An introduction to Employee Ownership Trusts

Andrew Hoad, who recently joined as a partner in our Corporate team, is an expert in disposals to Employee Ownership Trusts (EOT), having completed a number of such disposals since the start of 2020. In this article he discusses how an EOT works and some of the advantages of selling your company to one.

Historically there have been two primary options for owners of small to medium enterprise (SME) businesses looking to realise the value that they have built up in their company. These were a trade sale, or a private equity backed management buyout (MBO). Over the last two or three years a new alternative has gained more traction and, as advisers and funders develop a better understanding and more awareness of the benefits, a disposal to an EOT offers a genuine third alternative with certain clear advantages.

The concept of employee ownership has been around for decades but, until the changes to Capital Gains Tax (CGT) in the Finance Act 2014, there were no tangible tax advantages for owners to dispose of their company to an EOT. The 2014 exemption, however, means that there is no longer any CGT payable by the owners of a company that sell their shares to a qualifying EOT.

The ability to dispose of your company for full value without paying any CGT is very appealing, especially with rumours of further increases in CGT to pay for the cost of the COVID-19 pandemic, on top of the previous clawing back of the benefits of Entrepreneurs Relief.

Whilst the decision should not be driven purely by tax, it is certainly gaining traction. There are lots of advantages to selling to an EOT which we discuss further below.

So how does an EOT work?

In simple terms it works like this:

1. The target company establishes an Employee Ownership Trust where the employees of the company are the beneficiaries of that trust.
2. There are two main types of trustee structure, either a corporate trustee (which is a company limited by guarantee where the directors are made up of the target company management, an independent director and an employee director) or multiple trustees who are again made up from the management together with an independent trustee and an employee representative.
3. The target company is valued by an independent valuer.
4. The sellers and the EOT then agree a deal for the payment of the consideration. The structure normally provides for a lump sum payment upfront (depending on the available cash that the target company has) with the remainder being paid out over a period of time (usually five to seven years) depending on the profitability of the company.
5. The Trust has to gain control so needs to acquire at least 50.1% of the ordinary shares in the target company.
6. An agreement is drafted between the EOT and the sellers. Immediately prior to completion, the target company contributes sufficient funds to the EOT to enable it to pay the initial consideration (and the associated professional costs). The deal is then completed and the funds are paid to the sellers.
7. The remaining consideration is a contractual debt that the Trust owes to the sellers and as the company makes profits, it pays further contributions to the Trust to enable it to pay off the outstanding debt to the sellers until the whole of the consideration has been paid off.

Advantages of Employee Ownership Trusts

A disposal to an EOT should not be made purely to take advantage of the CGT tax exemption and, whilst that might be a factor in the decision making, there are various other advantages to selling to an EOT which sellers should consider:

1. Studies show that employee-owned companies have better staff engagement, higher rates of productivity and greater retention of staff. They are designed to provide permanent or long-term employee ownership of the company.
2. Once you have the independent valuation there is no negotiating over price and there is no need for an extensive due diligence process which can take the management away from running the business.
3. You don’t need to search for third party buyers and spend time marketing the business to them. You also avoid the risk of sharing company secrets with competitors who might be interested in acquiring your business
4. The sellers tend to stay involved with the management of the target company, giving continuity to employees, suppliers and customers as well as allowing for the development of junior management to enable them to take over the running of the business
5. The company can retain its identity, sellers are often loathed to sell their company to a third party only for it to be re-branded or stripped apart and for loyal employees to be made redundant.
6. The company can make an annual tax-free bonus of up to £3,600 per employee.
7. The individual employees do not get ownership of any shares, the trust holds the shares for the benefit of all of the employees. This means that there are no complications with departing employees having to sell their shares. As soon as they cease employment, they are no longer a beneficiary of the trust.

Can all companies set up an EOT?

The rules regarding EOTs means that it does not suit all companies. First, there needs to be sufficient employees to ensure that sellers don’t form too large a percentage of the ongoing employee group.

Secondly, the company needs to be a trading company or the principal company of a trading group but there are no restrictions upon the sectors that would be suitable for an EOT transaction.

Thirdly, unless the target company continues to make profits, it will not be able to make further contributions to the EOT and the outstanding consideration cannot be paid off. The sellers therefore need to have confidence that the target company will continue to be profitable.

Make-up of the trustee board

The most common structure is to have a trustee company with a board of directors made up from the management (which will probably include someone from the seller group), an employee representative (who can be voted for by the employees) and an independent trustee who normally acts as the chair.

Funding

It is possible to get bank funding for a disposal to the EOT whereby the bank will fund the company to assist it with the contributions to the EOT. This is quite a new area for most banks and so they are still a little hesitant but as more and more of these transactions are completed it is expected that the banks will become more comfortable with them.

Conclusion

If you are thinking of selling your company, please contact us. As well as discussing all the traditional routes, the team at Hugh James can talk to you about the possibility of undertaking a disposal to an EOT. It might not be right for your company, but we can work with you to explore the opportunity and if it is viable, we can put you in touch with experienced CF advisers who specialise in employee ownership and with independent trustees who will take on that role.

Our webinar

We are also running a webinar on Wednesday 6 October to provide an introduction to EOT’s and discuss the issues that need to be considered before embarking on a disposal to an EOT. The webinar will cover the following areas:

• legal practicalities
• trust structure
• advantages of EOTs
• commercial drivers
• valuations
• deal structure
• employee engagement
• company management in practice