Over the past three years, employee ownership trusts (EOTs) have gained significant traction as a model for business succession. It is estimated that, in the UK, there are now more than 1,500 employee-owned businesses using an EOT model.
A UK government initiative, EOTs promote employee ownership by giving business owners the opportunity to sell their shares to an EOT free from capital gains tax. An EOT is established to acquire a controlling interest in a company from the existing owners on behalf of its employees. The EOT becomes the legal owner of the shares, and the employees become beneficiaries of the trust.
All employees – not just the management team – acquire a controlling interest
The EOT is comparable to a management buyout, with one key difference: all employees – not just the management team – acquire a controlling interest, albeit indirectly through the trust vehicle.
The sale is typically funded by a mix of cash already in the business and vendor loan notes to be repaid to the sellers from future earnings. Bank and/or other external debt can also be raised.
No cash is required to be introduced by the employees, and there are attractive taxation and other benefits for business owners – not least that the sale is free from capital gains tax provided certain conditions are met.
Pros and cons
When advising clients whether to set up an EOT, there are a number of considerations that accountants should keep in mind.
There are many benefits to an EOT transaction: they provide a viable succession plan for business owners in a highly tax-advantaged way; the selling shareholders have a degree of control in setting the sales value; and there is no arduous external due diligence. An EOT transaction also rewards employees and acts as a strong recruitment and retention tool.
Accountants should keep in mind that strict qualifying criteria must be met to enable selling shareholders to benefit from tax and other incentives. EOTs are a highly attractive option – in the right circumstances. Crucially, they are not a replacement for traditional M&A deals.
Accountants must take the time to understand their client’s rationale
One disadvantage is that, typically, a significant amount of the sales value is paid to the sellers from future earnings of the business over a period of time. Usually, only a portion of sale proceeds can be funded upfront at completion. The selling shareholders must sell a controlling interest in their company and they should understand that they will no longer be the majority shareholder.
Key benefits
Employee ownership trusts offer a number of advantages for business owners:
- They provide an exit option when there is no obvious third-party purchaser.
- They offer shareholders a streamlined exit route.
- Individual shareholders benefit from tax-free disposal.
- The owner can retain some involvement (up to 49%).
- Share capital is still available to incentivise management and key employees.
Accountants must also take the time to understand the rationale for their client considering an EOT. Research indicates that employee-owned companies often have higher levels of profitability, productivity and innovation compared with traditionally owned firms – something that is attributed to the alignment of incentives between employees and management.
An attractive feature for a company’s existing accountant is that, following an EOT transaction, the business remains their client and, indeed, will often request additional support. This is often not the case when a client sells to a third-party or trade buyer.
Growing awareness
In the UK, by the end of 2023, statistics indicate there were around 1,500 employee-owned businesses using an EOT model. The top five sectors for employee ownership include professional services, manufacturing, construction, wholesale and retail, and information and communication, confirming that EOTs work in a variety of business activities.
In Northern Ireland, it is estimated there have been fewer than 10 EOT transactions to date. It is not uncommon for Northern Ireland to experience a lag effect and it is encouraging to see momentum building. Our team has advised on a number of EOT transactions this year, including Boyce Precision Engineering and Adman Group, and we are currently in the process of completing two more.
It is generally expected that the number of EOTs will continue to increase as their awareness as a viable succession planning option grows; Northern Ireland has a high proportion of owner-managed businesses that often lend themselves to EOT transactions. It will be interesting to see if the new Labour government makes any significant changes to EOT legislation in its first Budget.
Accountants should speak to, engage and work with specialist advisers who have the relevant experience
We are also approaching the point when early EOT adopters will have fully repaid loan notes owed to selling shareholders. It will be interesting to see how secondary transactions occur to realise and distribute value to employees.
EOTs are a specialist area, and there are many complexities and nuances to be considered. Getting the right structure (legal, financial, governance), obtaining relevant tax clearances, ensuring a robust and defensible valuation, assessing cashflow viability, and properly incentivising the senior management team are just a few of the key issues. Accountants should speak to, engage and work with specialist advisers who have the relevant experience.
