EMPLOYEE OWNERSHIP TRUSTS EXPLAINED
What is an EOT?
An EOT is a trust established on behalf of and for the long-term benefit of the employees
Company owners can sell their company to an EOT, rather than a traditional buyer, which not only gives employees incentives to contribute to the future success of the business but also provides business owners with practical advantages over traditional exit routes, including staying in control of the sale process and selling their business tax-free.
With employees benefiting from the future value of the company, they have a greater interest and incentive to ensure the ongoing success of the business and this mechanism is often cited to promote greater business resilience, employee satisfaction and profitability. However, it is important to understand that employees do not become owners and do not have control over the process – you are dealing with the Trust, not the individual employees. The company will continue to be run by the Board of Directors as before.
EOTs are an increasingly common sight on the UK business landscape. According to the Employee Ownership Association, they totalled 730 in June 2021, a 30% increase since June 2020 (itself a 28% increase over the prior year).
What are the advantages of an EOT?
The best-known advantage of an EOT is that the disposal can be completely tax free. However, there are also other significant commercial and practical advantages over a traditional company sale. Many of the usual difficulties of the sales process fall away:
Finding a buyer:
One of the biggest challenges of a traditional sale is finding a buyer in the first place; this can be a long-drawn-out process where a substantial amount of time is invested in meeting with potential acquirers, including tyre kickers, which often leads nowhere. A huge bonus of an EOT transaction is that there is no need for a buyer search, your buyer (the Trust) is formed by you, in essence, you are selling to a friendly party.
With a traditional sale, price negotiations can quickly turn into price renegotiations – and potentially a particularly disappointing last-minute price chip. Pricing is straightforward in an EOT transaction, the price is determined by way of an independent valuation agreed between you and the Trustees of the EOT. This is a fair market valuation that broadly equates to the value that might be achieved selling to a third party. The pricing is set before the process commences and there is no need to be concerned about last-minute price chips, you know the deal you are undertaking.
Another pitfall of a traditional exit route is the number of people involved; there are lawyers, due diligence teams, tax advisers and lenders or corporate finance team on both sides who take an oppositional approach leading to stress, delay, and escalating costs. In an EOT transaction, there are fewer parties involved and the process is collaborative rather than combative. Your tax advisors will seek advance approval from HMRC for the sale so that you can be confident of the advantageous tax treatment. The lawyer’s input is agreed from the start and is simply to implement what you have decided, not to fight over every detail.
Low-risk benefit for employees:
Employees do not become shareholders, instead, the EOT is the new shareholder. So, employees do not invest funds or take on any personal debt as they would do in many other deal structures, making it a very low-risk venture for them. Because employees have a vested interest in the success of company going forward, EOTs have been shown to increase productivity and employee satisfaction. This in turn can lead to increased growth and a more resilient company. A sale to an EOT is a positive outcome for employees rather than a source of concern as is usually the case where there are fears over lost jobs with a new owner.
Finally, a standout advantage over a traditional exit route – EOT sales are completely tax-free. With a traditional exit route, as a seller you could typically expect up to pay up to 20% in CGT on the sale, so EOTs can therefore deliver more value to owners. However, a word of caution – to qualify as an EOT, specific conditions must be met – if an EOT is established incorrectly, HMRC can come back and reject it, at which point the sellers must pay full tax on the sale. It is therefore imperative that you experienced tax advisers are involved from the start.
What should be considered?
Fundamentally, the key considerations fall into two distinct categories:
The Trust requires funds to pay sale proceeds to the owners. Where there is accumulated cash, which can often be a sizeable sum, this money is gifted by the company to the EOT to be paid to the vendors.
The agreed sale value is generally higher than the available cash and the shortfall is bridged using debt, this could be external debt raised by the company or the EOT itself and/or the sellers being given loan notes, which are paid out from future earnings. These loan notes can attract an interest rate of up to 10%, often more attractive than anything a seller could achieve by investing monies received. However, there are risks inherent should the company fail to perform in the future.
The sellers must lose ultimate control of the business – at least 51% must be sold to the EOT and HMRC will also expect the sellers will not control the board of directors or the EOT itself. However, the board of directors can continue as they were before the sale, and there is no requirement to involve the employees in decision-making processes. The vendors may have to identify suitable new board members and be confident in the ability of the remaining management team and their stewardship over the business to keep it running well and profitably, whilst servicing increased debt levels.
There are other mitigating actions owners can take to alleviate some risk here. They may choose to sell less than 100% of the business to the Trust and thus retain some influence throughout the business. It is also possible for a representative of the owners to sit on the Board of Trustees, although this must be structured carefully.
How is an EOT is structured?
It is never too early to start to plan for an exit and the sooner you start engaging and having conversations with advisers the better.
Below is a general four-step plan to a successful EOT:
- Once an EOT is decided upon, it is essential to get an independent valuation to determine a fair sale price. Once a valuation has been agreed the next step is to work out the best structure for the transaction, how to fund it and the makeup of the Board of Trustees as well as the expanded management team. It is important to carefully consider how proceeds will be paid, how much you will sell to the EOT and whether the company can afford the deal structure.
- Tax advisors will ensure the structure meets the detailed EOT requirements and submit an advance assurance application to HMRC to give comfort that the expected tax-free treatment will be available.
- Where third-party debt funding is a preferred option, conversations with lenders should start early in the process so that informed decisions can be made.
- Your lawyers will form the EOT itself and draft the Sale and Purchase Agreement (SPA) which can be a simpler process than it would be in a traditional exit due to the more collaborative nature of EOT transactions. Once these elements are completed it is a question of signing the paperwork and your EOT is in place; you have successfully navigated your exit.
EOTs have significant advantages but there are key financial and commercial considerations which need to be thoroughly weighed up before committing to a course of action. There are also detailed tax rules to achieve a tax-free disposal to an EOT.
Tax and corporate finance advisors are a key part of the process in arriving at the right value, deal structure and funding for your company. Your advisors will then work alongside the legal team who will prepare the documents to implement your chosen structure.
We can assist in exploring your options to achieve a deal that meets the long-term aspirations for the business and helps maximise value. If you are keen to protect your legacy and ensure the ongoing success of the business, an EOT offers a highly compelling option to allow just that, with the added benefit of generous tax incentives.
How can we help?
We offer a “one-stop shop” service for sales to an EOT. Within the K3 group we have the tax, corporate finance, and debt advisory experts to cover all aspects of designing your sale to an EOT. We work with partner law firms who will provide the legal services to form the EOT and implement the sale. We can provide a competitive price to cover all the services required and deliver a seamless service from start to finish.