Employee Ownership Trust

An EOT sale does not mean that the business has to become wholly run by the employees. The former shareholders can remain involved at management level, whilst they concede board control of the business to the trust they can remain involved as a trustee after the sale. The key points of the EOT approach are:

• The sale must be for 51% or more of the company’s shares to benefit from the 0% CGT rate. Many EOT sales are 100% share sales for simplicity.
• Typically, a new company is created which will act as the employee share ownership trust and the shareholders will sell their trading business shares to this EOT company.
• A sale and purchase agreement is executed, but the associated due diligence is typically lighter than a trade sale.
• After the sale, the company trades as a wholly-owned subsidiary of the EOT company.
• A trust document sets out the obligations of the trust to the employees.
• The fixing of the multiple used to value the trading company is a commercial discussion and there is no golden rule.

Contemporary management theory claims that the primary aim of a business is to generate profit, and this is linked to maximising shareholder value and returns. However, this view overlooks the interests of a diverse array of stakeholders beyond the shareholders, such as society, employees, and creditors. Ethical and social governance principles advocate for a more comprehensive approach that recognises the importance of balancing financial goals with the well-being of all stakeholders.

An employee-owned business is now viewed as a viable alternative to the more traditional shareholder value model. By structuring organisations with employee ownership trust , companies can prioritise contributions to society and employee welfare alongside commercial success and returns. Unlike traditional profit-centric businesses, employee-owned enterprises are not solely focused on shareholder returns. Many proponents argue that employee-owned businesses should still aim to be valuable and advocate for enterprise management schemes that align with shareholder-oriented principles. In essence, they view employee ownership as the ultimate share scheme thereby overlooking its broader objectives. Whilst shareholder value is traditionally emphasised, employee-owned businesses should also prioritise local investment, wealth distribution, and the long-term benefits of employees.

Typically, private company valuation multiples range between 4 to 7 but cashflow, financial headroom and reserves will need to be considered and will all have a bearing on the ultimate valuation. The valuation, which will be modelled by Avondale, is subject to HMRC clearance and will be assessed using comparisons with other private sale benchmarks.

There are three ways for the trust company to fund the buy-out – company reserves, vendor loans (typically over 5-7 years), and sometimes third-party debt is also used. The key financial aspects to consider are:

• Any debt or vendor loans are structured in much the same way as a management buy-out that is from future cashflow (profit after tax) analysing seasonality and the headroom to pay debt, plus interest from the income.
• Owners’ salaries are sometimes adjusted at the point of sale.
• The trade company will make payments out of profits, after tax, on the vendor loan to the EOT company which will then repay the selling shareholders.
• The vendor loan is often a ‘promise to pay’ and therefore may not sit on the balance sheet. From a practical perspective this means that if cash flow is struggling, the loan period can be extended.
• Interest on vendor loans must be charged to ensure that there is an incentive for management and trustees to repay the loans on schedule.
• Dividends can be restricted until all vendor or third-party loans are repaid.
• The vendor loans are typically structured as loan notes secured against the business.
• Any initial payout from reserves needs to leave sufficient working capital.
• Any third-party debt may need personal guarantees from the sellers and will rank senior to the vendor loans in terms of repayment. The trust will need to approve reasonable finance terms.

Employee-owned businesses aim to provide equitable wealth distribution amongst their employees and whilst employees may have a greater voice in company affairs, achieving a fully democratic business model may not be feasible in today’s fast-paced environment. EOTs must remain competitive and commercially successful to thrive, with an emphasis on strong management, a well-considered strategy, and maintaining market share and profitability. Therefore, yes, an EOT is fully commercial, albeit with different beneficiary owners.

Although employee ownership often leads to increased productivity and employee satisfaction, economic challenges can still cause these businesses to fail. Therefore, maintaining a competitive advantage through strategic planning is of paramount importance. New employee-owned businesses are particularly vulnerable, often facing financial strain as they transition to employee ownership with cash flow restricted by loan notes or third-party debt obligations put in place to pay out the former shareholders who want to achieve commercial and ‘open market’ values. This often results in there being long-term vendor loans to repay the sellers.

Management needs to balance reliability with long-term strategic risk and adaptability. Whilst some fear that employee ownership structures may hinder commercial competitiveness, when properly established, employee-owned businesses operate very similarly to traditional enterprises, with management driving decisions for profitability whilst considering employee interests. Additionally, the speed at which the sellers can go “hands off”, and how they recruit or train the management as they step back and implement a strategic business plan are all critical factors in successfully transitioning to a team-driven business.

Employees are usually highly motivated by employee ownership. Employees like the inclusivity and cultural approach that it brings to the company and their roles which can also benefit  future staff recruitment. Many also see that beyond any debt repayments the business can scale-up as the ongoing dividend requirement is lessened/eradicated. Typical employer benefits include:

• Pay for key managers typically moves into the upper quartile for the sector following the repayment of debt.
• Increased staff retention.
• Better productivity as employees increase the ‘stakeholder’ mindset.
• Tax-free bonuses of up to £3,600 per annum for each qualifying employee, typically from year one.
• The sellers can remain employees and gradually handover the reigns of the business.
• Strategy and culture can often be reset with increased team-driven initiatives.
• The trust acts in the best interests of the beneficiaries – the employees.
• There is usually a professional trustee, an employee trustee and an ex-shareholder trustee. Avondale will help establish your trust panel as part of its service approach.

In most cases, the long-term goals of employee-owned businesses will focus on being commercial and successful, but should maintaining shareholder value continue to be a primary objective? There are significant reasons why a focus on increasing shareholder value might not be optimal in an employee-owned business, in fact, it might be more beneficial to downplay or even disregard this aspect. We believe there are five material reasons to support this stance, which all centre on the fact that employee-owned businesses may not resell well in the future and therefore this should not be the primary goal of the strategic business plan going forward.

1. The buy-out to transition: Many employee-owned businesses are vendor-led buyouts structured to secure 0% Capital Gains Tax (“CGT”) at full commercial value. This setup usually involves loan notes being paid to the sellers over a long period. This automatically creates a barrier to a possible resale within the first 5-10 years as these loans would typically need to be repaid in full prior to or as part of any resale.

2. Tax: The 0% CGT break that the sellers benefit from through the initial EOT sale requires the company to qualify as an EOT for two years from the end of the tax year in which the business is sold to the trust. This means that for this qualifying period, the sellers will insist on having the right of veto concerning any potential sale. Once this qualifying period has expired, the CGT passes to the trustees of the EOT and therefore a sale could take place without impacting on the 0% CGT break the sellers achieved. After this period the EOT will take over the ‘base’ cost of the shares in the company from the sellers. This could be at the nominal amount paid for the shares on the incorporation of the company which could mean the whole of the increase in value of the company since inception is taxed as a chargeable capital gain at the prevailing rate on a resale. After the payment of CGT and the initial seller buy-out, any proceeds left from the company sale will be distributed as PAYE income to qualifying employees. This is because most EOTs are ‘indirect’ trusts and as such, there are no actual shareholders, just employee beneficiaries, therefore the proceeds will usually be treated as income subject to Income Tax and National Insurance. With a double charge of CGT and PAYE, this significantly discourages resales.

3. The original EOT driver: Many businesses explore employee ownership as a succession route when they are unsuitable for trade or an investment sale. If a company was challenged in securing a trade or investment sale before the EOT transition, why would it be more desirable to resell as an EOT later? Many sellers also want to secure a local legacy through a ‘letter of wishes’, and resales can contradict this.

4. The Trustees: Neither ex-sellers nor employees can control whether a business will be resold. The ultimate decision is with the trustees, whose responsibility is to ensure that any resale benefits the employees and the organisation. Short-term financial gains from a resale might not align with long-term employee welfare and stability.

5. Culture: Employee-owned businesses have a unique culture that may not match with potential buyers in the future. Transitioning from an employee-owned culture to a corporate one could create tension and impact talent retention. Additionally, once proceeds from a sale are distributed equally amongst qualifying employees, this could lead to a drain on talent if the post-tax proceeds are sufficient for an employee to take a break, or career change.

All EOT sales are bespoke as the approach is highly flexible. It typically takes Avondale 3-4 months to complete an EOT, working directly with the sellers on a one-to-one basis on all aspects from feasibility, financing and clearance to strategy and the establishment of the trust panel.

With significant expertise in valuing businesses, cash flow modelling and gaining HMRC clearance, Avondale is unique in the EOT market as we also have in-house expertise to lead the EOT cultural transition within a business. We believe EOTs should be completely commercial in terms of the return to the seller shareholders, and on the sale, the business should become an employee-driven and strategically advantaged business.