M&A in employee owned businesses

The UK has experienced a recent rise in business owners selling some or all of their company to their employees via an Employee Ownership Trust (EOT). The increasing popularity in this form of exit strategy has fantastic financial and cultural benefits for the selling shareholders, the company and, most importantly, its employees.

As the legislation surrounding EOTs matures, new scenarios and challenges arise that companies and their advisors are trying to navigate through – one such area considers future M&A opportunities for the EOT owned business. Here Price Bailey’s Simon Blake explains where we currently stand with regard to M&A activity in EOT owned businesses. 

How does part or whole ownership of a company by an EOT impact the opportunity for M&A activity? 

In essence, 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, such as the option 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.  

For the target company being acquired by the EOT owned business, there is the possibility of significant advantages for the employees who may also 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 in this way. 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.  

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.  

Funding M&A 

As mentioned above, ideally 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, 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 and, therefore, they have an interest in the future of the business meaning they are more open to conversations on renegotiation, or other arrangements such as 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 aren’t really any 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.  

A final note on legislation – 

While we do not have any insight as to its impacts on future M&A opportunities for EOT owned businesses, we expect to see some tightening of the EOT rules and, in some areas, an expansion on the legislation in the UK. The Chartered Institute of Taxation has recently put a paper forward to the Government regarding employee ownership, following fears that some exploitation has already taken place. As advisors, we accept that the legislation is young and therefore advancements in the legislation are naturally expected. Most advisors will welcome the clarification and enhancements to the legislation to cover some of the wider questions that we are beginning to ask.  

To summarise, in theory there are no legislative restrictions on an EOT owned business’s ability to pursue growth acquisition opportunities compared to non-EOT owned businesses. There are context specific considerations and quirks that need to be considered carefully when considering M&A opportunities, but ultimately if the EOT is set up affordably and for the true benefit of employees then M&A can only seek to enhance the future value extended to the employees. 

This article was written by Simon Blake, a Partner in Price Bailey’s SCF team, and Jay Sanghrajka, a Partner in Price Bailey’s Tax team. If you would like support regarding anything mentioned in this article, you can contact Simon or Jay using the form below.