By Kate Richards, Partner and Richard Sealy, Partner Gateley Legal
For a business owner looking to hand over the reins and realise their investment, a sale to an employee ownership trust (an EOT) can offer some attractive benefits.
An EOT is a form of employee trust offering indirect ownership of shares by employees. It is a collective vehicle which acquires a controlling interest in a company and then holds that interest for the long term benefit of the company’s employees.
- Employee engagement: EOTs were borne out of a desire to increase employee ownership of UK businesses. Studies have consistently shown that employee owned businesses perform better, demonstrating greater resilience, innovation and profitability. Employees show greater commitment to, and engagement with, a business when they have a stake in it.
- Tax advantages: To encourage a move to employee ownership, there are generous tax benefits available, both for owners who transfer their shares to an EOT and for the on-going employees. Significantly, a sale to an EOT can be made without attracting any charge to capital gains tax. With a standard rate of 20%, avoiding capital gains tax can provide a welcome boost to sale proceeds for those looking to exit a business. In addition, employees of a business owned by an EOT can receive tax free bonuses of up to £3,600 per person each year.
- Simplified sale process: a sale to an EOT is generally viewed as being a ‘friendly’ transaction. The sale process is often quicker and smoother when compared with a sale to a third party, and the seller can benefit from fewer residual liabilities under a reduced warranty and indemnity package. It also provides a ready-made exit for a business which could be useful where the seller has struggled to find a buyer or where a family business is hampered by succession issues with the next generation being unable or unwilling to takeover.
- Retained shareholding: as long as the EOT acquires a controlling interest (over 50%) in the target company, a seller can retain a shareholding. This could be useful for those who are not ready to withdraw from the business altogether but who wish to hand over control to the employees.
A sale to an EOT begins with the EOT itself being set up, governed by a detailed trust deed. Typically, the EOT will have a corporate trustee whose directors are usually a mix of executive directors of the target company, employee representatives elected by an Employee Council, possibly a seller and perhaps an independent professional trustee.
The seller sells shares in the target company to the EOT with the EOT acquiring more than 50% of the shares. Some consideration may be paid on completion but, typically, the majority will be left outstanding to be paid by the EOT on a deferred basis.
The company funds the EOT from its on-going profits, with the EOT using the funds it receives from the company to pay the deferred consideration to the seller over time, as the profits become available.
Funding the sale
The buyer of the shares is the EOT. So the liability to pay the consideration to the seller rests with the EOT and does not appear on the target’s balance sheet. But the EOT itself has no real assets and no way of generating assets. So it will be reliant on other sources to pay for the shares.
It may be possible for the EOT to borrow money to help fund the purchase. But any lender would require security for that borrowing and, as noted above, the EOT has no assets which it can leverage as security, other than its shares in the target company. Neither is the EOT certain to receive any money from the target. So any lender to the EOT is likely to require a guarantee from the target company.
Because of the drawbacks of lending directly to the EOT, it is preferable for any external funding to be given to the target which it then passes up to the EOT to fund the consideration. Any facility agreement will need to set out the circumstances in which those payments can be made with appropriate checks and balances to protect the lender where money is leaving the trading group. Security will be required from the target and the lender may also want the EOT, and possibly the seller, to enter into an inter-creditor agreement so that it can ‘follow the money’ if payments are wrongly made to the EOT. The contributions to the EOT will be deemed to be distributions by the target so they may only be paid out of available distributable profits.
It is common to see part of the sale consideration being funded by a loan to the target company with the balance being paid to the seller in instalments as deferred consideration. As the target company generates profits, these are passed up to the EOT and it uses them to pay the deferred consideration to the seller over a number of years. Clearly, this will only be possible where the target continues to trade profitably, putting the seller at risk if business takes a downturn.
Benefits for all
A sale to an EOT has some key advantages for the parties involved. To benefit from those, certain qualifying conditions must be met including the EOT acquiring a controlling interest (over 50%) in a trading company and all eligible employees benefitting from the EOT on the same terms. There must also be a genuine change of control in the target so the seller will be reliant on those to whom they hand over the reins continuing to run the company profitably and then using those profits to fund the EOT to pay the deferred consideration.
A funder involved in a sale to an EOT needs to understand the unique features of this atypical deal and ensure they are adequately protected. But good planning should ensure that all those involved – sellers, employees, lenders – can benefit from this inclusive model of busines ownership.