By Lizz Clarke,
Bizpedia Member & MD of LCM https://www.lcm.co.uk/
Many Bizpedia members who own their companies are at various stages in succession planning, and some are already considering an EOT.
Depending on a number of factors, which we outline in this article, an Employee Ownership Trust (EOT) could be an ideal option when you are planning your exit. This government-backed initiative, introduced in 2014 to encourage employee ownership and for more businesses to transition to a corporate structure similar to the ‘John Lewis model’, allows you to transfer ownership of your company to a trust, which benefits all your employees and gives you potentially a more flexible exit than from other alternatives such as a trade sale or an MBO.
This article has been written with expert input by Bizpedia members Menzies LLP (Peter Mills, Business Tax Director), and Laceys Solicitors (Sam Freeman, Partner Corporate & Commercial), and covers the pitfalls, as well as advice gleaned from experience in different cases.
An at-a-glance summary:
EOT’s are growing in number for a reason, and for anyone thinking about their exit, they should consider an EOT. The structure will not be for every business, but should form part of the ‘how am I going to exit’ conversation, because for the right person or the right business, it can be the ideal option. There are also generous tax reliefs that apply when selling shares to an EOT, and this can apply for a variety of types of businesses.
You need a good, financially-robust business to start with, and a strong management team, but this is generally true for any succession planning, and there is flexibility within the EOT structure to allow for a gradual transition which might not be possible in other scenarios. It’s also important to have clear communication and employee engagement, from when you are ready to make the announcement internally, and then throughout.
You need the right professional team, and early engagement will also save time, money, and a great deal of hassle. An experienced team will make transition to an EOT as smooth as possible, and ensure that any possible hurdles are identified and addressed. Your solicitors, accountants and any other advisers should work hand-in-glove on your behalf.
What is an EOT?
- An EOT is a legal structure where a specific type of trust holds a controlling stake (51% or more) in your company on behalf of your employees.
- Employees don’t directly own shares, but can benefit from the trust’s ownership through greater opportunity for engagement, profit sharing and potential to benefit from any future sale proceeds.
- The EOT acquires the shares from the existing owners and will generally pay for the shares out of contributions from the company over a period of time.
Benefits and downsides of EOTs for SMEs:
- Succession planning: An EOT can provide a relatively smooth and more flexible ownership transition and, providing your business is running well and has a good business plan, protect its legacy and secure its future. (read more) An EOT can be more flexible for the longer term. The trust and the trustees are the owners, and the structure endures potentially for as good as forever. The trust exists for the benefit of all employees, and will endure despite there being changes in employees. It doesn’t matter who the employees are at any time. This avoids the need for a series of transactions that can place a high strain on employees’ and the business’ cash flows. In one example a company had 20-30 shareholders who had bought in at various times throughout the company’s history, and it was proving highly complex and prohibitively expensive for them to buy and sell shares. By transitioning to an EOT, ownership vested with all employees and they removed the questions of who the direct shareholders are and how they would pay for shares, and were able to deal with renumeration and incentivisation separately.
- Taxation: You, the owner(s), can benefit from significant capital gains tax relief when you sell your shares to the EOT. This shouldn’t necessarily be your main incentive for using an EOT, as there could be longer term practical and financial implications both for you and the business if the structure turns out to be inappropriate, but it can be attractive. (Read more)
There is no CGT when shares are sold to an EOT in the first year it is established, and this is a big incentive for sellers. However, remember the government set up the scheme in order to promote employee inclusion, not to give company owners a tax break, so there’s much more to an EOT, and it still needs to be very carefully planned. There are also potentially significant tax consequences, either if certain conditions are breached, or if the EOT sells the shares in the future, which can include you (the original seller) becoming liable for CGT in future, or the trustees being subject to CGT not just on any increase in the share price since you sold the shares, but also on the amount that was initially eligible for tax relief. CGT and employment taxes will apply to any distributions made by the trust to employees, and so typically an effective rate of tax amounting to 55-65% can apply compared to the normal CGT rate (20%) that would apply for a normal sale.
- Shared ownership and employee engagement: When an EOT owns a business, employees become more significant stakeholders in the company’s success. In other company structures, it can often be only sales staff, shareholders, directors and other senior leaders who are incentivised to care how business is faring and perform accordingly. (Read more) The EOT structure is designed to give employees much more from their job. One incentive to become more involved is an allowable tax-free bonus of up to £3,600 per employee per year, which is intended to mimic a profit-share, and this can reinforce feelings of ownership, which in turn can increase motivation and engagement, leading them to be more invested in the company’s long-term wellbeing. However, whilst the EOT structure is flexible and can be adapted to a company’s culture, one of the biggest questions of all is, ‘Will employees actually care?’. Where there is a culture of strong engagement already, an EOT may be a better fit than in a company where management is less open and employees more cynical. Some EOTs also offer employees a say in company decisions, fostering a sense of empowerment and control, whether through an employee council, committees or because select or elected employees will generally have active responsibilities on the trustee board. This can make them altogether feel valued and heard, leading to greater satisfaction.
This point about culture is also critical to how the vendors get paid. In an EOT transaction, a significant part of the purchase price is often left outstanding and repayable over an extended period. Repayments can be more easily sustained if there is a robust management team, and an engaged workforce. If they need to stay onboard for a considerable time because there is not already a strong management team in place who can keep the staff engaged and run the business without the vendor, it can take many years for the business to generate sufficient profits to ensure they receive all the money. Our experts cited cases where owners expect to wait up to 15 years to be paid in full, which is fine, but such arrangements place a great deal of reliance on the enduring management structure, or may require the vendors to stay on board for extended periods of time, which is unlikely to be attractive if their dream had been to sail off around the world within a couple of years.
What type of company is best suited to an EOT? Industry; Size; Financial performance?
An EOT can potentially work for any company as long as there are at least five employees for every two sellers, and the structure can work regardless of industry. The structure works best for what are already fairly strong, stable businesses. The stronger the management team and the operational infrastructure, the stronger the chance of success. (Read more) The Employee Ownership Association https://employeeownership.co.uk/ carries out an annual study, and all kinds of industries are represented in it including construction, professional practices and manufacturers.
In the architectural profession EOTs seem to be particularly popular, and are almost becoming the norm, so much so that we have heard stories about this being a key consideration for employers looking to recruit architects.As well as much larger companies, those with as few as 10-20 employees have made EOTs work, but in companies with fewer than 10, and particularly if there is a very small management team, it can be potentially difficult to protect against the risk of something happening to one of that small team.It is critical that there is money in the business, either to start with (cash on the balance sheet) or money that can be earned out of the profits of the business. If the business does not make profits, there is unlikely to be money to pay the owners and there is a risk that the sellers don’t get paid. As there is no independent buyer and seller, there isn’t a strict negotiation, but a valuation comes from an opinion about what a fair market price is. Normal valuations use methodologies based on historic financial information, a multiple of EBITDA. If the company is not making an EBITDA, the valuation would be too low.
- Negotiating a price: As there is no independent buyer and seller, negotiation generally relies on a professional opinion about what is a fair market price. Generally, valuations will apply a methodology based on a multiple of maintainable EBOTDA which will often be established based on historic financial information. It will ultimately be a commercial decision for the sellers whether the price is acceptable, but if the company is not making an EBITDA, the valuation may be too low. It can sometimes be possible to achieve a higher price when selling to a third party, because an external buyer can benefit from economies of scale and synergies than an internal buyer will not.
- Long-term focus: By becoming part-owners, employees may develop a longer-term perspective on the company’s goals. This can lead to a more stable and committed workforce.
- Attracting talent: An EOT makes an SME more attractive to potential employees; some may already be seeking ownership opportunities. You can include EO status in your brief to your recruitment and HR teams and promote it on your website careers’ page, blogs, LinkedIn company page and other social media profiles. (See case studies below).
How does an EOT impact the financial statements and valuation of the company?
Financial statements don’t necessarily change; the business will continue to operate as normal with the same annual reporting obligations. The trust’s financial provision is private and only the company’s position is in the public domain The balance sheet will be eroded because of the money that’s paid into the trust – generally by quite a lot, because the sellers will generally want to receive as much as they can in the first instance, so often it is all the surplus cash.
What challenges might arise during the transition to an EOT?
The budgeting process is a possible challenge, making sure that the process is affordable and that the shareholders’ and trustees’ expectations are aligned on what the business can afford to pay and over what period. In order to pay money to the trust, the company has to have distributable reserves as well as cash. Our professional experts have seen cases where a company has cash but not distributable reserves, and so are not legally in a position to be able to make payments to an EOT as might otherwise be possible. Planning well ahead is key, as there are mechanisms that can be used to bridge the gap, if this is a critical concern.
It is also important to ensure that the requirements of the tax legislation are met, and as above that the management operating environment is robust enough to endure beyond the vendors’ tenure.
Can you explain the process of financing the EOT and any associated financial risks?
The main way that EOTs are financed is by contributions from the company in the first instance, whatever cash is available on day zero. Otherwise, the purchase price for the shares is left outstanding and the company makes further contributions to the trust to pay the vendors, as and when it is able to do so. There are some EOTs which are funded by third party debt, whereby the company borrows to create cash to enable the company to make additional contributions as early as possible.
It’s also possible for the trustees to borrow. If the company or the trustees do borrow to make payments faster, the vendors are less exposed to the risk of not being paid, but the company has to service interest as well as capital repayments, which will normally take priority over payments to the sellers. It will rarely be possible to borrow the full amount of the purchase prices, and so borrowing can expedite earlier payments but this will normally mean later payments will be delayed. There seem to be an increasing number of lenders supporting EOT acquisitions, with various types of products.
Planning 2-5 years ahead is strongly advised
Planning is very important. There are pitfalls and hurdles, both from a practical as well as a technical/tax perspective, and there have been situations where circumstances have prevented an EOT that could have been planned around. Requirements include that the company must be trading, and there are limitations on the composition of the shareholder base. Some of these conditions have to be met for 12 months before the transaction.
Our experts have seen situations where there have been assets within the company that have breached the trading requirements e.g. investment property. It is possible split these up, but this takes time, so the more time, the more tools are available. A large number of shareholders and/or option holders can also breach certain of the requirements, particularly in companies with multiple classes of shares, which can sometimes be remedied with sufficient notice.
For these reasons, a two-to-five-year timetable is advised, which will entail the owners knowing when they want to sell, and give them time to plan. Any longer than five years, it will be much harder to predict what the circumstances will be both in taxation law and in the company’s situation.
How will the EOT impact my future involvement in the company?
If the EOT doesn’t benefit both owner and employees, it won’t work. In principle, there is no reason why the founder cannot walk away as in any other sale, although it is more usual for the founder to stay involved, with the big difference that they no longer have control.
The most common scenario features an entrepreneur who has built a great company and workforce, and will want to transition to employee ownership with a view to a complete exit, but will want to ensure that they can still be heard on the board; whether formally or informally, as they probably have a reasonably big sum of money at stake.
They will possibly remain more involved than if they had sold to a third party and had been retained for a short transitionary period.
There are ‘right’ and ‘wrong’ employee groups for EOTs.
For the right employee group, it massively incentivises them. Listening to these people talk about their motivation afterwards, it sounds as if they have moved to a completely different – and much better – job. When it’s not so right for the employees it can feel like a complete disaster, as they have lost the guiding rudder, and this is why it is so important to have the right management team in place and a culture with open, emotionally mature attitudes. If not, the enthusiasm for the employees collectively will wane and the company will struggle.
What do the stats look like?
According to the Employee Ownership Association (EOA) businesses gain:
- 20% increase in performance, driving revenue increases of up to 43% after becoming employee owned
- 25% more likely to have seen profits grow in the five years post transition
- 50% more likely to invest in R&D
Society gains:
- 8-12% more productivity per employee
- 50% more likely to expand their workforces than other businesses
- Give more to charities and offer volunteering days
- Are more likely to have a net zero or carbon neutral strategy in place
Employees gain:
- 73% more likely to have increased employee satisfaction, motivation, and work-life balance
- 12% higher investment in training, skills, and on the job development
- £2,700 average higher basic wages and share profits
Popularity is growing, but despite this, there are still very few EOT companies in comparison with other types of company; at the end of 2023 there were around 1400 according to the White Rose survey.
What are the legal requirements for establishing and operating an EOT?
The legal requirements are fundamentally no different from any trust, except that the EOT must also satisfy the specific requirements of the relevant tax legislation. There is a trust document setting out how it should be run, how trustees are chosen, and qualifying criteria for employee trustees. It would have to be registered with the TRS (Trust Registration Service). Once set up, it is possible to change the document from time-to-time if really necessary, although there are limitations, and care needs to be taken to ensure that this does not cause any tax issues. Trustees need to operate partly by statute and partly by what’s in the trust.
One of the key aspects is not a legality, it is more ‘How is the trust going to interact with the company board? Who is going to communicate information? If the employees have a view, when, how and to what extent will they voice it?’
If there are 3-4000 employees for example, it’s not practical to wait for everyone to put their views forward, but it can be beneficial for there to be a route whereby they can do this; for example. monthly, quarterly or annual discussions or through employee committees, councils and specific representatives.
How do you construct a trustee board?
There is not a ‘one size fits all’ answer to this question, other than it is generally accepted that the founders should not be the majority. The trustee board may or may not still have the founders in it, generally for at least as long as the purchase prices is outstanding and due to them. The Treasury has also published best practice guidance which suggests that there should also be an independent or professional trustee as well as employee representatives on the board who can be changed from time to time, and it is worth spending more time than people think, not just picking the trustees in the first place, but agreeing and documenting how to change them.
How can I ensure the EOT structure aligns with my existing shareholder agreements? The truth is, it’s unlikely that an EOT structure will align with an existing shareholders’ agreement. Unless the EOT has acquired all of the shares in the company, there is no reason why the EOT couldn’t sign up to the existing shareholders’ agreement, but with an EOT and a change in majority shareholders, there is a whole change of dynamic, so the existing agreement is unlikely to still be fit for purpose. If the EOT is not purchasing all of the shares in the company then a shareholders’ agreement, probably a new one, is likely to be beneficial to all of the shareholders involved.
What legal documents are required to establish an EOT?
The trust document, just like any other trust, and the transfer of the shares into the EOT.
What are the legal responsibilities of the trustees in an EOT?
At the fairly generic, headline level, the trustee is required to observe the trust document, act in the best interests of the beneficiaries, not to favour some over others, and provide information. They should act carefully and distribute assets correctly. The default is that the trustees should act unanimously but most change this to being a percentage of trustees being in agreement. Usually more than any other trust, these requirements are expanded within the trust document, so it is run how it is envisaged; employees get heard, everyone gets what they expect, and do not accidentally fall foul of tax legislation. It is a constant looking-forward exercise.
How does the transfer of ownership to an EOT legally take place?
It is no different from a transfer of shares, on a stock transfer form – although there will always be the share purchase agreement, as there will be large sums of money outstanding with different payment terms and future payment dates. In a normal sale, where the owner is selling to a third party it’s around 100 pages long and contains guarantees and warranties to the buyer. With an EOT, this process is quite reduced, which can speed up the process, and can take away some of the after-transaction risks for the seller.
Are there any specific legal risks or liabilities involved in setting up an EOT?
In setting up the EOT itself, not specifically but the obvious risk is whether it is right for the business. This goes back to culture, back to the management team, how much you believe in the business plan moving forward as a seller. Otherwise, it is simply important to ensure that the process is properly planned with due input from accountants, tax advisers and legal advisers.
Case Studies
Most readers will have heard of Riverford Organics, and many may buy their vegetable boxes. Riverford talk freely about their Employee Ownership on their website, and outline the journey they have taken towards it. Likewise, Raynor Foods, ‘Britain’s top sandwich maker’ talks about their EOT on their website:
https://www.riverford.co.uk/ethics-and-ethos/employee-ownership
https://www.raynorfoods.co.uk/an-employee-owned-company