Employee ownership trusts have grown in popularity over the last year, with increasing numbers of business owners using them to facilitate sales of controlling interests in privately owned companies.
Full or partial employee takeover of private companies in the form of management buyouts or buy-ins has long been a viable succession plan for business owners but employee ownership trusts (EOT) provide an option for all of the employees of a company to co-own the shares in the company that they work for via a trust. If certain requirements are satisfied, this can be a tax advantageous exit strategy for selling shareholders.
The use of EOTs is fast becoming an attractive way for selling shareholders to release equity, rather than the more traditional trade sale or pursuing alternative investment.
Given the rising use of the EOT structure, debt providers are more familiar and much more open to supporting sales to EOTs.
What are employee ownership trusts?
An EOT is type of employee benefit trust, which is a discretionary trust established for the benefit of a company’s workforce (including former employees and, sometimes, certain of the employees’ relatives and dependants) which offers certain tax advantages depending on form and structure.
An EOT is established under a bespoke drafted trust deed. Careful drafting is required to ensure the intended tax benefits are achieved.
When creating the trust, another important point to address is who the trustees of the EOT will be. The trustees can be individuals (including the selling shareholders) or a company (UK or offshore). There are, however, various factors to consider (tax and conflicts of interest to name two) having regard to the organisational structure of your business and so detailed discussion around choosing the EOT trustees is really important.
What’s interesting about an EOT structure is that it can work for any sized private company in any sector or industry. Famous brands owned under this type of structure are the likes of John Lewis and Richer Sounds.
To enjoy the tax advantages associated with EOTs, the application of certain requirements to the EOT structure is vital and the requirements must continue to be met for specified periods. Failing to meet the requirements results in adverse tax consequences and so it is important to seek advice from a tax expert during the sale process and in dealings with the EOT’s property and assets (including the shares) following completion. These requirements include the following:
The controlling interest requirement: After completion of the sale:
- the EOT must hold more than 50% of the ordinary share capital in the target company
- the EOT must hold a majority of the voting rights in the target company
- the EOT must be entitled to more than 50% of the profits in the target company
- the EOT must be entitled to more than 50% of the assets in the target company on a winding up
- there must be no provision in any agreement or instrument that would reduce the EOT’s entitlement to the above without the trustees’ consent
The trading requirement: Generally speaking the company must be a trading company or the principal company of a trading group
The all-employee benefit requirement: The property and assets of the EOT must be applied for the benefit of all eligible employees and certain restrictions regarding the transfer of such property and assets to other trusts and the making of loans to beneficiaries of the trust must be adhered to
The equality requirement (which is a subset of the all-employee benefit requirement): The equality requirement is that any distribution from the EOT fund (or related bonus scheme) must be for the benefit of all eligible employees on the same terms. ’Same terms’ does not necessarily mean that all employees must receive equal amounts. It is possible to vary the size of distributions from the fund by reference to length of service, hours worked and remuneration.
- Provided the specified criteria is met, no payment of capital gains tax by the selling shareholders on a disposal of shares to an EOT.
- Provided the specified criteria is met, payments by the target company of up to £3,600 each year in tax-free bonuses to each employee.
- Certain inheritance tax reliefs.
- Providing reward for hard-work and loyalty by creating team ownership and personal interest in the company’s performance and success.
- In a sale of part only of shares, an effective succession planning objective whilst retaining equity stake and the day-to-day management of the business.
- A sense of ‘giving back’ for the selling shareholders and an opportunity for the business to retain independence.
- The structure can sit alongside other share schemes so key members can still be rewarded in this manner (although care must be taken to ensure that the trustees of the EOT continue to meet the controlling interest).
- Reduced transaction costs compared to a normal trade sale or MBO or private investment, depending on how the transaction is financed.
- Generally. a less-risky transaction for the selling shareholders. The terms of the transaction documents tend to be lighter due to ‘friendly’ nature.
- Employee-focused transaction which can increase engagement and staff retention, incentivise employees and drive growth.
- A sale to an EOT is inevitably funded by the target company which will usually involve raising debt finance or the seller agreeing to payment on a deferred basis with the profits of the target paying that deferred consideration over time, or a mixture of both. Additional borrowing to fund an EOT sale is likely to be on a secured basis and so whether this is feasible, depends on the level of existing borrowing and security over the company. That said, it is common for most transactions to involve some level of external finance (and sometimes deferred consideration) and so the concepts itself is not unusual.
- Stamp duty is payable on the transfer of the shares at 0.5% of the transfer price, rounded up to the nearest 5%.
- There will be time and cost involved in administering the trust following completion (tax/accounting/legal/any corporate or professional trusteeship).
- If only a partial sale and the selling shareholders remain employees going forward, they cannot benefit from the EOT property and assets.
- Potential conflicts may arise for selling shareholders if they continue to be involved in the operations of the company and act as trustee of the EOT.
A workable exit option for you?
If you are considering or planning for your succession, whether in whole or part, it is important to consider all workable exit strategies to find the one that best suits you, taking into account your priorities in terms of succession and your own values and those of the business, but an EOT sale should definitely be among those considered, given the potential benefits highlighted above.