Selling a business to an Employee Ownership Trust
07/11/2024
Introduction
Consider this scenario: an entrepreneur has built a great business over the years; he’s ready to sell and there are eager buyers waiting. He can retire comfortably and not have to work again – a sweet dream, break clean.
There are a couple of nagging issues though. Our entrepreneur cares deeply about the business he built, he’d like to reward his staff whom he has looked after well over the years, and he’d like to protect the legacy he leaves. He recognises the need for the buyer to take the business forward as its own. But he absolutely hates the idea that assets may be stripped, staff made redundant, sites closed, and his life’s work churned into a corporate buy-and-build platform. He doesn’t want to pay too much tax either.
One option which may address his concerns is a sale to an employee ownership trust (EOT) – a trust arrangement, which holds shares in a company for the benefit of the company’s employees. This allows employees to own a stake in the business, and potentially the benefit of any future sale proceeds. Our entrepreneur can remain involved as a trustee of the EOT, keeping him involved in the business with some say over its future direction.
Some background
EOTs have been around for a while. The 2012 the Nuttall Review was tasked with identifying the barriers to employee ownership of private companies. The 2014 Finance Act introduced measures and tax reliefs to remove them.
Think “employee owned business” and John Lewis springs to mind. Other well known employee owned businesses include Aardman Animations (the creators of Wallace and Gromit), electronics retailer Richer Sounds, Howden Group insurance and Arup Group engineering consultants.
There is plenty of evidence that employee owned businesses can have better staff retention and improved productivity, and be nicer places to work. Most governments talk up employee ownerships as a good thing; the Trades Union Congress has expressed its support for them (subject to principles of equality and fairness). It’s not a common ownership model – low thousands rather than tens of thousands – but it’s an interesting option.
Typical structure
In a “conventional” sale to e.g. private equity or a trade buyer, generally the seller sells, receives payment, and leaves the business. The buyer funds the purchase from its own resources or new money (e.g. investment or loan). The seller may spend some time post completion as a consultant to smooth the handover, but has very little influence on the business going forward.
With an EOT sale, the buyer is the EOT (typically a newly formed limited company). The EOT appoints new “trustees” (which can include the seller). Funding for the EOT to purchase the shares comes from free cash in the company (which might otherwise have been paid out as a dividend), a “loan” from the seller (effectively payment for the shares over time) or a bank loan – or a combination of all three.
So how might this play out for entrepreneur?
The upsides
Tax. This is likely to be the prime attraction, especially with Capital Gains Tax rates increasing up to 24% following the budget. The key tax points are summarised in the Tax section below.
Employee ownership looks good. Employee ownership is likely to reflect favourably on the company and the sellers. It is potentially a very positive message resonating well with clients, suppliers and other stakeholders – a great line to weave into bid documents for public sector or other procurement tenders. It’s a very positive ESG message as well.
Employees own a stake in the company. They potentially benefit from any future sale of the business. There is a real sense of ownership, translating into better staff retention and a stronger workplace culture.
The seller has sight – and potentially some control – over the business. If the seller is a trustee of the EOT, he is in a position to monitor operations and bring expertise and wisdom to the new management, as well as continuity of experience with key clients, suppliers and staff. To the extent he is able to influence things, he can help preserve the legacy.
The sale process is usually quicker, simpler and cheaper. As there is no new third party buyer dealing at arm’s length, seeking to de-risk the purchase of an unknown business, it should be quicker and simpler and hence cheaper to close the transaction.
There is less interruption to the business on change of ownership. Management does not change; there is continuity of experience and expertise; there is no new owner to reorganise and rationalise operations.
The issues and challenges
The seller’s level of control needs careful consideration. The seller cannot control and call the shots as he once did (and which he may expect to continue). There will be a new board. The seller will have a meaningful say, but ultimately will have to accept he cannot have a controlling interest. For a big and influential personality to whom most staff have deferred over the years, and who is used to getting his way, this may be difficult.
No big lump-sum payout. The transaction may need to be structured with “vendor finance” – i.e. the seller agreeing to be paid for shares over time. It relies on the business performing well, to be able to pay for the shares. Third party funding – e.g. a bank loan – can be used to fund all or some of the consideration. Cash that might otherwise be paid out as a dividend can be applied to fund the purchase.
A risk of default and conflict of interest. The seller will want any deferred consideration to be paid. He may use his presence and influence as a trustee of the EOT to influence this. It could bring about a conflict of interest where cash is applied to repay him ahead of investment in the business. The EOT model is likely to suit a resilient, well-established business, with strong recurring profit, best.
No interest in future value. Any value increase in the company over time will be for the EOT / employees, not the seller – unless he retains a direct ownership stake in the company (but he won’t get CGT relief on that).
Culture shift. Many businesses will need a subtle culture change, refocusing as an employee-owned organisation. As an example, employees may expect a greater say in management and decision-making, requiring the introduction of an employee council of elected staff to represent employees’ views. Management will need to actively encourage employee engagement and participation.
EOT trustees. A key element in success will depend on having trustees who understand the dynamics of an employee owned business, the tax issues and restrictions, and the influence the seller may exert.
Tax
There are potentially compelling tax reliefs available on sales to EOTs. Detailed consideration of tax issues is outside the scope of this note, but some of the key considerations are listed below. Tax advice is essential.
Control and residency. The seller cannot (whether directly or indirectly) control the company after sale to the EOT. The EOT trustees must be UK resident when the company is sold to the EOT.
Valuation. All reasonable steps must be taken to ensure the purchase price is market value, and any interest charged is a reasonable commercial rate. It is likely that a formal valuation will be needed.
Tax treatment of contributions. There is some doubt in relation to the tax treatment of contributions to the EOT by the company where these are used to pay the seller for his shares.
Capital Gains Tax. A 0% Capital Gains Tax rate on the sale of shares to an EOT – but only on the first sale. If a 60% stake was sold, followed by a further 40%, CGT relief applies to the 60% stake. Tax relief may be lost if a “disqualifying event” – which may include a sale out of the EOT – occurs for up to four years post-sale.
Tax-free bonus payments to employees. Employees of companies owned by EOTs may receive bonus payments of up to £3,600 a year exempt from income tax (though NI is still payable).
Other tax-advantaged schemes. Enterprise Management Incentive (EMI) schemes could be used in parallel with the EOT regime, giving employees access to share ownership.
Conclusion
EOTs have had been around for a while, but are not widely used. The increase in CGT in the recent budget may make them an increasingly attractive option. There are certainly some big issues to overcome, but these are manageable. For anyone selling a business in the near future, an EOT is a potentially very good option.
If you would like to discuss anything in this article, whether about selling to an EOT, or about selling your business more generally, please do get in touch.
This article is not legal advice, which it may be sensible to obtain before you take any decisions or actions in the areas covered. Please do contact me if you would like an initial discussion of your situation.
