Why an Employee Ownership Trust (EOT) may be a good mechanism for your MBO

According to research by Price Bailey, 57% of companies cease to exist if the owner becomes unable to operate in the business*. Therefore, over the last few years, there has been an increased focus on mechanisms that assist owner-managers in protecting the continuity of their business. One of the mechanisms that has gained increased coverage is an Employee Ownership Trust (EOT). In this article, we provide clarity on what an EOT is and why it is an increasingly viable exit option to owner-managers looking to transfer ownership to their employees.

 

  • What is an Employee Ownership Trust?
  • What are the benefits?
  • What’re the criteria?
  • Who can be a beneficiary?
  • Does this structure lend itself to a Management Buy-Out (MBO)?
  • Valuation and funding

The EOT legislation is still in relative infancy, and its coverage low when compared to other employee tax benefit and ownership incentive schemes. Therefore, below, we’ve provided a summary of what an EOT is and the key benefits.

What is an Employee Ownership Trust?

An Employee Ownership Trust is a tax incentivised mechanism that transfers control of the business for the long-term benefit of employees. It was introduced in its current form in 2014 when the Finance Act bought in new legislation to try and incentivise more employee ownership. The legislation was to incentivise more scenarios where owners of businesses could be encouraged to sell out to employee-owned vehicles.

It is, in essence, a vehicle for a planned exit – it is not considered a quick sale, and it isn’t just for owners who want to step out of business in the foreseeable future. Instead, it is a way to ensure that the right succession is in place. Sometimes employee ownership is considered because the current owners believe it will be difficult or have experienced difficulty in finding a suitable buyer. More often than not, however, the choice is made as it is in the best interests of the business going forward.

The process to set an EOT up is not overnight, the quickest we’ve seen is about three months whereas in other instances we’ve seen it take up to 1 year to put in place. It typically takes a minimum of 4 weeks to gain clearance from HMRC, with the most arduous proportion of the process being the mind-set shift of the owner and employees. Therefore, it is advisable to avoid layering the transaction with complex conditions, as it will likely take longer to set up.

What are the benefits?

Under the legislation, there are two key tax benefits:

  1. When an owner-manager sells the business to an EOT, they do not pay any capital gains tax so long as control passes to the EOT. With the announcement in the 2020 budget that Entrepreneurs Relief is being reduced from a lifetime limit of £10m to £1m per shareholder, this benefit will undoubtedly become all the more attractive to business owners.
  2. For employees, they can also benefit as business owners can grant them a bonus of up to £3,600 per annum on a tax-free basis.
An EOT is, in essence, a vehicle for a planned exit. For the selling owner, they don’t pay any capital gains tax on the sale. To qualify, HMRC has to be satisfied that it is for the benefit of the employees.

An EOT does not mean employees directly own the shares; it means that the shares the trust holds will be ultimately used to the benefit of the employees at the point of a distribution an annual bonus distributions. That doesn’t necessarily mean it will be today’s employees; instead, it will be the employees in the business at the time of the bonus grant or on exit, i.e. it is employees as a body rather than individual share ownership.

What’re the criteria?

There are four main conditions that you have to meet to set up an EOT:

  1. The trust must at all times own more than 50% of the share capital of the business (or Parent Company, if part of a group) and must control the business in both income, capital and voting terms. Which means owners have to watch what happens in the company post-acquisition, such as the issue of share options diluting all shareholders or the EOT, particularly if the trust doesn’t acquire all of the share capital on day one.
  2. All employees must benefit from the scheme, excluding any employees in the business who already holds 5%+ of the share capital in the business at the time the trust is set up, who cannot benefit from the scheme.
  3. All employees must also be treated equally; benefits from the trust can be distinguished by a small number of factors (e.g. remuneration, length of service or hours worked) but otherwise, treatment must be equal.
  4. Ensure that the company is either a trading company or a trading group – here, we are distinguishing businesses that carry on a trade as opposed to property or investment companies.

EOTs can be set up in new businesses and, in this instance, new shares are issued to the trust rather than shares acquired from selling shareholders. If set up from inception, the trust can either own 100% of the shares, or a proportion of the business (50%+) alongside individual shareholders or investors.

Who can be a beneficiary?

Under the EOT legislation, all employees are beneficiaries of the trust, subject to a few conditions, which are as follows:

  • Companies can require an employee to have been with the company for a minimum term before becoming a beneficiary. This minimum continuous period can be up to twelve months;
  • Relations or dependants of a deceased employee have the option of becoming a beneficiary;
  • Non-executive directors and freelance company secretaries can be beneficiaries (this does not extend to contractors or agency staff, employees need to be on the payroll to benefit);
  • If the company ceases trading or the trust no longer holds shares in the company, any individual who has been an eligible employee for the preceding two years continues to be a beneficiary; and
  •  “Excluded participators” may not be beneficiaries, this means any individual who has rights to acquire or already hold 5% or more of the company’s share capital and anyone connected with such person.

Does this structure lend itself to a Management Buy-Out (MBO)?

While the legislation surrounding structuring an EOT is fairly stringent, MBO regulations are relatively flexible and, therefore, the two could conceivably be structured together to form a planned exit for the current owners.

For example, the incumbent management team could acquire a stake in the business, say 10%, 20% or even 30%, with options to acquire move over time up to the maximum of 49%, and have 51% of share capital in the hands of the employees via an EOT. The incumbent management team are likely, given their position, to be trustees and beneficiaries of the EOT (unless their individual holding within the MBO exceeds 5% of total equity), supporting the handover of control that is expected as part of an MBO.

By structuring the transfer of ownership this way, it is likely to minimise the disruption usually caused to the business in a sales process, as the current owners gradually transfer complete ownership and management of the business to the incumbents. If the EOT is already in place and the incumbent management team serve as trustee, the structure of the Board may well also be unaffected by the MBO. However, even if there is not a pre-existing EOT in place, there is no reason why the two could not be set up in parallel and still create less business disruption than a more traditional, private equity-backed MBO. In fact, from a cultural perspective, having the two set up in conjunction with one another could have a positive impact on the entire employee body as they participate in the overall sale of the business and feel part of the business’ next stage. While a transition of ownership as set out above is possible, the vendors will need to ensure it is structured carefully and that any consideration paid to them, particularly in the instance of deferred consideration, is precisely that and not employment-related remuneration.

It is also important to remember that the incumbent management team members acquiring shares individually, as part of the MBO, will benefit from capital returns on their shares at the point of exit in the future. Whereas, as an EOT is about the employee body owning shares in the business, and not the individual employees, the returns on holdings in the EOT are only realised by those in the business at the point of exit (beyond the tax-free, annual bonus that employees can receive). For those beneficiaries with limited prior exposure to, or knowledge of, company ownership and capital value growth this can be difficult to understand; however, the mechanism is expected to encourage loyalty and longer service in the business.

The business may also have to acquire a double tax clearance as both an EOT and an MBO require a business to seek clearance from HMRC.

Valuation & funding

An EOT is very efficient because there’s no tax to pay for the vendor. Which can usually mean one of two things:

  1. Better results for the vendor, or
  2. The vendor can offer a lower purchase price but still receive the same net return because of the tax differential, which can be quite significant.

A professional valuation when setting up the trust and transferring ownership is vital. It has to be a valuation that can be defended by an independent specialist and that the EOT trustees can rely on. The independent valuers’ role is not to show a range of valuations that depend on certain conditions and circumstances, instead, they need to agree upon a valuation that they believe reflects the market value and that can, therefore, be relied upon by the trustees and if necessary, defended to HMRC. If HMRC considers the consideration paid to be above market value, then the excess will be taxed to income tax which will be expensive. Further, it has to be affordable as EOT’s do generally not attract external funding, and hence capital contributions fund the purchase price out of profits in the business. In most circumstances, while the valuation for the business should be similar to that arising from a trade sale (or more often than not a little lower, it is common that the payment terms for the consideration by an EOT will be over a much longer period (3-10 years) than would be expected from a trade sale (1-2 years).

Under the current market conditions caused by the Covid-19 outbreak, businesses have experienced reductions in 2020 revenue income that in many instances will not be recovered, surplus cash reserves have been used to bolster working capital and growth developments halted. All-in-all, when considered alongside an expected loss in market confidence, we expect that company valuations will be adversely affected. While these conditions could also impact on the valuation achieved on setting up an EOT, the tax efficiencies may outweigh any reductions in valuation, and therefore multiple returns that would’ve been achieved in more favourable conditions.

Funding

Similarly to many MBOs, most EOT transactions include an element of cash consideration and usually not an insignificant amount of vendor loan. The vendor loan is likely to be on commercial terms but also likely to be subject to a standard loan note arrangement, which only really gives negative power to the lender. The bank may also often lend money to the business to enable contributions to the EOT to fund the acquisition.

If a seller wants to build in more complicated aspects to a sales, approach, e.g. earn out, or conditional payments, all of that is more difficult to consider for the trustees for the EOT who are bound to act in the best interest of the trust for the benefit of the employees, rather than their own personal gain. That said, it is possible to input ‘earn out’ type conditions into the consideration of the transaction, for example, it can dictate that cash flow from the successful running of the business is used to pay the owner/ bank for the consideration owing on the sale of the shares.

However, a crucial point in regards to EOT funding is to make sure the trust, and therefore the funding structure around it, is there for the benefit of the employees in the future. Most EOT transactions involve the vendor maintaining some shares in the business, so if the vendor is going to 1) maintain a portion of the business, 2) want an earn out and, 3) expect profits to fund the vendor loan for some time, then care is needed to mitigate the argument that there will be no benefit to the employees.

COVID-19 – Providing an opportunity for employee ownership

This mechanism for the sale of a business may be particularly relevant and beneficial in light of the COVID-19 pandemic. We have seen an unsurprisingly significant slowdown in buy and sell-side M&A activity due to the pandemic, so looking forward, EOTs may provide a viable alternative to trade sales where a business has been unable to attract a valuable buyer. This would still be the case in normal economic conditions. However, as we stated earlier in the article, an EOT is not a mechanism for overnight sales, and so there will have to be level of patience on the vendor’s side in receiving any cash consideration; the playoff being that it will provide certainty to exit and capture a very efficient tax position. As discussed earlier in this article, in some cases the tax efficiency and savings achieved through an EOT may serve to mitigate some of the multiples that may be lost on the sale price, due to current market conditions.

An MBO sale structured around an EOT could also serve as a good investment. Typically, an EOT is funded in part by vendor loan to earn interest in place of cash paid out on day one, with interest rates usually between 5%-8%. The interest rate on a vendor loan is as attractive as any interest rate at the moment, but with the added benefit of the vendor remaining a partial shareholder and, therefore, has privileged insight into the business’ ongoing performance. However, in terms of the vendor cashing out, a loan of this nature is relatively illiquid and, therefore, not dissimilar to capital investment. It is also at risk if the company’s trading dips dramatically.

The future for employee ownership

The popularity of EOTs is driven both by the tax and employee benefits, as well as the social and philosophical benefits to the business, its employees and its external reputation. In the current climate, we may see a furthering of its popularity as M&A activity continues to be sluggish and downturns hit valuations in business performance and a reduction in market confidence.

While employee ownership, particularly by way of an EOT, is becoming a mainstream planning option, there is still an understanding gap for most businesses and some advisers. We’re very excited about how this structure will work and think it will be an eye-opener to many business owners.

If you are an owner-manager and would like support in understanding what exit options are available to you and your business, or would like to discuss if an EOT and/or MBO might be right for your business, please contact one of our team on the form below.

 

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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