Employee ownership trusts (EOTs) are increasingly popular. High-profile examples include Go Ape, Richer Sounds, Riverford Organic Farmers and Aardman Animations, the creators of Wallace and Gromit.
EOTs are a useful tool for company owners looking to wind down their day-to-day involvement in their business in a tax-efficient way. However, they also have major benefits for the company’s employees.
An EOT is a trust established for the benefit of a business’s employees. The trustee of the EOT is normally a company limited by guarantee. The business is sold by its owner to the EOT and the EOT then owns the company, whose own directors normally retain day-to-day control of the company’s affairs, answering to an EOT board.
Basics
When a business owner sells to an EOT, they receive a negotiated price for their shares, as determined by an independent valuation.
Consideration for the sale is normally in the form of cash and loan notes. The EOT typically funds the consideration from any surplus cash available in the target company at completion and then from the ongoing profits of the business. The terms of the loan are normally flexible to allow for fluctuations in the company’s performance post-completion.
The current rules around EOTs were created with a view to encouraging employee ownership. There are, accordingly, generous tax breaks for business owners selling to EOTs, including, if certain qualifying criteria are met, a 0% rate of capital gains tax (CGT) on all of the gain arising from a sale.
There are also tax advantages for the employees of the target company, such as an exemption from income tax on bonus payments of up to £3,600 per year.
Criteria
There are strict rules for an EOT to qualify for the tax reliefs, to ensure the structure is genuinely used for the benefit of employees and not simply to avoid CGT, with five main conditions:
- The company must be a trading company
- Minimum percentage of employees who are not the owners or connected persons
- The EOT must hold a controlling interest and
- It must be established for the benefit of all employees
- The seller must be an individual(s) with UK tax residency.
Advantages
From the employees’ point of view, the main advantage is that they share in the profits. Employee-owned companies are also often more generous with employee benefits. The £3,600 a year exemption from income tax on bonuses for each employee is clearly attractive.
A sale to an EOT is also often less stressful to employees than a normal trade sale, which almost inevitably leads to upheaval and redundancies. Research suggests that EO companies tend to be more successful and sustainable, with increased employee motivation and retention.
For sellers, a major advantage of the EOT structure is the saving in CGT. Many of the advantages, however, are not tax related. One attractive feature is that the seller can remain involved in the business after the sale, winding down their involvement over a number of years as the loan notes are redeemed.
The sale process is more straightforward than with a trade sale, with lower transaction costs. While it is necessary to get HMRC clearance, this is not an onerous process. Nor is it necessary to market the business for sale. The amount of due diligence and negotiation required is reduced, as is the risk of a failed sale.
Many sellers like to place their business into a structure that benefits the very people who have made the business a success.
Downsides
A disadvantage to this route is that the seller is unlikely to get paid out for a number of years. This is an issue both for the sellers and the employees.
These deals tend to be self-financing – in other words, the seller gets paid from the profits of the business. It is difficult for an EOT to raise bank financing to pay the sale consideration. As a result, it typically takes a seller five to seven years to get all the sale proceeds, with low distributions to the employees during this period.
EOTs also tend not to work for businesses that are valued at a high multiple (over ten as a rule of thumb) of their EBITDA or with high or volatile internal cash flow requirements.
Practicalities
An EOT sale typically takes three to five months to complete. There is not such a need for due diligence given that the buyer is deferring a large part of the purchase consideration and payment of the consideration is a function of the future profits of the business. The purchaser will benefit from vendor warranties. There is little motivation for the seller to hide information about the business.
In contrast to a trade sale, however, time is needed to arrange for an independent valuation of the company and HMRC clearance. It is often also a good idea for a corporate finance specialist to work with the management to map out the future prospects of the busi- ness. This will help all involved to have an understanding of how profits will be allocated to pay down the purchase consideration and thereafter pay profit-share bonuses to employees.
Governance
Once the sale has completed, the employees remain employed by the same entity and the company carries on trading as before. The change in shareholding does, however, result in changes in the governance of the company.
A key change is that decisions at a shareholder level will now be taken by the EOT board rather than the seller. This board must represent the employees as well as having members with suitable expertise in company governance. Directors of the trustee company commonly comprise a mix of employees, independent professionals and the original seller or a representative of the exiting shareholders.
Is employee ownership something you could or should consider when planning your exit strategy?
Find out more by contacting Adrian Pryce on 07720 297402 or via Adrian.pryce@northampton.ac.uk or visit www.rvecf.com/about-us-eot-experts
Associate Professor Strategy & Society CSBP
University of Northampton
Business Development Director
RVE Corporate Finance
