What to consider before selling your business to an employee ownership trust

This year the employee ownership trust (EOT) celebrates its tenth anniversary. The concept of employee ownership is certainly not new, but the introduction of the EOT in the Finance Act 2014 saw a renewed enthusiasm for employee ownership. I could certainly feel this when speaking with sellers and employees at last year’s employee ownership association conference in Liverpool.

We have helped with the transition of many companies into EOTs and I have been fortunate enough to help a number of these businesses start their employee ownership journey. There are many technical and practical issues to deal with when moving to an EOT. It is therefore easy for advisers to focus on the technical issues and miss some practical points, which are often important.

In this blog, I want to share a few key points to consider if you are exploring the possibility of selling your business to an EOT.

It is not (just) about the tax

This might sound strange coming from a tax adviser, but the capital gains tax relief available on a qualifying sale should not be your main motive for selling to an EOT. While the tax benefits will always be part of the decision, key drivers should include legacy and genuine employee participation.

If receiving maximum value for the business is your key motive, a trade sale may be a better option. A higher sale price may be achievable through a trade sale compared to other exit options. If you take your company to market, there is a possibility that you will find what is often termed a “special purchaser” (i.e. a purchaser willing to pay higher than the rest of the market for your company because of synergistic benefits of the deal).

Understand the tax rules

Although tax should not be the main driver, it is important that all concerned in a potential sale to an EOT understand the tax rules involved.

As well as the potential capital gains tax exemption there are other tax implications which should be understood. This will include the implications on any subsequent sale of the company. We advocate transitioning to an EOT for long-term succession planning without a subsequent exit event. One of the reasons for this is the inefficient tax treatment on a subsequent sale.

Understand the funding structure

Typically, an EOT will be funded from surplus cash held by the company and deferred consideration. Deferred consideration is essentially debt owed to sellers which is paid back out of future profits of the business. The deferred consideration is often repaid over several years.

We have advised on cases where property held by a company is extracted by the sellers. This can then be rented back to the company as a future source of income and used to fund part of the consideration. There are several tax and legal implications which must be considered on the transfer of any property.

Securing third party funding can be valuable, especially if the sellers wish to receive additional up-front cash consideration on completion. While the appetite and understanding of debt lenders to fund an EOT acquisition is increasing, it can be challenging to find lenders for an EOT.

Understand the legal structure

Some of the key points which need to be understood are:

• The company will be purchased by the EOT (ordinarily acting through a corporate trustee)
• An EOT is a special type of employee benefit trust, the property (i.e. the shares) will be held for the benefit of the employees
• Property held on trust will be managed by trustees. As mentioned above, often in the case of an EOT a corporate trustee will hold the property. Therefore, the individuals who manage the property held on trust will in practice be the directors of the corporate trustee
• As the trustee will manage the property held on trust on behalf of the employees, it is worth noting that the employees will not directly hold the shares themselves

Consider who will be on the board of the corporate trustee

It is important that you consider the composition of the board of the corporate trustee and identify individuals who might be suitable for the role of director.

Typically, we would expect to see employee representation and, until the deferred consideration is repaid, representation for the sellers.

We recommend appointing an independent director on the board of the corporate trustee. Two benefits of having an independent director are that they can:

1. act as a tiebreaker for difficult decisions.
2. bring professional experience of EOTs to help navigate some of the issues which may arise as part of being a trustee.

Although we are aware of instances where the sellers have retained control of the corporate trustee, we advise against this. There are potential conflicts of interest to manage in the on-going operation of the trust. Managing these risks is even more challenging if sellers make up the majority on the board of the corporate trustee. The corporate trustee should act in the interest of the employees. It may be the case that the sellers’ interests and the employees’ interests do not always align. It is not unreasonable to suggest that arrangements where the sellers retain control are not in line with the ethos of EOTs.

In their response to the recent government consultation on EOTs, the Chartered Institute of Taxation has echoed concerns which I (and my colleagues at PKF Francis Clark) share regarding the sellers retaining control of the corporate trustee. The CIOT have called for changes to the legislation to deter anyone looking to ‘abuse the process’ in this way.

Engage with your staff – especially the management team

As part of the decision-making process about transitioning to an EOT we would recommend structured engagement with your management team and wider staff.

Communication with employees is essential to yield the full benefits of an EOT. Clear communication can help increase employee motivation and ensure that they are engaged with the process and vision for employee ownership.

Post-completion, without proper communication, there is a risk that your management team may be left feeling as if they are working to pay off a debt to the previous owner with no upside to them personally. A demotivated management team may be particularly problematic if there is a significant amount of deferred consideration owed to the sellers, as you will need a motivated management to help ensure prompt repayment of this loan.

This is why it is important to be clear with your management from the outset to make sure that they are onboard with the EOT. If they are not, an EOT may not be the right fit for your business. You could consider whether another form of succession planning (such as a management buyout) would be a better option.

Valuation is important

There are tax and legal risks of over-valuing the company. For example, if the seller is an owner-manager the shares would ordinarily be employment related securities (ERS). A disposal of the shares for more than market value would give rise to an income tax charge. This would be subject to pay as you earn (PAYE) and employee’s and employer’s class 1 national insurance contributions (NIC).

We are aware that HMRC has recently been issuing enquiry letters requesting information on the valuation process that was undertaken in relation to EOTs. Instances where shares have been sold to an EOT based on an over-optimistic valuation may have been a catalyst for these enquiries.

It is worth bearing in mind that there are two parties in a sale to an EOT – the sellers and the trust. As such, we would recommend that the trustees (as well as the sellers) seek independent advice on the valuation of the business.

Looking to the future

I am sure you will have seen headlines in the news about possible tax changes which could be introduced by the new Labour government in the Autumn Budget, due to take place on Wednesday 30 October 2024.

It has been suggested by many that there could be changes to the current rates of capital gains tax. This currently sits at 20% (or 10% depending on your marginal tax rate and the availability of special types of relief) on the sale of shares. There is unquestionably a significant disparity compared to the rates of income tax, which are currently 20% (basic rate), 40% (higher rate) or 45% (additional rate).

The rate of capital gains tax could very well go up, or it may not. The relief for qualifying sales to EOTs may remain but the rules may be tightened. We will have to wait to find out.

If you would like to have a discussion to explore whether an EOT may be the correct succession route for your business, please do not hesitate to reach out.

This article is written by Matt Chester, part of the share schemes team here at PKF Francis Clark, contact him at [email protected]