Employee Ownership Trust gone wrong!
Chris Maslin of Go EO and Andrew Evans of Geldards consider how to ensure things do not go wrong when implementing a sale to an EOT.
Of course, we think EOTs are great. But they can have issues.
We recently spoke to the senior team of an EOT controlled company that’s had a very rough ride! For reasons that may become clear, they didn’t want to be named.
In this article we discuss the various safeguards to help ensure an EOT transfer goes well…and how these can fall apart!
The company was a typical small business:
- Founder owned/controlled,
- Stable team of employees,
- Loyal customer base etc.
3 years ago, the founder decided an EOT could be a good route forward for everyone.
All good so far…but this is where things started to go wrong.
Run up to EOT sale day
The senior team were aware of the decision to sell to an EOT several months before sale day but given no details. No valuation/sale price, nor proposed repayment schedule. These crucial elements were only shared the day prior to sale.
Management had no input in the decision or set up in the lead up to sale day, when they were suddenly presented with sale documents and asked to sign without time to read/understand them, or seek advice. They were only informed of their new roles and responsibilities a week before sale.
Whilst employees will generally have no control over the terms of the deal, it’s normal to discuss with senior team some time before sign off. It’s important they understand and are happy with the plan. If they’re not, and they leave, the business can quickly die, meaning payments to founder stop too!
This is particularly true if the founder moves on very soon after sale, as happened here.
The gradual transfer of power/knowledge should start at least a few months before sale date. Ideally it would’ve been drip fed over several years pre-sale.
Potentially it can be done after sale date, with the founder staying for a while to try to ensure a smooth transition. However, this gives no scope to backtrack if significant problems arise. Hence why it’s strongly advised to consider and discuss things beforehand.
Normally with significant transactions the seller would have their adviser, and the buyer would have a separate adviser. Each party has an expert “on their side” in the negotiation.
Conflict/who is the client
Some advisers take the view that an EOT sale is one of the few situations where it seems acceptable that one adviser can act for the whole transaction.
The logic is with EOT sales it’s an “amicable” sale, focussing on a “win-win” outcome. If the deal doesn’t work for staff, there’s a real risk it doesn’t work for the founder either. As typically the founder is reliant on the team making sufficient profits for multiple years post sale to pay the founder off.
However, Geldards take the view that it not possible to act for both the company/EOT on the one hand and the founder/sellers on the other. Although the transaction should be amicable, there is still potential for a conflict of interests between the parties. Geldards prefer to advise the company and the EOT as the work is more interesting and we advise the founder to obtain separate legal advice – we would be disappointed if any material issues in the legal paperwork were identified!
It is important that the EOT obtains an independent valuation of the business and not rely on the valuation provided by the founder. In practice for EOT sales the valuation should be based on what the company can realistically afford to pay, over a reasonable timeframe.
This is one safeguard. A layer of protection to help ensure EOT sales are fair, and work for all sides. This valuation figure forms the upper limit the founder can sell for.
Valuations can be a tricky area. They are subjective. A “fair” valuation will typically be based on future profits…which of course aren’t known with confidence pre-sale. Hence you could ask 3 different advisers and get 3 different valuations. None of them would necessarily be right/wrong.
What went wrong?
The founder provided the adviser with very optimistic forecasts, well above historic trends. The adviser used those, then made further arbitrary upward adjustments to predicted EBITDA to get to a valuation the founder was happy with. They also recommended more cash be leveraged from the sale via a high interest loan arrangement.
Combine these and you get a very high sale price, with pressure to pay it quickly to minimise excessive interest.
No alternative valuations were sought, nor was affordability considered based on previous growth patterns. In the senior team’s view, the adviser acted in the founder’s sole interest, i.e. financially the EOT deal was set up to pay top whack to the founder, as quickly as possible, with minimal thought to viability for the ongoing team.
EOT sale sign off
Another safeguard is the purchase side of the transaction needs to be signed off by the EOT trustees. Their role is to act in the best interests of the staff. Whilst the founder is often one trustee, there should also be an employee trustee and independent trustee.
However, often the founder will choose these people. Plus, peer pressure can work wonders!
Therefore, the situation can be:
- Founder sets up a deal great for themselves, not great for staff.
- Independent trustee is a mate of the founder, not that “independent”, perhaps not that informed either.
- Employee trustee has minimal understanding of the deal. If the founder (their boss) tells them to sign, they’d need to be brave to refuse/delay.
That’s what happened here.
- Founder of course keen to sign off on deal skewed heavily in their favour.
- Independent trustee was the founder’s mate, with minimal involvement.
- Employee trustee was given information last minute, and told to sign.
Hence these safeguards were of no real protection either.
Post sale – options considered
The sale completed. The founder disappeared into the sunset, though did remain as a trustee.
The senior team were left to it and felt like a rabbit in headlights. Not prepared. They were good at their jobs but had no experience in business operations. Far from ideal!
The senior team tried to discuss this with the founder, but were met with a harsh “come on, you don’t want to fail do you? Be more optimistic!” response.
The senior team definitely didn’t want to fail! They loved their jobs, the team they worked with, and the clients. They just hated the situation thrust upon them.
Over the many months that followed, they considered various options.
At various stages they considered taking legal action, possibly against:
- the founder for putting the whole thing in place without suitably consulting/agreeing with the rest of the team.
- the professional advisers, for making no effort to ensure the senior team knew what was going on, and/or agreeing an over-the-top valuation.
- the independent trustee, for signing off on a deal they didn’t understand, or take care to ensure it was in the best interest of employees.
In practice, they knew these would be an uphill battle. The safeguards had technically been followed. Litigation can get very expensive, with no guarantees of success.
This was in theory an easy option. If most staff quit soon after an EOT sale, as long as those staff are able to get similar jobs elsewhere (and not bound by lengthy restrictive covenants), they don’t lose much. The founder on the other hand could lose a huge amount. Without staff the business would collapse, leaving founder to get virtually none of the sale proceeds for selling their shares.
Whilst this option was seriously considered multiple times, the senior team really wanted to make it work. They didn’t want to be seen as having failed (even if it was largely due to being given a handicap!). They also cared about the team and didn’t want to abandon them.
This was an area the senior team had success. In particular they’d say a big thank you to:
- Sue Lawrence of Independent Directors and Trustees Ltd
Sue helped them understand how the trust works, who has what power and how to make the best of things
- Andrew Evans of Geldards LLP
Andrew helped them understand the legals of the situation. This included correcting a few misconceptions they’d learned from the founder.
- Employee Ownership Association
The business signed up as EOA members. Senior team members found the courses on how to be a good director/trustee invaluable. These are skills most founders learn gradually over many years. But the senior team had it dumped on them suddenly.
Between the above they helped ensure good governance practices were put in place. Educating both the trustees and senior team members where the lines of involvement and responsibilities are drawn and boundaries set. The company could begin to operate independently, in confidence, and thrive.
With assistance from their new advisers, a few months post sale they renegotiated a more realistic payment schedule with the founder. This included lower interest rates for an initial term, after which the higher interest rates would resume.
This process was a struggle, but they convinced the founder this was the only way the company might succeed (hence his payments continue).
The end result
Through the grit and determination of the senior team, they’re now over the worst of it. Whilst there are still payments owed to the founder, they’re no longer losing sleep over the repayment schedule.
It’s been a baptism of fire for them. Their attitude is one of “what doesn’t kill us makes us stronger”. They certainly don’t want to re-live the last few years, but are proud of what they’ve achieved, and optimistic for the future.
Financially the founder has done very well. The company has managed to pay most of the hefty price tag plus interest.
However, the legacy is that his name in the company is mud. For John Lewis/Julian Richer etc, most staff think fondly of the key person who gave them the opportunity they now have. In this company, the founder is viewed as “a self-interested miser”!
It could easily have ended badly for the founder financially too. The senior team could have decided it wasn’t worth the long hours and sleepless nights and found jobs elsewhere. This would have killed the business, hence the repayments. Fortunately for the founder, they didn’t, and found a way to make it work.
Key learning points
A few key messages come out of the above:
- Involve the team in the EOT decision. Ensure they know what’s going on and understand at least the big picture.
- Make sure the people who will run the business are comfortable running it before you leave. Provide support and training, transfer the operational management ideally before the sale occurs.
- Opt for a reasonable valuation, that’s comfortable for the business to pay within a reasonable timeframe. Demonstrate the thinking and logic behind valuation and payment schedule.
- Choose trustees who are truly independent of you and will work in the best interests of the staff. Understand that it’s healthy if at some point they stand up to you.
- Ensure you’re happy both the valuation and payment period are realistic and achievable.
- Ensure key documents are all made available to the senior team well ahead of the sale date.
- Arrange a follow up review meeting to the above, to provide answers and advice, and check management team are comfortable and ready for what lies ahead.
- Ensure the employee trustee and independent trustee understand their role and the deal they’re signing off on.
- Consider conflicts of interest and whether you can realistically act for all parties.
- Do not rely solely on the word of the founder.
Trustees (both independent and employee):
- If you’re signing off on the purchase, take this seriously. Are you happy it’s a good deal for the staff?
- Ensure you understand the deal and agree it seems positive for the staff before signing off.
- If you don’t understand, or are unsure of affordability for the company, have the confidence to refuse and/or ask questions. The deals will usually take several months to progress even on the most optimistic timetable so a delay of a few days is not the end of the world.
- Ensure you understand the deal, the payment plan, and additional responsibilities on you.
- Seriously consider the EOA’s courses on how to be a good director/trustee. Ideally go on these before the company is sold to an EOT.
- If you don’t understand, seek outside help. You’ll control the company going forward, so if you need to pay for expertise to help you do your role, get the company to pay for it!
- You always have the option of bailing. Whilst it may not appeal, there’s no shame in it. If you’ve been set up to fail, it’s not your fault if that happens.