Employee Ownership Trusts: A new company ownership model
Employee Ownership Trusts (EOTs) are not new, as they were introduced in the Finance Act 2014. However, the usage of EOTs has increased over the last 18 months, with Employee Ownership Association statistics showing over 120 companies transitioning to employee ownership in that period.
In summary, EOTs involve:
· The purchase of shares in a trading company
· A trust created for benefit of employees
· Holding a controlling interest in the company (at least 51 per cent of the ordinary shares and voting rights)
· A Capital Gains Tax (CGT) free disposal for selling shareholders where the shares are sold in the same tax year in which the EOT obtains control
· The payment of up to £3,600 income tax free annual bonus for qualifying employees of the company.
Why are EOTs suddenly popular?
The pandemic may have caused company founders to rethink whether they wish to continue with their current commitment to their businesses. One solution was the sale to an EOT, which can be an easy transaction to process, particularly compared to alternatives like a trade sale, an MBO or a private equity backed transaction.
The founders of a business may have a number of reasons for selling to an EOT. In our experience, the protection of their business legacy and retaining employees’ jobs is the top priority. Founders considering a sale to an EOT usually have a paternalistic attitude towards their employees and want to protect their welfare. The alternative of a trade sale provides no guarantee that the purchaser will maintain the business ethos or be concerned about employees’ welfare and job security.
The pandemic and subsequent economic uncertainty may decrease management appetite for undertaking an MBO and potentially putting their home at risk. The structure of an EOT transaction allows payment over a long period of time out of cashflow/profits of the business. Deferred consideration periods of up to 10 years are not uncommon. Insurance products can also reduce the risk of non-payment or at least ensure payment in the event of the death of the founders.
The tax savings on a sale to an EOT compared to Business Asset Disposal Relief (BADR) on other sales cannot be ignored. The sale of shares to an EOT in the tax year in which the EOT obtains control of the company are exempt from CGT, even if the consideration is deferred. There is no upper limit on the amount of the consideration compared to BADR, which provides for a 10 per cent rate of capital gains tax on the first £1m of lifetime gains and 20 per cent tax thereafter.
Traps for the unwary
An initial observer may think a sale to an EOT is straightforward; set up a trust and prepare a short share purchase agreement plus stock transfer form to sell the shares. However, a more cautious observer will soon discover a number of potential traps as the transaction progresses.
Indeed, the tax legislation contained in sections 236H to 236U of the Taxation of Chargeable Gains Act 1992 contains several pitfalls. These include an equality requirement on the payment of benefits; a participator fraction limiting the number of founder shareholders compared to other employees; and disqualifying events all of which can result in the removal of the CGT exemption, triggering a payment of tax by the sellers. The tests are not just applied at completion but continue for a couple of years after completion in the case of the CGT exemption.
Security for any deferred consideration cannot be taken over the shares sold to the EOT. This leaves the possibility of taking security over the assets of the company, if it has any, and negotiating a deed of priorities with the company’s bank.
As advisers, you should be clear on who is your client – are you acting for the founders or for the company establishing the EOT and then the trustees of the EOT? The founders may be more interesting in extracting as much cash on a tax-free basis as possible. You need to ensure:
o The management team and trustees have received independent advice (if you are acting for the founder)
o The valuation of the company for the benefit of the EOT is truly independent
o The company can actually afford to pay the deferred consideration.
Engaging with and involving the employees in the sale to an EOT is usually critical for a successful EOT transition. Employee engagement may not play to the strengths of some corporate lawyers who are used to dealing with high powered executives. A key part of the EOT transaction includes ensuring:
o The employees know the transaction is happening and the benefits for them
o The employees understand the ramifications of the sale; the sale will not result in business by committee but require some form of management to direct the strategic and day to day operation of the business
o The trustees understand their role in protecting the interests of the employees and not being involved in the day-to-day operation of the business.
Furthermore, there must be a clear demarcation of the various roles and responsibilities. Ideally, there should be documentation setting out who can do what and when, and the separation of powers between the management team and the EOT trustees. Or more likely, the directors of the trustee company. This can avoid the founder becoming too involved in the day-to-day business after resigning as a director of the company.
A sale to an EOT should not be seen as just another corporate transaction. It can require a deeper understanding of the founders’ reasons for the sale and the use of ‘soft skills’ in developing employee engagement and long-term support for client.
Carried out correctly, an EOT transaction can provide an opportunity to cross sell other legal services including advice on trustee/director duties, employment issues, perhaps with employees becoming trustee directors and having to deal with confidential information, plus the usual commercial contract support for trading companies.
The future for law firms?
Sales to EOTs have been particularly prevalent in the architecture and planning sector. However, the last couple of years have seen an increasing number of law firms announce that they are either partially or fully owned by an EOT.
Law firms operated as a partnership or a limited liability partnership (LLP) are dependent on lawyers wishing to invest and join the equity structure, to expand the firm or buyout retiring partners. An unwillingness of younger lawyers to progress to equity ownership, for whatever reason, could lead to an increasing number of legal firms considering a sale to an EOT rather than a sale to an acquisitive law firm.
Sales to EOTs are now appearing to enter the mainstream and can provide a viable alternative to trade sales and MBOs. However, EOTs certainly contain a number of traps for the poorly advised or for advisers lacking an understanding of the tax and legal technicalities, plus the soft skills required to deliver a successful transition to employee ownership.
This article was first published on Solicitors Journal on 05/09/2021 and is reproduced by kind permission.