Employee Ownership Trusts (EOTs) spotlight

8 June 2022

This quarter the Fortus Construction & Built Environment Sector team talk all things Employee Ownership Trusts (EOTs) and how this particular solution has become the fastest growing form of business ownership in the UK.


Question 1 – I’ve been saying EOTs have been the flavour of the month for 18 months now! They’ve proven particularly popular in the Construction & Built Environment sector with businesses across all disciplines making the move to EOTs. Why do you think this is?

PATRICK FAUGHNAN – Completely agree! Following their introduction in the Finance Act in 2014, we’re seeing EOTs being considered by business owners as a viable form of exit strategy across an increasing spectrum of sectors; ranging from young professional service firms through to mature construction and engineering businesses. Currently, in the region of 25% of the AJ100 firms are owned by their employees, which isn’t surprising given the egalitarian nature of architects.

Much has been publicised about the tax benefits for an exiting shareholder. The sales proceeds in respect of their initial disposal of shares to an EOT would qualify for Capital Gains Tax (CGT) relief i.e. it’s deemed to be ‘neither at a gain nor at a loss’. In effect, this means that no tax is payable on the sale proceeds. These tax savings are clearly highly attractive!

PAULA CARTER – The government, when it established this model, hoped to encourage the creation of efficient and sustainable ownership structures. The success of this can be seen by the level of employee owned businesses reporting significant improvements in operational performance, employee engagement and staff loyalty. I’m sure the company’s ability to pay employees income-tax free bonuses of up to £3,600 per person has been a significant contributing factor! In addition, if the business is ever sold in future, the employees will benefit from a share of the sale proceeds.

Because of this, EOTs may also present an opportunity for businesses to address the ‘next generation’ skills gap. This is particularly prevalent within certain sectors such as engineering where a highly skilled workforce within a technical service offering is often a key success factor. Tax-free bonuses are clearly advantageous and viewed by many as a key benefit, to help to retain experienced staff and attract new talent. Obviously, this also helps counter the ‘great resignation’ that’s currently being experienced within the job market.

The overriding attraction of EOTs for many business owners is the ability to affect a smooth transition of ownership whilst ensuring that jobs, skills and business know-how are preserved – which ultimately results in a sustainable business legacy.

CHRIS WILSON – Since being introduced in 2014, EOTs in the early years were a slow burner for various reasons.

  1. They were largely misunderstood in the market by both advisors and clients due to the apparent complexity in the legislation – a lack of demand perhaps curtailed advisors from investing into properly understanding their use and benefits.
  2. General lack of motivation – a 0% tax rate was intended to promote use of the EOTs, but it was perhaps not enough to overcome the perceived added complexity when compared with only a 10% tax rate that most business owners would’ve been suffering on their disposals via other means given the availability of entrepreneurs’ relief (now business asset disposal relief “BADR”).

As more advisors and, in turn, their clients, have become comfortable with what’s achievable with an EOT, it appears to have driven its popularity. Add to that the reduction in the BADR lifetime allowance from £10m to £1m during a period when many business owners were looking for the door during a difficult time – the EOTs presented a compelling combination of tax efficiency, immediacy and a relatively risk-free legacy for the employee base that helped to build the company.


Question 2 – How would the phased exit work in practice then in terms of control and deferred consideration, both for the owner and employees?

PAULA – Under the EOT model, there’s a great deal of flexibility for an owner to phase the timing of their withdrawal from active involvement in the business as there’s no third party to negotiate with. Their exit from the day-to-day operations may extend beyond the typical requirements of a trade buyer who may, for example, be keen for the owner to step back within a clearly defined timeframe so they can make their own stamp on the business!

As mentioned below, the sales consideration’s often funded from vendor loans which are associated with much a longer pay out period. This is why EOTs often work well for mature, established businesses where past profits are a clear indicator of future earnings, and an owner can have confidence that vendor loans will be fulfilled.

During this period, and indeed beyond, the owner may continue as a director in the business, helping to maintain stability during the transitional period.


Question 3 – Is there a risk that the Chancellor may clamp down on the beneficial tax rates you mention? 

CHRIS – I think a clamp down is unlikely, but not out of the question. I think there’ll continue to be a preferential rate of tax offered on gains made on qualifying EOT disposals but just how preferential will probably be determined by the main and BADR rates of CGT. The speculation around increases in CGT rates has largely died down, but if we were to see an increase in CGT, or even an alignment with income tax rates, I suspect the rate applied on EOT disposals would increase. So, as to still present an incentive to use them, but without creating such a disparity between the ‘ordinary’ rates and the rate applied to an EOT, the EOTs then became the go-to option for everyone selling a business, whether appropriate or not.

Tax applied on EOT disposals would require some knock-on tinkering elsewhere in the legislation to fit, but it’d be relatively simple I expect.

There’ve been discussions around some improvements to the EOT legislation to prevent perceived abuse through the use of offshore trustee arrangements and a lack of rescinding of control by shareholders, which I think are more likely to be addressed in the short term.

PAULA – There’s always a risk that the Chancellor may clamp down on the tax advantages that are available for both owners and employees, particularly in light of tough current economic conditions. That said, it’s clear that the EOT structure is commonly achieving exactly what the government intended it to achieve in the first place! This begs the question, why would the government seek to alter the incentives when an EOT model is evidently working for many?

Perhaps, we’re more likely to see a clamp down on where the EOTs can be located i.e. UK versus overseas, as opposed to any immediate changes to capital gains/income tax reliefs.


Question 4 – What’s the appetite in the funding market to support EOTs in the sector?

PATRICK – Debt funding of EOT transactions is often being provided through vendor loans rather than borrowing from external commercial sources.

The number of EOT transactions that’ve been completed is relatively small, and a number of the challenger banks and specialist lenders have yet to enter the market to provide funding for them.

The high street banks were quick to enter the market and have funded a number of transactions but have become increasing selective about the deals they’ll consider because of their experience with those transactions.

Consequently, unsecured funding has become difficult to obtain, although commercial mortgages, asset finance, and invoice discounting facilities are available from high street banks, a growing number of challenger banks and specialist lenders that’ve entered the market as the number of transactions has increased.


Question 5 – If any readers are contemplating an EOT as a solution for their succession, what advice would you give them now?

CHRIS – I’d advise to look beyond the ‘golden’ tax-free exit opportunities that an EOT can present and consider all options in the round.

Given the typical deferred consideration model, sales via EOT for the exiting shareholders are generally only as successful as the trading business continues to be. So it’s key that not only does the EOT present an attractive option for the exiting shareholders, but to really be feasible they need to garner the support of employees, banks, lenders, customers and suppliers to secure the success of the business for the long term benefit of everyone involved.

As advisors we’re able to compare and contrast the various options that business owners could consider as part of their succession plans to give well rounded advice on the most appropriate structure, or structures, as the case may be.

PAULA – The two questions I always pose to any business owner are; 1) what are you looking to achieve? and 2) what’s important to you? From this, we can then start to build a picture of possible exit routes and fully consider the suitability of each option within the context of the owners’ ultimate desires and ambitions.

An EOT is a fantastic ownership model when you’ve an established and profitable business, but it’s not suitable for all. Carrying out an options review is, in my opinion, absolutely vital in determining whether we’ve got the exit strategy right.

People like to be presented with choices and have their eyes opened to all possible avenues. Whilst the final decision is theirs, we’ll ensure the right path is clearly laid out for them.


Question 6 – How do business valuations for EOTs tend to compare to a trade sale or even a Management Buyout (MBO)?

PATRICK – With a trade sale, business valuation is distinctly identifiable as the price that a willing buyer’s prepared to pay for a business. Strategic trade buyers have historically been associated with crystallising a maximum price for a vendor – this is enhanced by the creation of competitive tension amongst potential acquirers during the sale process.

In addition, a trade sale will often result in savings of role duplication, or the opening up of new sale channels. These ‘synergies’ aren’t available in an EOT or Management Buyout (MBO) transaction, and so the value’s rarely enhanced in the same way.

MBOs rarely produce the highest business valuations, which are often suppressed by the level of personal investment in the business that the management team’s able to commit.

PAULA – A sale to an EOT doesn’t involve engaging a third-party buyer and as such, business valuation can, initially, appear less than clear cut. That said, certain key principles such as determining a fair market value and identifying affordability still hold true. This is a fundamental area where we can lend our expertise and knowledge to objectively value a business.

This involves striking a balance between recognising the value that the owners have created within the business and the level of debt funding that the business is able to support. Additionally, careful consideration also needs to be given to the level of continued investment that the business will need in order to ensure its continued success.

Creating an efficient, sustainable structure whereby the underlying business and its employees continue to thrive is absolutely essential in valuing a business for the purposes of an EOT!


Question 7 – And finally, what are the common misconceptions and pitfalls that you come across when talking to clients on EOTs? 

PAULA

  • The owners believe they cannot remain involved as directors or otherwise.

A common misconception is that owners often believe they cannot remain involved in the business once it’s been sold to an EOT. However, as mentioned earlier, there’s flexibility to remain involved in the management of the business and to phase the ‘stepping down’ process in line with what is best for them and the business.

  • The owners believe that the staff need money to invest in the EOT.

No investment is needed by staff in an EOT.

  • The owners believe they can use an EOT to pass the business on to family members.

Family members are excluded from the EOT.

PATRICK

  • Because the proceeds are ‘tax-free’, the owners want to inflate the valuation.

The value has to be independently determined at ‘market value’.

  • Employees believe they will become shareholders.

Some employees incorrectly believe they will become shareholders in the business under the EOT model. This is an area in which we’ve had a great deal of experience. We can proactively manage the communication process to ensure employees are appropriately informed, highly engaged with the process and on completion, suitability incentivised to help drive the business forward!

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