will be investing in the company. Subscription is where the employees effectively buy their shares from the company itself, rather than from an existing shareholder. This puts the employees’ investment directly into their company, but it does not realise funds for the local authority that owns the other share(s).

Those local authority shares will still need to be divested in some way (in order to effect the local authority’s exit from the company). The simplest route is to transfer them to one of the employees. This should be factored into the calculations when allocating the new ownership proportions between the shareholding employees if the subscription route is chosen.

The likely approach to share ownership or membership of the company is therefore something that should be considered at the outset.

Process for “Handover”

At the point of handover, the existing shares in the Teckal company held by the local authority will be transferred to employees and those shares, plus any additional new shares subscribed for by employees, will form the total shareholding in the company.

Therefore, at a point in time prior to the envisaged handover date (for example six months prior to the end of the term of the underlying contracts) the public body and the key employee stakeholders should sit down and agree whether mutualisation at the end of the contract period is an appropriate option.

If the public contract that is currently let to the company is substantial then it might be necessary to hold this planning meeting earlier.

At this stage, assuming that the parties wish to continue along the path to mutualisation without local authority ownership, the new shareholding position going forward should be agreed between the key employees. This will help to ensure a smooth transition at the appropriate date.  

Another factor to determine at this stage is the value at which the shares will be sold to, or subscribed for by the employees.

If the point of handover will coincide with or follow the termination of the majority of the company’s contracts, the individual shares in the Teckal company are likely to have a relatively low value. Consequently, the price paid for the shares should be relatively low (because at that point the company will have very little on-going business in it).

This is important because any employees acquiring shares as part of the mutualisation process should expect to pay “market value” for the shares they are getting at the relevant time. If they are “given” or otherwise acquire shares at less than their market value the tax treatment can be punitive and there could also be consequences under public law (for example, the transaction could trigger the rules against state aid or the requirement to achieve best value).

Advice should always be taken from a finance or internal audit perspective and of course the employees should seek their own financial and legal advice separately.

The value of the shares would be expected to increase again as the company’s trading builds up, especially if it is awarded new contracts. It is essential that, as part of the planning process for mutualisation, appropriate tax advice is taken to ensure that no unforeseen tax issues arise.

Given the amount of planning required, it is important to start the discussions as to whether mutualisation is desirable well in advance of the proposed handover date.

Similarly, if at that time the appetite amongst the employees to take over the company is not there, early planning will give plenty of time to consider how to take the Teckal company forward.

The options at that point would be basically whether to continue the company within the ambit of Teckal status by entering into another round of direct contracts with the public body, or whether to wind the company down in an orderly fashion.

Other practical considerations at the point of transfer

Another practical consideration that should be dealt with in advance of any transfer (and indeed right at the outset if there will be more than one local authority owner in the Teckal company) is to have a properly drafted shareholders’ agreement between the employee-owners.

This would regulate matters such as appointing directors of the company, the level of influence that minority shareholders could exert on the day-to-day running of the company, and what should happen if an employee wishes to leave or transfer his shares.

Employees within a mutual company should expect to have to give up their shares if they leave employment with the company and this is something that needs to be set up at the point that the employees acquire their shares. The shareholders’ agreement should deal with this question, along with the question of what happens to the shares and what price (if any) is paid for them upon exit.

A shareholders agreement should also regulate matters such as the company’s ability to raise finance and how the shareholdings of the employees will change as new members are brought in over time.

As one of the main attractions for mutualisation is the greater freedom it offers, consideration should also be given at an early stage to the business basics such as remuneration, employment terms & conditions and company policies. Extensive guidance is available from the Cabinet Office Mutuals Information Service [4].

Amy Auton-Smith is Service Manager and Deputy Monitoring Officer at Bristol City Council. She can be contacted by This email address is being protected from spambots. You need JavaScript enabled to view it.. 

Simon Thomas is a partner at Clarke Willmott LLP specialsiing in company law. He can be contacted on 0845 209 1359 or by This email address is being protected from spambots. You need JavaScript enabled to view it..