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 are 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:

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.
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 are the criteria?

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

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.
All employees must benefit from the scheme, excluding any employees in the business who already hold 5%+ of the share capital in the business at the time the trust is set up, who cannot benefit from the scheme.
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 and/or hours worked) but otherwise, treatment must be equal.
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

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

Better results for the vendor, or
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 views 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 EOTs 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 price paid for the business should be similar to that arising from a trade sale, 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).

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 and not 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.

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 also expect to see, and are seeing, a furthering of its popularity alongside MBOs, as business owners consider alternative methods for exit to trade sales.

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.

What about other M&A activity?

The directors of the trading company are in no different a position to be able to consider acquisitions, having transitioned to EOT ownership, as they would be otherwise. The only real difference or potential issue in the case of EOT ownership is the availability of cash to fund an acquisition which otherwise would be earmarked to fund further contributions to the EOT in order to pay down the original purchase price of the shares it acquired from the previous shareholders.

However, it should be said that in any EOT scenario we advise that some cash is left in the business; not all the cash being generated from profits should be used to fund the repayments made by the EOT to avoid the business being too leveraged. Therefore, there should always be some surplus cash in the business for reinvestment and growth, which may mean cash available to pursue acquisition opportunities. The majority of EOTs will want the trading company to be investing in and looking at the long-term, so there is a conversation to be had between the Trustees, the Directors and the vendors (particularly where they have an ongoing shareholding still in the business) regarding how the business can pursue relevant opportunities.

Acquisition opportunities

For a target company being acquired by the EOT owned business, there is the possibility of significant advantages for the employees of the target who may benefit from tax free bonuses and participation in the EOT on a future exit, in the same way that the existing employees of the acquiring business benefit. There is no particular tax advantage for the sellers of the target business, they get the same tax treatment as they would have selling to any other business. However, the employees of the target may be more positive about the prospect of being sold to an EOT owned business over any alternative, because of the benefits available to them.

If EOT ownership is structured for true employee ownership and not (as unfortunately we have seen in some cases) just a way to get an exempt Capital Gain for the vendors then M&A is only going to enhance those benefits. While there are not many UK examples given the relative infancy of EOTs here, from what we’ve seen over in the US where employee ownership is slightly more mature, employee owned businesses can buy for a slightly lower multiple because of the tax effectiveness of the transaction for the target vendors. In other words, if the vendor is willing to receive the same net sum but through selling to an employee owned business where he isn’t going to pay any tax and can therefore sell for a slightly lower number, giving the EOT an advantage on price over a trade buyer. In the UK, that difference is currently between paying a 20% Capital Gains Tax (CGT) rate (or 10% for gains up to £1m with Business Asset Disposal Relief or BADR) which can provide a significant advantage on the valuation.

Growth and exit opportunities

Outside of EOT owned businesses acquiring other companies (whether employee owned or not), we fully expect EOT owned businesses to be acquired. We also expect to see mergers of two employee owned businesses or M&A by the EOT owned company. In addition, provided the two year window has passed in which the vendor to the EOT is exposed to a CGT claw-back on their exemption, then it may be that the Trustees of an EOT owned business will accept dilution by external investment perhaps through a listing or Private Equity to fund growth (including further acquisitions), and that may also include the EOT selling shares for the benefit of employees as well, whilst continuing to hold some for future growth and employee benefit.

The tax scenario here is that the employees never pay anything for the benefit they will get from the sale of the business. The Trust will pay CGT on the profit it makes from the sale, and the gain will be the amount it receives for the shares held in Trust, less the original price paid for the shares by the original vendor shareholders (which is often par value of the shares). Therefore, while there is quite a big tax bill for the Trust to pay, the remaining value left is then distributed to the employees, taxed in the same way as salary or bonuses.

M&A funding considerations

As mentioned in earlier sections of this article, the trading business should have sufficient surplus cash remaining in the business for reinvestment. However, if the business is over leveraged and doesn’t have sufficient free cash to invest in acquisitions, yet there is an opportunity presented to the business that could result in significant value gains, then there is a conversation to be had with the original vendor to the EOT to see if there is a way to free up cash. Any borrower can go to its lender and seek a renegotiation but the power is, naturally, always in the lender’s hands. If the lender no longer has any invested interest in the business other than the loan (e.g. in the case of EOTs, if 100% of the vendor’s shares were sold to the EOT), then they may not necessarily be motivated to renegotiate the repayment terms as there is no benefit to them, other than perhaps a higher interest rate or some additional security. On the other hand, we see a lot of partly owned EOT scenarios and typically the original vendors will have retained a stake meaning they have an interest in the future of the business and could be more open to conversations on renegotiation, deferrals, extended period of repayment or repayment holidays. If they are still getting paid interest on the loan, and these opportunities will grow the value of the remaining equity in the group, then there are not many reasons for the lender not to be interested in negotiating a way to free up cash.

The difficulty might come if the proposed transaction marks a major change to the direction of the business from the plan that existed when the EOT was set up, before the EOT owned business has finished paying off the contributions to the EOT to fund the repayments of the purchase price to the vendor. In this instance there may reasonably be some concerns from the vendor that would need to be negotiated through.

Another option available to the company, as in a non-employee owned scenario, is to secure debt funding to fund the acquisition. Being EOT owned should not impact on the company’s ability to borrow; provided the target has been valued appropriately, a proposed acquisition adds assets and/ or profits into the value of the group which will generate further revenues, profits and cash flows to enable both the original cost of any debt to fund the acquisition, as well as the contributions to the Trust, to be met. Clearly every scenario needs analysing carefully, but the opportunity is going to be just as appropriate to the Directors as it would be if the business was not employee owned.

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.