Employee Ownership Trusts (“EOTs”) are becoming more and more common since being introduced in 2014. Take up initially was quite slow but they have become more widespread in the last couple of years. This has been driven by many factors including:
- increased awareness, as more high-profile businesses follow the EOT route, like Richer Sounds; and
- actual and anticipated changes in Capital Gains Tax including the reduction in Entrepreneurs’ relief in 2020.
In June 2020, there were 470 employee-owned businesses in the UK. This was up from 370 (c.28% increase) in June 2019, and around 300 in June 2017. Prior to this the number was growing at around 10% per annum.
EOTs provide a route for existing shareholders to transfer ownership of a business to the employees in a tax attractive manner. High profile examples of businesses which have an employee ownership model are John Lewis, Mott MacDonald, Arup, Unipart, and Hyperion, where employees have a stake in the success of the business and are granted more influence over decision making.
However, for EOTs to work certain factors need to be in place and they will not be the right answer for many businesses. We have detailed some of the key points of the scheme below, along with the advantages and disadvantages:
What is an EOT
- The outgoing shareholders sell their shares to the trust (the EOT), which then owns the trading business.
- The value is based on an independent valuation of the business.
- The trust is managed by Trustees who generally form a trustee company. The trustee company is in turn operated by a board of directors, that will usually include employee representatives and a professional trustee or non executive director (NED) to provide advice. The outgoing vendor is likely to be a trustee given the ongoing financial interest they retain in the business in the form of any deferred consideration.
- The sale of the business to the EOT gives rise to a debt owed by the trustee company to the outgoing shareholders, in respect of the value of the shares they have sold. This can be paid by a combination of existing cash in the business, future profits/cashflows of the trading company and, if appropriate, additional debt that can be secured on the trade and assets of the trading company. As such the selling shareholders will receive some consideration on completion of the sale of the business to the EOT and the remainder will be deferred and paid from the future profits/cashflows of the business.
The qualifying conditions for an EOT
- The company must be trading or a holding company of a trading group.
- A minimum of a 51% shareholding must be sold to the EOT.
- The EOT must retain on an ongoing basis at least a 51% shareholding in the company.
- The EOT must meet the ‘all-employee benefit requirement’, also known as the ‘equality requirement’ – any benefit to employees must be on the same terms for all eligible employees. So, the trust cannot prioritise benefits to the advantage of particular employees, but it can allocate benefits of differing amounts according to factors such as salary and length of service.
Advantages of an EOT
- A friendly transaction between parties that are involved in and understand the business.
- Shareholders can sell their shares for full market value and receive their consideration through the ongoing trading profits of the business.
- The transfer of shares is free from Capital Gains Tax (compared to 10/20% in a normal sale), Inheritance Tax and Income Tax.
- It facilitates wider employee ownership without employees having to use their own funds.
- Employees can be paid tax-free annual bonuses of up to £3,600 so long as these are paid to all qualifying employees on the same terms.
- Transfer to employee ownership might result in a positive culture change and release significant amounts of previously untapped potential.
Disadvantages of an EOT
- Transfer to employee ownership might result in some negative outcomes with key decisions needing to be made by the Trustees and employees influencing decisions. This might result in a lack of direction, poor decisions being made and inertia, leading to the business losing market position.
- Once an EOT is in place it is not straightforward to revert to a more conventional ownership structure. Such a move would also risk the tax incentives being clawed back, depending on the timing.
- The amount of cash payable to shareholders on completion of the transaction will be more limited than in other transactions. It may be limited to existing cash in the business and deferred payments from future profits/cashflows. There may be some scope to raise debt, but it is likely to be more limited than could be achieved in other transactions.
- Discussions around how much of the business profits/cashflows should be used to service the deferred consideration and how much to invest in the business or pay to employees can be challenging.
- There may be some tax challenges in transferring cash from the trading company to the EOT.
- Key employees such as the Senior Management Team may prefer a model that provides the opportunity for them to have direct ownership following a transaction for example, a Management Buy Out (MBO).
- It is not straightforward to ensure all employees are engaged in the transaction, with 75% of employees required to agree on decisions.
- Payment plans for the deferred consideration may be 7 or 8 years meaning the shareholders must wait significant periods of time to be paid in full.
- EOTs will work best with companies of a certain size. If too small then the complexity may not be justified and, if too large then it may be difficult to ensure appropriate levels of employee engagement.
- There is the potential for conflicts of interest to arise between the Trustees, given that existing shareholders may be become Trustees of the EOT.
Summary
Shareholders need to think very carefully about whether an EOT is the right answer for them and their business.
There are many factors and complexities to consider. It is a great solution if the shareholders genuinely want to see their business transfer to employee ownership for the right reasons, and the business model is a good fit.
However, EOTs should not be viewed as tax-free alternative to MBOs – they are very different types of transactions with very different dynamics.
Should you wish to discuss an EOT, or any other similar type of transaction, please get in touch.
Photo by Sebastian Herrmann on Unsplash