Employee Ownership Trusts (EOT) – Key Considerations
Employee Ownership Trusts (“EOTs”) are a great way for shareholders to sell their companies for the best value in a more tax-efficient way than a traditional trade sale. EOTs were introduced by the Government in 2014 as a way to encourage wider employee ownership. The EOT model provides for every employee to be a part-owner of the business – a model famously adopted by John Lewis.
What are the benefits of Employee Ownership Trusts (EOTs)?
For shareholders wanting to exit, EOTs are a really attractive option as when structured correctly, the shareholders will pay no capital gains tax (“CGT“) on the sale. Typically, on a sale of shares, a shareholder will pay CGT at a rate of up to 20% on any increase in value of the shares since they were acquired. Other benefits for selling shareholders include:
- Lack of market – provides an option to sell where there is no willing purchaser available.
- Flexibility – the deal can be structured in many different ways to suit all stakeholders
- No tax bill – no CGT, income tax or inheritance tax should arise.
- Reduced costs – transaction costs are typically lower than with a trade or private equity sale as the transaction is a “friendly”, less risky process.
- Friendlier, less risky process – can make the deal process quicker and allow management to focus on the business.
Employee Ownership Trusts also offer benefits for the company and employees in the long-term, such as:
- Retention of employees – by owning part of the business, employees have a personal interest in its performance and growth.
- Drives success – employees are encouraged to be more entrepreneurial and motivated to help grow the business.
- Culture – EOTs give founders a way of exiting a business whilst retaining the same culture and values, as the management team remains the same.
- Ongoing tax savings – for example, companies controlled by EOTs can pay out tax-free cash bonuses to employees of up to £3,600 per employee each year.
What are the qualifying criteria for Employee Ownership Trusts?
There are certain key qualifying criteria which must be met in order to benefit from the CGT and income tax reliefs.
- Trading – the target company must be a trading company or the principal company of a trading group.
- All employees – any trust property must be applied by the trustees for the benefit of all employees of the target company.
- Equality – any distributions made by the trust or bonus payments must be made to all employees on the same terms. The trustees can distinguish between employees based on their remuneration, length of service and hours worked.
- Control – the trustees must have control of 51% or more of shares in the target company.
How does a sale of shares to an Employee Ownership Trust work?
The first stage of an EOT sale is to set up a qualifying EOT. An EOT is a form of trust, which means it must have a trustee which is responsible for controlling the assets on behalf of the beneficiaries of the trust. The EOT will adopt a set of trust rules which must be complied with by the trustee.
The existing shareholders will then sell their shares to the EOT by way of a share purchase agreement. It is usual for the EOT and the sellers to jointly obtain an independent market valuation of the shares to determine the purchase price for the shares. The selling shareholders will usually sell their shares on day 1, but receive payments over a period of time (known as an “earn-out period”) and remain involved in the running of the business during that earn-out period. There are various options available to enable the EOT to fund this price:
- Vendor loan – no payment is made to the sellers on day 1. Instead, the sellers receive deferred payments over a period of time from the profits of the business.
- External loan to EOT – the trustee of the EOT could obtain a loan from a bank or other funder to cover the purchase price. Usually a bank will require a guarantee from the company to support this.
- Loan from the company – the company could grant a loan to the EOT.
- Contribution from the company – the company could make contributions to the EOT, which may be treated as distributions for tax purposes.
Who should be the trustee of an Employee Ownership Trust?
The trustees of an EOT are responsible for ensuring the success of the trust for the benefit of the employees. They are not responsible for management of the company itself (which remains with the management team), but instead ensure that the company is being run in a way to maximise employee commitment and participation.
It is therefore important to consider who takes on the trustee role. The trustee will usually be a limited company which has a board of directors. It is usual practice for the board to comprise:
- Employee Trustee – their role is to represent the interests of the individual employees. Depending on the size of the company, this may be one manager or an employee council.
- Shareholder Trustee – the selling shareholders may appoint a trustee to assist with the transition process. This is particularly the case where the sale is funded by way of a vendor loan. This also allows the shareholders to retain some control where they either leave some shares or cash behind.
- Professional / Independent Trustee – their role is to provide a true independent view and ensure that the interests of the employees and sellers are balanced.
What are the considerations for Employee Ownership Trust funders?
With the popularity of EOT sales increasing, we are seeing more EOT debt funders in the marketplace. Selling shareholders will need to be aware that debt funders are likely to require certain protections during the loan period:
- Proper management of the target company for the period of the loan with selling shareholders remaining as directors
- Information rights to allow the funder to monitor the company’s performance
- Security from group companies and/or directors, particularly if the loan is made to the EOT rather than the target company
- Representation on the trustee board
How can we assist?
If you are considering an employee-ownership model, please get in touch with our corporate team who can advise you on the options available to your business. Our team is experienced in advising shareholders of owner-managed businesses navigate sale processes and in setting up employee share ownership structures.
This reflects the law at the date of publication and is written as a general guide. It does not contain definitive legal advice, which should be sought as appropriate in relation to your own particular matter before action is taken.
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We are solicitors in Camberley, Wokingham and London. In 2019, Herrington Carmichael won ‘Property Law Firm of the Year’ at the Thames Valley Business Magazines Property Awards, ‘Best Medium Sized Business’ at the Surrey Heath Business Awards and we were named IR Global’s ‘Member of the Year’. We are ranked as a Leading Firm 2022 by Legal 500 and Alistair McArthur is ranked in Chambers 2021.