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Employee Ownership Trusts – A Win/Win?

Have you considered selling your business in a way which is not only tax efficient but which can reward and incentivise your employees at the same time? A sale of your shares to an Employee Read more...

James Lyons

Director

Employee Ownership Trusts (EOT)

Have you considered selling your business in a way which is not only tax efficient but which can reward and incentivise your employees at the same time?

A sale of your shares to an Employee Ownership Trust (“EOT”) can achieve all of these things, and is increasingly being considered as a chosen exit route for business owners.

So, how does it work?

Tax advantages for sellers

There are a number of conditions which need to be satisfied but, provided these are met, the sale of the shares to the EOT will be deemed to occur at a value which produces neither a gain nor a loss for the sellers for capital gains tax purposes – so there is no tax payable by the sellers.

The main conditions for this to apply are as follows:

  • the seller(s) must be an individual or a trust (not a company);
  • the shares must be ordinary shares, not preference shares;
  • the company must be a trading company, or the principal company of a trading group, which broadly means that at least 80% of the activities must be trading activities;
  • the EOT must acquire a controlling interest in the company (which it did not previously possess);
  • the trust must generally be for the benefit of all employees of the company or group, who must benefit on the same terms (although employees who have worked for the company or group for less than a year can be excluded, and the trust can permit funds to be applied for charitable purposes);
  • the trust must exclude employees who in the last 10 years have owned 5% or more of the shares in the company (or of any class of shares in the company), or who on a winding-up would be entitled to 5% or more of the assets of the company, and anyone connected with such employees must likewise be excluded; and
  • the trust can allow employees’ entitlements to vary with their remuneration, length of service or hours worked, but all eligible employees must have some entitlement.

Other benefits to an exit through an EOT

  • The EOT can be set up relatively easily and is a ready-made buyer; there is no need to spend time and resources to market the company for sale or pay broker fees.
  • The trustees can include the existing owners/employees, so with no “third party” buyer there is a seamless transition and minimal disruption to the day to day running of the business;
  • The price is often arrived at by obtaining a professional valuation of the company and selling at that value (which might include an earn-out element).  So, very little negotiation needed.  The trustees must satisfy themselves that they are not overpaying for the company but the process should be smoother than on a sale to a third party;
  • The employees, now as owners and stakeholders in the business, feel valued, rewarded and incentivised.  It can also help in the recruitment of new staff.
  • The sellers can continue to remain involved in the business: whilst they must sell a controlling interest, they can generally retain a minority shareholding and remain as directors of the company receiving remuneration in the ordinary course, providing the conditions described above are satisfied.

So, what are the drawbacks?

  • Funding of the purchase: The principal difference between a sale to an EOT and a sale to a third party buyer is the availability of the cash to fund the purchase.  On a typical sale to a third party buyer, the buyer will often make an immediate cash payment on completion with, perhaps, a proportion of the consideration payable on a deferred based (whether or not on an earn-out formula).

However, an EOT, once set up, has no funds.  If the company has surplus cash then it may be possible for the EOT to be funded by the company, otherwise the EOT would need to borrow.

In practice, a significant part of the consideration is therefore likely to be paid by the EOT to the sellers on a deferred basis, funded out of future dividends which the EOT receives from the company.

The Sellers’ proceeds are therefore largely contingent on future profits, and the sellers may seek some form of security for the deferred payments (eg a debenture granted by the company).

  • Loss of control:  After the sale, the company is controlled by an employee benefit trust, operating for the benefit of the employees.  Whilst the sellers may still have an influence (eg as directors), they can no longer exert control.
  • There may still be tax to pay:  Although a sale to an EOT is generally considered to be tax advantageous, the position in practice is more complicated than that.  For example, the tax relief on the sale of the shares will not apply to any ‘earn out’ element of the consideration.  Furthermore, on a subsequent sale by the EOT of its controlling interest, the EOT is deemed to have acquired the shares at the price which the sellers originally paid for them – effectively, the sellers’ tax is rolled over so that the EOT bears tax on its gain and the sellers’ gain when the EOT eventually sells.

Business owners are encouraged to take tax advice at an early stage.

A win/win?

A sale to an EOT can benefit both the business owners who choose to sell and the employees of the company with minimal disruption or change to the business.  From that perspective, it is a win/win, and business owners looking for an exit route would be well advised to consider it as an exit option.

But it will not necessarily suit all companies or business owners, and both legal and tax advice should be taken to ensure that all the requisite conditions are met to make it work for all parties.

If you would like to discuss any of the topics raised in the above article, please call us on +44 (0)20 7936 8888, email on enquiries@lawstep.co.uk or contact a member of the team below.