Employee ownership trusts are becoming increasingly popular for those looking to sell up, and for good reason, as we discuss below.
When we first sat down to write this article, the Budget was approaching and the expectation was that the Chancellor might align capital gains tax rates with income tax rates. This, combined with the curtailment of Entrepreneurs' Relief (now Business Asset Disposal Relief), all pointed to a difficult situation for business owners wanting to sell up.
Now that the Budget is behind us and the tax changes have not materialised, although the rumour mill suggests that there will be some kind of alignment at some point in the future, it seems appropriate to revisit the prospects for sellers.
What is an Employee Ownership Trust?
A trust established for the benefit of the employees of a company. The trustee is the legal owner of shares but holds the shares for the benefit of the employees.
In much the same way as an entrepreneur might sell his or her shares in their company to a third party in a traditional M&A transaction, the sale and purchase of the shares is documented in a properly negotiated share purchase agreement between the sellers and the trustee of the Employee Ownership Trust (EOT).
Why are they popular?
There are a number of key reasons.
- You can't sell your company unless you have a buyer. Sounds obvious, but finding a buyer at the right time, and the right price, is difficult. An EOT is your buyer on a plate.
- An EOT is not likely to be aggressively negotiated. As the EOT is a known entity, the deal can be cleaner, less stressful and less time consuming.
- Employee ownership is widely supported. Governments have long regarded increasing employee ownership in businesses as a positive thing - it decentralises control and is a logical, practical answer to populist critics.
- They can be tax efficient for sellers. As touched on above, BADR has limited ER benefits available to shareholders but by selling into an EOT, providing the conditions are met, no CGT is payable on the sale.
- They can be tax efficient for employees. Once set up, employees can benefit from income tax relief for bonus payments of up to £3,600 per year.
What's the catch?
In a word? Funding. As the EOT will start out as (effectively) a shell, funding the purchase can be tricky. On a normal sale you would expect most of the consideration to be cash with the rest made up on a deferred basis - i.e. earn out. The CGT benefit is lost for deferred consideration, so sellers will want to maximise upfront consideration.
The solution tends to involve a combination of bank lending to the EOT, use of surplus cash in the target and loan notes issued to the vendors. Of course, these come with their own challenges - not least, how does a 'shell' provide adequate security to a third party lender? They can, however, be overcome.
It is also important to note that a third party lender will likely expect management to remain part of the business post-completion so this may appear unattractive to those looking for a clean break at the end of a long career. However, this has to be balanced with the fact that if the business is strong and the sellers are comfortable running it and preparing second tier management to take over, there is (unlike in a MBO) no real change to how the business runs post-completion so staying on for a little longer may be a price worth paying. Banks tend to look to refinance around 18 months after completion, and this provides another opportunity to extract a lump sum. Of course, any tax planner will tell you that receiving a large amount of cash sounds great but can also scupper best laid inheritance tax plans.
And one other thing: the tax rules.
The tax rules need to be carefully navigated; there are some key conditions which must be fulfilled, both before and after the sale.
Two such conditions are that control passes to the trustee, and that the settled property must be applied for the benefit of all eligible employees on the same terms. Slightly confusingly, this does not mean all employees must get the same benefits; rewards can be linked, for example, to length of service.
What if you already have an EMI scheme?
EMI schemes include an independence requirement and for a company to qualify it must not be a 51% subsidiary of any other company. Even though an EOT controlled company would breach this requirement, EOTs are excluded, so an EMI scheme would not be affected. That said, share issues will need to be treated with some care so as to ensure continued compliance with the controlling interest requirement.
If you are interested in learning more, please get in touch.