Succession planning

Why consider an employee ownership trust?

If you have been exploring company succession options with your advisors, you might have come across the idea of selling to an employee ownership trust (EOT).

What is an employee ownership trust?

An employee ownership trust is a special type of trust where trustees hold shares in a company (and its subsidiaries) for the benefit of all employees on the same terms. If you sell a controlling stake in a company to an employee ownership trust and meet the relevant legislative requirements, the transaction will result in a ‘no gain no loss’, meaning there will not be any capital gains tax (CGT) for you to pay.

While the CGT relief available makes the employee ownership trust succession route popular, the reality is that employee ownership trusts are not right for everyone. Key commercial considerations should come before the tax.

In this blog I’ll consider:

a) The impact of the changes to the CGT rates on employee ownership trusts
b) Why employee ownership trusts might not be the right succession route for every business (including an example).

EOTs post-budget – the impact of higher capital gains tax rates

Following the budget, I can’t imagine there will be a slow-down in the number of businesses transitioning to an employee ownership trust structure. We’ve noticed more clients interested in employee ownership trusts. With higher CGT rates payable on chargeable gains on shares, the potential tax savings from a CGT-free sale of a company to an employee ownership trust have increased.

In my previous blog, I mentioned that if maximising value is your main goal, a trade sale may be a better option than an employee ownership trust. In a trade sale you might find a ‘special purchaser’ willing to pay more due to synergistic benefits. Whilst it is still likely in many cases greater ‘gross sales’ proceeds can be achieved via a third-party sale, if this would incur CGT payable on gains at a rate of 24%, would a seller’s ‘net position’ really be better than what could achieved on a sale to an employee ownership trust? For a growing number of business owners, the answer could very well be “no”.

Does this mean an employee ownership trust is suitable succession option for every business owner moving forward? Not necessarily.

Employee ownership trusts work best when a seller is motived by the ethos of employee ownership and believes their business is the right cultural fit for the model. Commercial realities should be prioritised over the tax savings. Ignoring these could leave the seller in a worse position than other succession routes.

Example scenario

Imagine a company with three ambitious senior managers who can run the business without the input of the owners, who have stepped back in recent years and are considering selling. The senior managers want to drive the business forward. Without them, the business would not be able to operate at the same level and generate the same level of profits. If they are going to stay, they want an opportunity to participate in the growth of the business as much as possible.

Would an EOT be a suitable solution here?

Given the importance of the senior managers to the business, they need to be incentivised post-sale. Whilst an EOT can offer employees the opportunity to participate in the growth of a company, i.e. via bonuses or equity incentives, the senior managers can’t hold a controlling equity stake in the business. An EOT must hold more than 50% shares in the company. Therefore, assuming they are to receive equal holdings, each senior manager could be awarded up to c.16.6% of the shares in the business.

Furthermore, EOT shares are intended to be held long-term. Any onward sale of the company would need to be in the best interests of the beneficiaries (i.e. the employees of the company). Whilst it is within the realms of possibility that an offer is received that is simply too good for the trustee(s) to refuse; there are limited instances where a sale to a third-party will be a good outcome for most of the employees because, for example, such a transaction could risk job security. As an EOT is unlikely to sell the shares it holds, there may not be any ‘exit’ that manager shareholders can participate in. Without an opportunity to sell their shares and realise value, this could reduce the incentive impact of the equity incentives. However, it is possible for the company to buy the shares back from the employee or create an employee benefit trust (EBT) which can be used to buy the shares, but these routes will not always be a good fit. They give rise to tax complexities and are less likely to provide employees with the significant profits on selling their shares than a whole company sale to a third party can offer.

If the company is unable to incentivise the senior managers under an EOT structure there is a possibility they could leave, which will likely impact the success of the business moving forward. Since EOT sales are often funded with upfront cash and deferred consideration, key employee departures could jeopardise repayment.

What could be a better solution?

In this scenario, a management buy out (MBO) might be a more appropriate succession route. MBOs are funded similarly to an EOT – upfront cash with an element of deferred consideration typically paid back over several years. However, an MBO, can provide an opportunity for the senior managers to acquire a significant equity stake in the company (possibly c. 33.3% each) which could help motivate them to grow the business, pay off the sellers’ deferred consideration and then realise the growth in value at a later date. The downside to an MBO is that, unlike an EOT, CGT would typically be payable on any gain on the disposal of the shares.

Another option is a trade sale to a third-party buyer. While this usually involves intense negotiations and due diligence, it might be better for the business with an ambitious management team. A trade buyer might not hold the business forever, offering managers a chance to participate in a future sale.

Key takeaways

Although I’m a big proponent of employee ownership, it is not the right succession route for every business. Tax considerations are important but should not be the main focus. With higher CGT rates following the budget, there is a risk that the potential tax savings of selling to an employee ownership trust could cloud judgement.

If you’re considering an employee ownership trust , I would encourage you to:

Discuss the prospect of an employee ownership trust with your management to understand their openness to the employee ownership trust model and their ideas for the business’ future
Speak to professional advisers who can offer different perspectives and help you understand the technical aspects of succession routes

If you would like to discuss and explore the possibility of selling your business to an employee ownership trust, you can contact Matt Chester or tax partner Nicola Manclark.