Preparing for an exit or implementing a succession plan can be daunting. There are a variety of factors to consider, including the challenge of meeting both the business’s needs and the selling shareholders’ objectives. The optimal solution will vary case-by-case. However, one of the exit options we are frequently asked about is selling to an Employee Ownership Trust (EOT).
What are EOTs?
An EOT is a trust that holds a controlling interest (50%+) in a company on behalf of its employees. The government introduced the tax-advantaged initiative in September 2014 with the aim of encouraging more employee-owned businesses, like the John Lewis model.
For business owners, one of the main incentives of an EOT transaction is the generous tax breaks available. Provided the transaction is structured correctly, any gain made on the sale of company shares to an EOT is exempt from Capital Gains Tax (CGT).
How do EOTs work?
An exit to an EOT can be broadly split into the following steps:
- An EOT is set up to acquire a controlling stake of the business (50% – 100%). The trustees, typically a corporate, are responsible for ensuring the success of the trust, and the employees are the beneficiaries of the trust.
- The company shareholders sell their shares to the EOT. Typically, a debt is then owed by the EOT to the selling shareholders equal to the purchase price. Note this debt can be lower where surplus cash of the business and/or third-party debt can be introduced to pay an element of the proceeds to the selling shareholders at completion.
- The future trading profits generated by the company are then used to make contributions to the EOT, which in turn uses these contributions to repay the outstanding debt (i.e. the purchase price).
The trustees/corporate board can be comprised of a mix of target company directors, employee representatives, as well as independent and professional trustees. They’re responsible for ensuring the company operates in the best interests of its employees, but don’t participate in the day-to-day running of the business. This remains the responsibility of management and the target company’s board of directors.
Who’s eligible to exit an EOT?
An exit to an EOT is not available to all. It requires clearance from HMRC and these following key qualifying conditions to be met:
- Controlling interest — a controlling interest must be sold to the EOT (i.e. 50%+ of share capital). Further to the initial transfer, the EOT must retain a majority shareholding to maintain eligibility.
- Trading status — the company must be a trading company or the holding company of a trading group. This means that the company must be engaged in commercial activities and not primarily involved in non-trading activities, such as investment or property rental.
- Beneficiaries — all eligible employees must benefit from the same terms, although this can be triaged based on remuneration packages, length of service, and working pattern.
- Continued shareholder participation — the number of continuing shareholders (plus any other 5% ‛participators’) who are directors or employees must not exceed 40% of the number of employees of the company or group.
Why consider an EOT?
There are a number of benefits associated with EOTs.
Tax benefits — one of the main benefits of an EOT is the associated tax advantages:
- Business owner: disposals into the trust are free from Capital Gains Tax (CGT) and Inheritance Tax.
- Employee: the EOT can pay employees annual bonuses of up to £3,600 per year tax-free.
- Company: a corporation tax deduction is available to the company for the value of the bonuses.
Valuation — the shares can be sold at a full market valuation (subject to an independent valuation report). Despite this, valuations are frequently set at a lower level than might otherwise be obtained in a conventional trade sale, given the tax advantages associated with the sale to an EOT.
Smooth succession planning — EOTs provide business owners with the ability to exit the company while ensuring continuity of the business and preserving company culture etc.
Increased productivity and profitability — EOTs can help create a more engaged and motivated workforce, which can lead to increased productivity and profitability.
Social impact — some business owners are attracted to the idea of selling their business to an EOT because it allows them to create a legacy and have a positive impact on their employees and the wider community.
Quick exit — EOTs can offer a quick and streamlined exit. This is especially relevant when there are no obvious third-party buyers.
Continued ownership — the selling shareholder(s) can maintain some involvement (up to 49%).
However, there are also downsides to an EOT that you need to consider:
- Deferred consideration — sale proceeds are paid in instalments across a number of years, rather than upfront. If the company underperforms, there’s a risk that instalments will not be paid on time, which results in an extension of the payment period. Further, the payment of this deferred consideration impacts the trust’s ability to pay bonuses to employees.
- Lack of control — once the shares are transferred to the EOT, the original shareholders will no longer have direct control over the company (although it’s common for them to retain a minority equity shareholding). The trustees will be responsible for making decisions on behalf of the trust, which may not always align with the owners’ vision for the company.
- Impact on day-to-day operations — whilst an EOT can create a more engaged workforce, it may have a significant impact on day-to-day operations. Employees may not have the skills or experience necessary to make key operational/management decisions.
- Risk of conflict — whilst an EOT can create a sense of shared ownership among employees, it can also lead to conflicts between different groups of employees, particularly if some employees feel that they are not receiving a fair share of the company’s profits.
- Limited access to external capital — once the shares are transferred to the EOT, it may be more difficult for the company to raise external capital, as investors may be less willing to invest in a company where the ownership is distributed among a large number of employees.
- Limited liquidity — if an employee wants to sell their shares in the company, it may be difficult to find a buyer, as the shares will be held in the EOT rather than being freely tradable.
If you’re looking to sell your business, considering an EOT, or just looking for some succession advice options, let’s talk.
