Employee Ownership

Typically, EOTs are intended as a business succession option — they provide a way to sell all, or a majority, of a company to its employees.  Whilst EOTs can help with selling a minority stake in the company to employees, this is not typically the best route to achieve minority employee ownership and there are better models for that purpose.  So, unless you’re looking to sell all, or the majority, of your Company to the employees, the EOT probably isn’t for you.

However, anyone who is considering selling their company in the next few years, or advising business owners who are considering selling, should be aware of the EOT and how it works. Employee ownership has a long track record of being good for employees, companies and the local and wider economy.  The UK government has helped to accelerate the growth of employee ownership across the UK through significant tax incentives for company owners who sell to the employees through the EOT model.

Yes, you could sell your company to the employees without using an EOT model, but it’s arguably more complicated, offers less tax benefits and would typically need all/majority of employees to purchase shares – for most companies, this last point will often be a deal breaker.  The EOT solves two of the biggest barriers to sales of companies to their employees: how do employees fund buying their business, who makes decisions and leads the company after the owner sells?

Business owners and their advisors naturally question how employees are going to come up with the money required to buy the company from the current owner(s).  The major feature and benefit of an EOT is that they don’t have to.  In the majority of EOT transactions, the purchase price is funded out of existing cash reserves (if available) and future company cash flows.  Where a company has a history of cash generation and/or asset cover, finance providers are increasingly willing to consider lending to an EOT to fund the buyout of the existing owner, and the company’s future cash flow is then used to pay back finance over a period of time.

The business owner will sell their shares to the EOT in exchange for fair market value.  This fair market value is typically determined by an external valuer who will consider valuation approaches such as multiple of profits, net asset value, discounted cash flow, etc.

Using a simple example, let’s take a company that generates £500,000 in EBITDA every year and the valuer determines that the fair market value is £2,500,000 (using a multiple of 5).  If the owner sells 100% of the company to the EOT and the transaction is funded out of future cash flow, it should take roughly 6.6 to 7 years to pay the owner back the £2,500,000.  The cash used to repay the (now) ex-owner comes from the company’s retained profits.  This means that from the £500,000 EBITDA we need to factor in Corporation Tax liability (currently 25%) and therefore the actual cash available from the company to fund the EOT will be closer to £375,000 each year (£2,500,000 / £375,000 = 6.66 years).  In non-legal jargon the business owner is essentially selling his shares in the company to the EOT and receiving an IOU from the EOT in return.  The EOT will own the company from the date of the transaction and the debt owed to the ex-owner will be repaid over a period of time.

A company could also approach a bank to lend some/all of the money needed to fund the purchase of the shares by the EOT.  This approach means that the business owner can receive some or all of the purchase price up front. For example, a bank might lend up to 50% of the transaction to the company to fund the purchase, meaning in this case the owner would get £1,250,000 up front, and an additional £1,250,000 over time, once the bank is paid off.

The EOT’s role here is to hold the shares on behalf of employees, now and in the future, and committing to payback the owner the purchase price over time funded through cash contributions made by the trading company.

The EOT owning the shares is also essential for the second common barrier to selling to employees: decision making. Most company owners and the directors that lead those companies want to know how the company will be led once they sell and whether all the employees get to vote on every decision after the sale (they don’t).

Typically, whilst EOT ownership will naturally set an expectation that the company will adopt forms of participatory management, the company’s directors still determine strategy, make key operational decisions and lead the company’s activities. This is part of the reason why the EOT model is so popular – it allows for companies to be largely managed the same way they’ve always been.  EOTs are referred to as “indirect ownership” because employees benefit from the financial success of the company, some degree of direct or indirect influence over key decisions, a better understanding of business performance and the company’s future strategy without owning the shares directly.  The EOT is managed by trustees, who will typically make a limited set of decisions (about the company) on behalf of the employees.  The company will have a Board and a management team that will make the decisions required to run the company.

The EOT gives company owners a new alternative for selling their business, financed by the future cash flows, and in a way that limits disruption at the company as much as possible.

In order to qualify as an EOT, at least 50% + 1 share of the company needs to be sold to the EOT in the initial transaction.  An EOT needs to be the majority/controlling shareholder of the company.  There are also rules around the number of Sellers vs the number of employees and rules around the company being a “trading company’.

Under the EOT model you are required to sell to an EOT that will hold shares on behalf of all your employees (both current and future). This is one of the most attractive features of the EOT model – all employees benefit and they don’t need to have money to pay for shares.  Owners often see this as a legacy for all the current employees that have contributed to the company’s success.

First, benefits:

The employees are the beneficiaries of the EOT, which means if the company has surplus cash it will look to pay some of this to employees in the form of an income tax free bonus.  Companies owned by qualifying EOTs can pay bonus of up to £3600 per employee, per annum, and this bonus is free of Income Tax (but not NICs).  There are a series of rules around how the bonus can be paid that ensure that this cannot be easily abused.    

If the company is sold to a third party in the future (which to be clear is unlikely), the sale proceeds received by the EOT goes to the employees (according to the percentage owned by an EOT. If the EOT owns 100%, they get all the money and if they own 51% they get about half, etc.  For the sake of clarity, there would be significant tax liabilities on any future sale by the EOT).

Second, rights:

While employees don’t vote on every decision, employees do have important rights in an EOT.  Typically, they have representation on both the Trustee Board and, possibly, the Company Board.  The intention here is to ensure that the company is operating for the benefit of the employees by creating profitable and sustainable trade and keeping employees informed and motivated.

The employees, through the EOT, are also the majority shareholder in the company.  That means both the Trustee and the Board have a responsibility to do what’s in the best interest of the employee beneficiaries of the Trust.  Typically, the company Board and the Trustee are aligned in terms of the desired outcome – a successful business venture keeping employees gainfully employed and rewarding them, where possible, for their contribution to the company’s success.  The company can continue to be managed the same as it was before, but the employees now have a voice and a vested interest in helping the company succeed.

Potentially.  Lots of employee owned firms are led by their former owners in the initial years after the EOT acquires the company.  This is often because there is a need to develop the future leaders of the business.  It’s also because a lot of owners are not ready to retire and they continue to have an important role to play.  Equally, EOTs are typically used because the business owner knows that they need to retire at some point.  This means that leadership succession is vital in any employee owned firm.  One key difference is that the ex-owner is no longer the majority shareholder and will now need to report to a Board that will have employee representation, and that the ex-owner won’t control.  Ex-owners want the same outcome as the EOT – a successful company – because this is what pays off the IOU.  Many ex-owners continue to run their companies after selling them to employees and report how this ensures a smooth transition over time.

Yes.  The UK government provides a tax incentive to owners for selling to employees in the form of capital gains tax relief.  The Finance Act 2014 introduced a relief from capital gains tax (CGT) on gains derived from the disposal of at least a controlling interest (over 50% of the entire share capital) in a trading Company (or in this case a holding Company of a trading group) to a qualifying statutory EOT.  The relevant legislation can be found at section 236M Taxation of Chargeable Gains Act 1992.  In simple terms, if certain qualifying conditions are met the owner is treated as making neither a gain nor a loss on their disposal to the EOT – there is no capital gains tax liability.