Why/when to trade?
Trading covers a broad range of arrangements from shared services to establishing new companies. The model used will be dependent on what you are trying to achieve but if you are pursuing a ‘commercial purpose’ then the law requires councils to do this via a company. While shared services are a familiar arrangement for most councils, the establishment of new companies to trade to the public sector and beyond, is becoming increasingly popular.
Trading as a separate company can have many benefits when aligned to your overall strategy but it should not be treated as a quick win as it will take time to fully explore and then implement a new model. With risk involved, developing a strong evidence base and robust modelling pre and post decision is vital, as is good change management.
You need to be clear about your drivers and what you’re trying to achieve as this will have a direct consequence on the type of model that you adopt. Different approaches will be needed depending on whether you are trying to reduce your costs, fill a gap in the market, increase quality or grow; and these drivers are not mutually exclusive. It is still important to consider other options available, for example, stopping the direct delivery of services if another provider can meet the outcome or if there is no longer demand.
As part of the exploration stage you should consider the scope of services involved in the new model; it is not a case of all or nothing. Different elements of a service can be provided seamlessly to the end user without the new model delivering everything directly.
It is therefore important to understand the different options available to create a model that creates value.
There are many benefits to establishing trading arrangements. When successful, there can be direct financial benefits such as reducing delivery costs, allowing growth and increased income to be reinvested locally, contributing to the local economy and safeguarding and/or creating local jobs. A trading venture can benefit from a level of freedom and flexibility that is harder to achieve as a council or public sector body because both organisations have a very different purpose; with fewer services to deliver and different levels of risk, council trading companies can reduce hierarchies, increase autonomy amongst staff and speed up decision making. All of this can improve the quality of services and outcomes for service users.
Key features:
- different models to choose from
- greater scope for income generation
- less control for the council than in-house delivery
- greater control than outsourcing model
- greater opportunity to innovate
- more complexity and cost for set up.
Cost and investment
As outlined in ‘1. Overarching considerations’ it is vital to have an in-depth understanding of your finances, built on credible baseline and benchmark information. Full understanding of the delivery costs, anticipated income and the factors that could affect either figure will create a strong foundation and early warning signals.
While budget pressures may drive the setup of a trading entity, there will be a cost associated with developing and implementing a new model; investment should be considered, with a funding source identified. Reserves can be a source of investment if the business case stacks up, but robust financial modelling should be used to fully understand the financial impact over the short, medium, and long term. It is common for companies to be in deficit for the first few years of operation so access to finance should be in place.
The business case should include the financial impact for both the new organisation or model and the council. While there will be a desire for the new organisation to be successful and profitable, it should not be to the detriment of the council. For example, establishing an alternative delivery model for a service that was achieving income for the council and therefore contributing to support services could leave a budget gap. This all needs to be considered as part of the overall business case to the council.
There will be a cost to exploring the options and developing a business case and business plan. As a minimum, staff time will be required to assess the options, and specialist advice is likely to be required at some stage in the journey, particularly when setting up a new company. As part of the business case, you should consider the cost of implementation. This may include legal fees, tax advice, training and development, recruitment and equipment. Additional resources may be needed as part of shadow or transition arrangements.
A new model will inevitably have new running costs to consider. If you are transferring staff then you need to transfer pensions; actuarial evaluations will be needed and decisions made on new pensions arrangements. This can have an impact on running costs and even if you want to keep the same conditions for staff the Local Government Pension Scheme will not necessarily be available to them when employed by the new company. Corporation tax will be need to be incorporated into financial models in most scenarios when trading commercially, with the exception of certain charities. Tax advice should be sought to fully understand the implications of different models. Additional cost such as property, new staff roles, bidding for contracts, and building a reserve fund may also be important for long term sustainability and future investment. But the new company should be designed to be agile in other areas allowing for savings to be made to offset additional costs.
It may be appropriate to put buy back arrangements in place between the new organisation and the council. Support services such as HR, finance and ICT can be particularly attractive. There are benefits for both parties; the council receives income towards its existing services and avoids having to downsize certain services, and the new company can enjoy a certain level of security and consistency that can allow focus to be on other matters. Buy back arrangements for a set period of time can also be beneficial for both organisations to transition and mature; the council has time to reduce provision or strengthen their offer to customers, the new organisation has time to understand what it needs and commissioning services accordingly. But these can create tensions as the new company may feel that it can get better value for money and customer service from elsewhere and may feel that this option diminishes the control and autonomy of the new company, with blurred lines between the two organisations. Whatever the outcome, buy back arrangements should be considered as part of the business case.
Modelling for efficiency, growth and income targets should form part of financial modelling with a clear understanding of the ambition, but also the reality of the market in which you are operating. Market analysis can provide information on the costs and performance of competitors which can help to identify the targeted customer base and set realistic milestones.
Market analysis and understanding operating and unit costs should inform price setting which is regularly reviewed to stay competitive.
State aid
When setting up a new company it is important that state aid and specialist advice in this area is recommended for your unique circumstance. Under EU legislation public authorities are forbidden to provide subsidies or other aid to private entities in order that there is fair competition across the whole of the EU. There are exceptions and some exemptions may apply.
The state aid rules are intended to ensure that market forces may operate freely across Europe with no unwarranted interference through the state (national government) or an ‘organ of the state’ such as a local authority.
Meeting any of the following criteria could constitute a state aid issue:
- the aid has the potential of affecting competition and trade between member states
- the measure granting aid is capable of or could have the effect of distorting competition by conferring an advantage or benefit on a selective basis
- the aid is paid through (directly or indirectly) state resource, and this can take a variety of forms such as grants, interest and tax reliefs, guarantees, government holdings of all or part of a company, or the provision of goods and services on preferential terms
- the aid favours certain undertakings, or the production of certain goods.
When setting up a separate company it can be easy to fall foul of state aid rules if considering transferring equipment in to the new company below market value or providing start up finance. You should treat the new entity exactly the same as you would any third party provider to avoid any direct or indirect subsidy which would breach state aid rules.
If a state aid issue arises, the assistance proposed must be approved in advance by the European Commission through:
- the Commission approving a formal notification
- the assistance being compatible with an existing approved scheme, or
- the assistance being compatible with one of the state aid block exemptions issued by the Commission.
The consequence of unlawful state aid is potentially serious, including damages payable by the authority to any third parties who can show that they have suffered a loss as a result of the aid (plus interest) from the recipient.
Legal and delivery models
When it comes to considering the legal model for commercial activity there is one main rule; form should always follow function. It will be important to consider what you’re trying to achieve and then see which model fits; strategic fit, partnership opportunities, ownership distribution, control and influence, procurement regulations, tax considerations, risk allocation, sources of additional investment, whether private sector capabilities are desirable, exit strategies and competitive advantage, will all form part of the decision making process.
Shared services, contracts and partnerships with other public bodies have been popular; typically for back office functions such as management teams, transactional services, commissioning, etc. but it has also been used to provide frontline services. However, while shared services still have value, we are seeing an increase in the use of joint ventures and separate legal entities. In 2014, the Cabinet Office announced that 100 new public service mutual have spun out.
There are a growing number of delivery models and legal arrangements available with no one approach gaining dominance. While such choice can allow you to tailor make your design to your unique circumstance, it can be difficult to navigate through all of the options.
When considering which legal form is the most appropriate, it is important to get legal, tax and business advice. A common pitfall is to seek legal advice alone. A legal expert may be able to advise on the technical implications of each model but they may not be in a position to provide the business expertise which you will require to maximise the opportunities available.
An overview of each of the most commonly used models is included below:
Model |
Overview |
Shared services or joint working |
A number of bodies come together to deliver services to each other that they previously provided separately. The main driver is achieving efficiency; bringing independent departments and resources together can release efficiency without a reduction in standards, however, the financial benefits are limited. Developing and implementing shared services arrangements still takes time to design and plan while relationships can have a significant impact on the outcomes. Other key considerations for shared services are being able to directly employ expertise that individual authorities couldn’t afford and providing resilience in service continuity. |
Joint ventures |
A commercial arrangement where two or more organisations establish a new entity for a specific purpose. When between the private and public sector it can provide advantages over traditional contractual arrangements. Shared ownership, risk and reward creates a different dynamic and can build more positive, collaborative relationships than traditional contracting. A typical driver is to attract private sector investment and joining up the different knowledge and skills from the two sectors. Robust governance and contractual arrangements that suit both parties are vital. |
Local authority trading company |
These are 100 per cent owned by a local authority but can operate commercially therefore can participate in a much wider market than a council could. A key benefit is that financial return comes directly back into the council while the council can maintain a high level of control as the parent organisation. This in turn makes it easier to retain a public service ethos and have the company share the goals of the local authority. However, too much control can stifle the innovation and entrepreneurialism that the trading company was set up to take advantage of. |
Mutual |
There are many different types of mutual but in short, they are owned and run by and for the benefit of their members who can be employees, customers, suppliers, investors or other organisations. They fit well with a public sector ethos and benefits include employee control which in turn can improve productivity, staff morale and innovation as staff are active agents. |
Limited company |
These can be limited by shares, by guarantee or public limited and provide limited liability to the members/owners for the activities and debts of the company. A memorandum and articles of associate are the governing documents outlining the objectives of the organisation along with powers, duties and responsibilities, in line with the Companies Act. Charites and CICs can take a limited form, adding additional legal and regulatory requirements. |
Community interest company (CIC) |
A company must satisfy several criteria to become a CIC. They must then comply with CIC law and the CIC regulatory framework. Everything that it does should contribute towards benefit for the community. This focus provides greater access to funding, albeit not to the same level as a charity. There are restrictions on how assets and profits can be used to safeguard their use for the community; these restrictions are outlined in the articles of the company. |
Trusts |
As a non-profit-distributing organisation, trusts are an effective way of managing an asset or resource for the benefit of a third party. Councils can transfer responsibilities and functions to other organisations through a trust, for example, transferring a local park to a town council. |
Charity |
A charity must comply with charity law and the charity regulatory framework. The main aim of a charity is to provide benefit to the public and a key attraction is the ability to increase access to different funding streams such as grants and donations as well as benefit from tax advantages. Charities have the freedom to trade but do have restrictions on what they can do with their profit. |
Governance and the role of scrutiny
Effective scrutiny improves the strength of decision making as well as ensuring that decisions are transparent and in accordance with the needs of the local community. Getting the governance right is integral to the success of any good decision making process. Councils should develop a clear commercial strategy and governance framework which operate within the parameters of their constitution. The governance framework should clearly articulate the role of councillors and scrutiny.
The governance framework will be specific to your local context, the organisational constitution and will vary based on the enterprise that you are developing and the type of activity that you will be undertaking. It will also be dependent on the scale of activity, the risk profile, the legal model and the existing council governance arrangements. It is likely that this is area where specialist advice may be required.
Careful consideration is required to ensure that the governance framework is compliant with the councils existing legal and financial framework and constitution whilst also adhering to company law. Particular care should be taken to identify any conflicts of interest; this can be done through the initial options appraisal and decision making process and also once your commercial activity becomes operational.
Councils should consider governance early in the options appraisal process prior to making any decision to embark on commercial activity. The decision making process should clearly articulate:
- who sits on the board, whether that be councillors, officers or independents and if that creates any potential for conflicts of interest
- the nature of the decisions that are reserved for the shareholder (ie the council) and those that are taken by the board
- what is being requested of councillors and officers and the training and support they will receive
- the risks and potential benefits
- how these risks will be proportionately managed
- under which legal powers is the decision being taken
- any delegated powers
- the governance framework and scrutiny process
- consideration of having non executives on the board.
A good governance framework should:
- define the distribution of rights and responsibilities between shareholders, the board and managers/employees, commissioners and contract management
- be compliant with the councils existing legal and financial framework and constitution whilst also adhering to company law
- articulate the rules and procedures for making decisions (within any new legal entities and within the council)
- balances the need for control to manage the councils shareholder interests with the flexibility required to achieve company objectives
- have a clear separate role (from shareholders) for commissioners which defines the role, and controls in operation to ensure the council is achieving value for money for the services it purchases from any external organisation.
- enable administration’s priorities to be fulfilled and reporting back into the councils reporting arrangements is in place.
Risks and contingency planning
While implementing major change always carries risk, many of our case studies felt that the risk of doing nothing was more severe than any other risk they faced. Instead of being risk adverse, you can be risk aware and put effective mechanisms in place at every step of the journey. This is the value of a robust options appraisal, business case and business plan; to help you to understand, avoid and mitigate risks.
As outlined throughout this guidance, approaching the task in an appropriate order will create a strong foundation; decide on your objective and outcomes, then decide on the model.
A part of your planning process you should consider the impact of failure and identify an appropriate exit strategy. While a council may have no legal obligation to step in if a company which it set up fails, some may choose to minimise the impacts of failure to remain aligned to their values or avoid additional reputational damage.
In some instances of failure, if the customers are buying the services directly, and the entity is not providing a statutory service, then there may be other providers for the customer to turn to. While it may cause reputational damage to the council there may be little action necessary. However, if the council is a customer of the new entity and relies on it to provide services to residents then the risk and need for direct action is far greater. The council may need to bring the service back in-house, taking on board the disruption, reputational damage, and any additional costs that may be incurred. If the council has decommissioned a service it can take time to deal with the practicalities of bringing it back in-house; finding property, procuring equipment, and bringing back skills that may have been lost. Alternatively, the council may choose to find an alternative provider but again, the costs and time involved could disrupt services and may rely on expensive emergency provision, for example, if providing adult social care.
Buy in, skills and capabilities
When developing the option for a trading company, you will need to consider where the workforce will come from. Existing staff could be seconded from the council and any partner organisations or TUPE could be used to transfer staff into the new company. Seconding staff can help to keep positive relationships between the new organisation and the council and can help staff to feel more comfortable and secure about the new arrangement. But it can also make it more of a challenge to create a culture and dynamic that is different to the council and can place limits on more innovative approaches to reward and incentives as well as financial levers.
Using the Transfer of Undertakings (Protection of Employment) Regulations 2016, SI 2006/246 (TUPE) to transfer staff into a new organisation can give provide more autonomy for the company and greater clarity for staff about their new role. It can make developing a new culture easier and allow the company to take ownership of approaches to recruitment and retention. But it does leave the new organisation with a greater liability should anything go wrong. Terms and conditions and liabilities for any future redundancy cost, etc. should be made clear through legal conditions.
There may be new requirements for roles at all levels from board member, managing director to sales and marketing and you should consider if the required skills and knowledge already exist within the organisation or whether it will need to be brought in. It’s not just the new company that may need new skills and functions. The council may find a need for increased commissioning and contract management capabilities and capacity as relationships with service providers change. This will be different depending on the type of model used and the scale.
While transitioning into a new model can be a time of anxiety for staff, there are many who report feeling re-energised, engaged and optimistic about their new situation, particularly if they have had the opportunity to influence and design the new arrangements. It can result in a change in dynamic and culture that allows innovation and autonomy, while staff get the opportunity to learn new skills.
Leading staff through change, helping them to see their place in the future of the organisation and ensuring opportunity for input will help to retain individuals through times of uncertainty. But while working in a new company can be exciting for some, it is not for everyone.
New companies will also be competing in a wider jobs market so pay and conditions need to reflect that and alternative models allow for more flexibility and innovative ways to incentivise staff. This can include performance and/or attendance related rewards tailored to the market they are operating in such as additional annual leave and bonus payments.