Talking Business podcast: a guide to employee ownership trusts

So to chat about EOTs today, I'm joined by Rachel Dean, who's a legal director in our corporate team. So Rachel, let's start at the beginning, start with the basics. So what is an employee ownership trust?

Rachel Dean: An employee ownership trust is a form of employee trust that offers an indirect ownership of shares to employees. It's a collective vehicle which acquires controlling interest in a company and then holds those interests for the long-term benefit of the company's employees.

Sophie Brookes: Okay. So what are the key kind of benefits of employee ownership and why might a business be looking to move to that structure?

Rachel Dean: There are a number of benefits and I think that the greatest one and which has been shown by studies, is that employee-owned businesses perform better. They demonstrate resilience and innovation and profitability. This is often because the employees show a greater commitment to and engage with the business because they've got a stake in the business and therefore they feel like they're getting something out of the business.

Sophie Brookes: I think I saw another stat actually from the Employee Ownership Association, which said that productivity in the top 50 employee-owned businesses of 2020 was up by 6.9%. So I think that kind of links with what you're saying there, about that increase in profitability and just kind of business success, if you like. So let's think about, if a business is thinking of converting to an employee ownership structure, then how does that sale work?

Rachel Dean: In essence, what would normally happen is an employee ownership trust is set up. Typically, we'll have a corporate trustee whose directors are a mixture of executive directors of the target in question and often also an independent director. And then the corporate trustee itself will then acquire the shares in the target. It needs to acquire more than 50% because it has to acquire a controlling interest.

Sophie Brookes: Okay. So we've got our employee ownership trust, the seller sells shares to that trust. So how is that then funded? Because presumably the trust has to pay the seller for the shares. So how would that acquisition be funded?

Rachel Dean: Yeah. Often in circumstances like this, a lot of the consideration is deferred, so is outstanding for periods of time. There are a number of ways in which it can be funded. There are banks who are willing to fund employee ownership trusts to acquire shares. But as said, in a lot of circumstances, there's some consideration potentially prepared up front with a lot of it being deferred and it's often the company itself that will need in the long-term to fund the EOT to enable the EOT to pay the sellers.

Sophie Brookes: Yeah. So the plan is the company continues to trade profitably, it then makes profits which it then transfers, contributes to the EOT, to the trust, and the trust then uses that money to pay the seller with the money going round. But as you say, the seller has to wait there for those profits to be generated and for the consideration to flow through the trust and back to the seller. You mentioned earlier the sort of key benefit of employee ownership being that increased employee engagement, but can you just mention the tax advantages of selling. If we're thinking about it, maybe from the seller's perspective in particular, what are the tax advantages on a sale to an EOT?

Rachel Dean: Yeah, there are actually really, really good tax advantages on a sale to an EOT. The key one being that there is no Capital Gains Tax on the transfer of the shares to an EOT. As mentioned previously, it's important that a controlling interest of the target is acquired. So provided the EOT acquires a controlling interest, their sellers can dispose of the shares to the EOT and not have to pay any Capital Gains Tax on that transfer.

Sophie Brookes: And that could be a massive saving potentially, couldn't it? Particularly at the moment, because I know there's been a lot of interest in looking at Capital Gains Tax and maybe the Chancellor looking to that particular tax to help plug the gap in the country's finances at the moment, kind of post pandemic. There was a report from the Office of Tax Simplification last year, which specifically looked at changes to Capital Gains Tax. Lots of things like aligning Capital Gains Tax rate with Income Tax rates, reducing the Personal Allowance and possibly doing away altogether with Business Asset Disposal Relief or Entrepreneur's Relief. So that 0% Capital Gains Tax on a sale to an EOT I can see is really attractive at the moment.

Rachel Dean: I think that's probably one of the big drivers as to why we're seeing EOTS much more regularly now and they're happening very often. I think a lot of it is because, I mean, let's face it, every year the budget is always speculating about what's going to happen to Business Asset Disposal Relief. Sometimes it changes, sometimes it doesn't, but I do think that the big driver is the fact that there is no Capital Gains Tax on the sale to an EOT.

Sophie Brookes: Yeah, definitely. So that's obviously a big driver for the seller. I know that there's also advantages for employees in relation to bonuses that they can then receive going forward. Is that right?

Rachel Dean: Yeah. That's right. So the company itself can pay tax-free bonuses of up to £3,600 each year. So although the bonuses are not subject to income tax, the company still has to pay National Insurance Contributions, but that's also a big incentive for the employees. That they know that they can potentially get bonuses of up to that amount each year tax-free.

Sophie Brookes: Yeah. That's great. So we've got those tax advantages of a sale to an EOT, but I'm guessing that simply focusing on those particular advantages kind of misses the bigger picture of a move to employee ownership. So are there some other advantages around that that you could benefit from?

Rachel Dean: Yeah. As mentioned, one of the big advantages is the employee engagement. As mentioned, you have much more employee engagement in the business because they can see what they're working towards, the employees. You often see greater commitment and a drive to increase the profitability. In addition to that, from a legal perspective, you've got a friendly buyer because you're buying into an EOT and it's in essence an internal transaction that doesn't really involve any third parties. So it's often viewed as a friendly transaction, which can be easier and at times quicker and smoother to negotiate.

Sophie Brookes: Okay. So there's a friendly buyer there, which makes the process kind of smoother. I can see that. Maybe the seller might be asked to give fewer warranties and indemnities. Have a reduced kind of residual liability there. But I guess as well, the fact that you're selling to an EOT, which is effectively selling to the employees, does that mean that there's kind of a ready-made exit if you haven't managed to find a buyer in other circumstances?

Rachel Dean: Yeah, I would agree that that is actually the case. Often it does create a ready-made exit, especially where the seller struggled to find a buyer. In particular, family run businesses, you often have issues with succession, the next generation. So yeah, entrepreneurs who built a business from scratch, they prefer the idea of transferring ownership to the employees rather than say selling to a competitor.

Sophie Brookes: And I guess as well, they're selling to their employees rather than, for example, selling to a competitor or something like a PE house, a rivate equity house where the private equity investor is probably going to want them to stay on, certainly for a while post sale to kind of have a smooth transition in the business maybe. And then they end up working for somebody else at the end of their career, which they might not be so keen on. Another thing that occurred to me is I guess, because of that 0% Capital Gains Tax, a seller could potentially achieve a better return than they might otherwise do because they get the whole of the proceeds. There is no Capital Gains Tax, or I guess, alternatively, they could offer to sell to the EOT at a reduced price to help facilitate that sale. But actually because they don't have Capital Gains Tax on their proceeds, their overall return is the same as it would have been on a kind of a regular third party sale.

The other thing, I mentioned a PE investor there. And the other thing that occurred to me with these sales, because you mentioned before that you've got to sell a qualifying interest. You've got to sell more than 50%. But actually provided you sell that, then you can retain a shareholding in the company. So I guess for a seller who maybe is thinking of retiring, but isn't sort of ready to completely hang up and take a complete back step, that provides a bit of a halfway house potentially?

Rachel Dean: Yeah, it does. I mean, they can retain or a minority shareholding, as you say, as long as a controlling interest is sold. And it allows the seller to effectively hand over the control of the business to its employees, but also still keep some involvement in the business. The employees themselves might see that as something beneficial, especially if they're having to step up and be on the Board and start running the company, they may feel comfortable having the existing owner sat there beside them helping them out and helping them with the transition.

Sophie Brookes: Yeah. Helping, as you say, that transition and providing a kind of a smooth bridge between one and the other. Yeah. And I think as well, it's possible, isn't it? To combine some of the advantages for that kind of second tier management that they might have had with an MBO. So for example, being involved through share incentive schemes, you can still combine that with that sale to the EOT, but without the management being subject to the kind of additional restrictions that would come on a private equity buyout where you've got an investor looking to protect their investment all the time. So like you said, potential advantages for the employees going forward there in various different ways. So we kind of talked about the advantages of that sale, both the tax ones and then various wider ones as well. So looking at it now from the seller's perspective, what are the kind of risks for the seller of the particular structure with an EOT sale?

Rachel Dean: Yeah, I mean, as mentioned, I think the biggest risk to the seller is the fact that a large part of the consideration is often left outstanding and payable on a deferred basis. And in those circumstances, the seller is very reliant on the target, company continuing to trade profitably in order to generate profits required to fund the consideration via the EOT.

Sophie Brookes: Yeah. You mentioned earlier, it can be possible to borrow to do the funding, but actually, typically, even if you borrow, you probably only borrow some of the funding and the majority of it is still left outstanding on a deferred basis. So the seller is kind of a bit exposed there, I guess. And we'll talk in a minute about the various qualifying conditions, but I think one of the key things is that point about there has to be that change in ownership, that change in the controlling interest. Which means, like you said, the seller might be able to perhaps stay on as a director or maybe even as a trustee of the new EOT, but they can't retain any control through those kinds of mechanisms. It's just enabling them to have a seat at the table, a voice to be heard. So the seller is potentially quite exposed there with that deferred consideration. But then I guess that that's just the quid pro quo in return for that very attractive 0% on their capital gains on the sale proceeds, isn't it?

Rachel Dean: Yeah, yeah. I think it is, yeah.

Sophie Brookes: So we mentioned the qualifying conditions, so we've talked about that, the fact that the EOT, the trust, has to acquire a controlling interest, which is more than 50% of the shares. And also you can't manipulate the share rights in the articles. It's got to acquire more than 50% of the shares, more than 50% of the voting rights and an entitlement to more than 50% of the profits. So that's one of the conditions. What are the other conditions that have to be met in order to be able to take advantage of those tax benefits?

Rachel Dean: Yeah, there are a number of other conditions. There's the all employee benefit requirement, which means that all eligible employees should benefit from the EOT. That is those who hold or have previously held 5% or more of the target shares. They won't be eligible, sorry. Those who hold or have previously held 5% or more of the target shares won't be eligible. It's also possible to exclude employees that have had less than 12 months continuous service. This, the equality rights, all employees must benefit from the EOT on exactly the same terms. This doesn't mean that all employees get equal amounts. And it is possible to determine the size of the awards by reference to remuneration and length of service and hours worked. But generally all employees have to benefit from the EOT.

And there's also the limited participators requirement. So the number of people who are 5% shareholders and are officers or employees of the company, cannot exceed two fifths or 40% of the total number of employees of the company. That might be an issue for a company with a small workforce compared to the number of 5% shareholders who are officers or employees. There's also the trading requirement that the target company whose shares are being acquired by the EOT, must be a trading company or the holding company of a trading company.

Sophie Brookes: Okay. So those are the conditions that you have to meet. You have to satisfy those in order to take advantage of those tax benefits that we talked about, particularly the 0% CGT, and then also those tax-free bonuses for employees. And you need to make sure that you get your documentation, particularly I think the provisions of the trust deed that constitutes the employee ownership trust rights, so that they take into account those qualifying conditions. But what happens if there's a breach of those conditions? So for example, let's say the EOT maybe sells some of its shares, so that controlling and it no longer has a controlling interest in the target company. Or it ends up allowing employees to participate in distributions from the trust on equal terms so it doesn't meet the equality requirement. Or it breaches that 40% limitation that you mentioned on a number of participators in the company. What's the consequence of that happening after the sale?

Rachel Dean: Well, it can be quite a big consequence to be honest. So if the event that you mentioned, the disqualifying event, occurs in the first tax year following the disposal to the EOT, the Capital Gains Tax Relief can be clawed back from the seller. So they would lose the benefit of that 0% Capital Gains Tax. If the disqualifying event occurs in or after the second tax year following the disposal to the EOT, there's a deemed disposal, an immediate reacquisition at market value by the EOT of all the shares it holds in the target company. This would result in a tax charge for the EOT and satisfying that tax charge would reduce the assets in the EOT available to pay the deferred consideration to the seller. So consequences can be quite extreme.

Sophie Brookes: Yeah. Absolutely. So I guess probably sort of within the overall structure documents, it's going to be important to try and build in protections to ensure that those disqualifying events don't happen. So for example, I guess preventing the EOT from disposing of shares or disposing of a controlling interest rather, certainly within that first year and second year after the sale takes place. So I guess, sort of in conclusion, it seems to me, potentially, it has some real benefits there. Sort of the employee ownership model as a whole has benefits. And I guess if the business isn't right for that kind of employee ownership model then just simply taking advantage of a sale in order to get those benefits isn't going to be worth it. Your business has got to be right for employee ownership in the first place.

But it struck me there, there are perhaps kind of three key takeaways in a way that it could work for a business. So it could be a win for the business in the sense that you get that improved employee engagement, you get hopefully better performance, better resilience, profitability. Potentially it's a win for the employees. They get a stake in the business. They get a say in management and potentially they get to take advantage of those tax-free bonuses. And then also potentially it's a win for the seller because they can achieve that exit. They've got a ready-made buyer and they've got there, hopefully, tax-free proceeds. But at the same time, if they're not ready to withdraw completely, they could be able to retain a stake in the business.

So if you want any more information about employee ownership trust, then we've got a dedicated page on our Gateley Legal website. So have a look there. And also I've mentioned a couple of times the Employee Ownership Association, which is there as an independent body to help support businesses as they transition to employee ownership, and there's loads of great information on that website as well. So thanks very much, Rachel. That's been a really interesting discussion about all things employee ownership.

Rachel Dean: Thank you.

Sophie Brookes: Thank you for listening to Talking Business. To find out more about the series, please visit our Talking Business Podcast page. From there, you can subscribe for updates, meet our speakers and get more information on all of the topics being discussed.