Employee Ownership Trusts (EOTs)

 

Employee Ownership Trusts (EOTs) are becoming increasingly popular.

Why are Employee Ownership Trusts (EOTs) growing in popularity?

What are Employee Ownership Trusts (EOTs) and how do they work?

In this episode of the MLC Show, host Sean Rogers sits down with Andrew Bloom to interview one of the country’s leading experts on Employee Ownership Trusts (EOTs).

You can read the interview if you scroll down or if you prefer to listen click on the Spotify/Apple Podcasts logos or if you prefer to watch click on the YouTube logo below. 

Andrew is a partner at Moore Kingston Smith LLP and is head of Legal Services. He is a corporate solicitor who works with clients ranging from startups and owner-managed businesses to larger SMEs and international public companies.

In this interview we explore the intricacies of EOTs, address all the key issues, and answer the most common questions from employers and employees alike.

With a keen focus on empowering listeners with actionable insights, Andrew shares a wealth of knowledge on everything related to EOTs.

Key Takeaways:

-How does an employee ownership trust work?

-What are the pros and cons of employee ownership trust?

– What are the tax implications of EOT?

– Is employee ownership trust good for employees?

– What are the problems with employee ownership?

– How is an EOT funded?

-What is the most common form of employee ownership?

-Q&A Session

This episode of the MLC Show is a must for anyone looking to make informed decisions regarding EOTs.

Andrew Bloom’s extensive knowledge and Moore Kingston Smith’s commitment to client success ensure that listeners leave with a clearer understanding of EOTs and the key steps to consider and implement a successful EOT.

Whether you are an employer, employee, or just interested in EOTs generally this is a MUST for you!

Employee Ownership Trusts Advice

If you live in England & Wales and want to explore a potential EOT you can get in touch with Andrew here

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Employee Ownership Trusts (EOTs)

 

Employee Ownership Trusts (EOTs) with Andrew Bloom.

Andrew is a partner at Moore Kingston Smith LLP and is head of Legal Services. He is a corporate solicitor who works with clients ranging from startups and owner-managed businesses to larger SMEs and international public companies.

The interview was conducted in September 2023

Andrew, how does an Employee Ownership Trust (EOT) work?

Broadly speaking, it’s when you sell a majority of the shares in your business to a trust for the benefit of the employees, the owners get to sell the shares at the current market value, and the capital gain that they make on the sale is at 0%.

These transactions are usually self-funded, with the consideration for the sale being settled out of any existing surplus cash and any future profits. So it’s a bit like a management buyout (MBO) in that respect. It is particularly attractive to businesses with lots of surplus cash in them and the upfront payment can then be quite a meaningful one.

They are also a great way to incentivize employees because they are now the co-owners of the business and they stand to benefit from future value creation in the trust and they can be a very attractive alternative to selling to a third party.

Is it something any business can consider or is there a particular set of criteria that would apply and or a particular set of business owners that this may be suited to?

I’m thinking of people who might be listening, reading, or watching this and are thinking, “Well, is this something that would be suitable to me and my business?”

There are some restrictions, but we can easily, at an early stage, help clients identify whether or not those restrictions would be a problem for them.

Some of the main restrictions to make the sale to the EOT free from capital gains tax are that the shares must be held in a standalone trading company or the holding company of a trading group. There’s also what’s called a “limited participation requirement” which is quite a complicated formula about the number of employees who are or aren’t shareholders.

That’s something that we and our tax people can quickly get to the bottom of.

If you’re a business owner looking at EOTs, are you able to retain any share capital at all? If so, up to what level?

Absolutely. I’d say that based on some of the EOTs that we’ve worked on over the last few years, I’d say probably around half of the owners do retain some shareholding and that amount is effectively up to 49%.

The trust has got to have a simple majority, so effectively 51%, and the remainder can be held by the selling shareholders and they’ll retain different proportions. Some decide to sell completely.

Once an EOT is in place, how is firstly, control of the company affected, and secondly, how are potential future dividends distributed? E g would employees receive dividends?

Those are really good questions and the first one is really important about control. When you sell to a trust you can’t just carry on with the same decision-making processes that you had before. One of the main obligations of company directors is to consider the interests of the shareholders.

When an EOT sale has happened, those majority shareholders are effectively the beneficiaries of the trust. So after the sale, you do have to make decisions differently, often with increased corporate governance compared to when it’s the founders who own and run the business themselves.

Importantly, in the HMRC rules for EOTs, there’s also a requirement that there is a genuine change of control and there are certain things we put into the documents to make sure that happens.

In terms of the second question about dividends initially, for the first few years after the EOT’s sale has happened, any excess profits are largely going to go to pay off the founders who’ve sold their shares.

Once that’s happened and the shares have been sold off and there are excess profits in the company, those probably would not be distributed by dividends via the trust because that could be tax inefficient.

But when there’s that excess cash sitting in the company, the trust would certainly direct the company to pay it as bonuses to staff because there wouldn’t be the traditional shareholders sitting there to take the profits as dividends. Certainly, that’s one of the key ways in which staff benefit

What are the advantages to the business owners when contemplating an EOT? What are the pros of an EOT?

I think for business owners, one of the most attractive ones is obviously the ability to sell free of capital gains tax. As long as those conditions I discussed earlier are met. A lot of the business owners that we work with are really delighted by the opportunity to sell the business effectively to the staff, rather than selling to a trade buyer or one of their competitors.

A lot of the owners get really enthused. They feel that their staff and their people have helped them build the business up from scratch. If the business owners and the founders are looking to take a backseat to be able to pass on the baton to their staff, a lot of them find that they get a real sense of pride in that.

What are the benefits to the employees with an EOT?

Well, one of the employees, which can be from day one, even before the price is paid off to the founders, is that employees of employee-owned trust Companies are allowed to receive a tax-free bonus of up to 3600 pounds each year. So that’s free of income tax.

There are various criteria that can be used if the full amount isn’t available to pay for everyone. But the rules are quite strict in terms of how you proportion that, but certainly that 3600 pounds in the early years is very attractive.

Once the initial sale price to the founders has been paid off, then larger bonuses could be paid. If there’s excess cash in the business, those wouldn’t be tax-free. Eventually in the future, if a further sale happens to perhaps a trade buyer or a competitor, there’d be an additional windfall, hopefully for the employees of the asset.

What are the disadvantages of an EOT for business owners? I’m thinking here that employers may be thinking, “Well, would I get more money if I sell to a rival?” Or is it a market value rate that I’m looking at with an EOT?

Things like the loss of control element to this would be a major thing for a lot of people. Also, how do you go about financing that? Is it tricky trying to finance an EOT from a bank as an example, to get to that purchase price? Then, as a result, the sellers may have to get paid out over a very long period.  What are the main disadvantages of an EOT? What are the cons of an EOT for business owners?  

Well, you’re right. There are some pros and cons with any alternative.

I’d say most business owners who are coming to us to do an EOT have also looked at the strategic alternative to sell to a trade buyer. So they’ve had an opportunity to see what a trade buyer is likely to pay. Our valuations team will help them do a professional valuation as part of the EOT sale so you can get to compare the financial aspects at that stage.

You’re right, you may be paid out longer over a longer period with an EOT sale rather than if the buyer is just showing up with its own cash.

Some of our clients have used bank finance to get some additional early payments on an EOT sale. There’s a variety of banks who our clients have worked with in that regard and the banks they’ve spoken to have obviously been happy to fund it. So that’s always an alternative.

You do get the loss of control and you do have to hope that the business carries on making profits over the future years to make the payments. But some people would regard that as an advantage, that they’d be happy to stay involved, that they’re not quite ready to completely walk away. As long as the directors of the company want them involved, they can stay involved and carry on driving the business while maybe the next generation of management step up and get involved.

What are the negatives of an EOT from the employee’s perspective

What would be the concerns that employees would have, or hurdles to overcome, in respect of an EOT?

Well, some businesses and some employees might actually prefer to be part of a large corporate group with a traditional management structure. In some industries, and for some employees, they may prefer that and think that’s a more comfortable way of working.

However, EOTs are becoming increasingly popular. With an EOT, you can still have management incentivized with things like being given shares and share options and things like that. So you can still have what resembles, in some respects, a traditional management structure and top performers can be rewarded that way.

What expectations should business owners have in respect of receiving the full sale price?

There’s a big balance in that there in that if they sit tight and wait, they’ve got to wait for profits, for the company profits to be diverted to them for the sale price.

So they might fear they’re waiting forever. You touched on bank finance there. What are the options for them to either accelerate or decelerate receiving the sale price once they’ve decided to commit to an EOT.

Well, for most of the EOTs we worked on, I think the owners are expecting to receive full payment over something between four to seven years, and as long as the business carries on making profits, they’ll be able to do that. If, the business hit some tough times and wasn’t able to make those profits, they’d probably waive the right to receive those payments for a while because to start enforcing the debt more formally would likely cause significant complications.

But certainly, if you could secure some bank finance and there’s enough cash in the business to give you a decent payment on day one, you may be comfortable with getting paid out over a longer period in that way.

I believe there are some lenders like Shawbrook out there that can do things like that. I guess, as you say, if turnover and/or profitability suffered due to economic factors, you wouldn’t want to cut your nose off to spite your face, would you?

In terms of discussions before an EOT, what kind of discussions do business owners have with employees prior to formally deciding to pursue an EOT and/or instruct someone like yourself, Andrew, to go ahead with an EOT?

Well, we always encourage clients to have really thoughtful engagement with staff because we regard that as one of the main advantages of an EOT. There’s lots of research that show that employee-owned companies are really successful. You get really well-motivated and engaged staff, but a key part of that is to involve them so that they genuinely are involved.

One of the things we often do is participate in meetings with the management and staff to brief them and explain it to them, give them opportunities to ask questions, give them opportunities to go away and think about it, and then ask questions again. Lots of people wouldn’t necessarily think of the questions that they want to ask on day one.

There are also opportunities for staff to get engaged with the process. One of the things we always recommend is that as part of an EOT, the company forms something like an employee council or an employee forum, so that the trustees of the EOT have a forum in which to engage with staff, take their views, consult them on key points, and you can find staff getting really enthused in that process.

Perhaps having the ability to vote team members onto the employee forum or council and get involved that way. Some clients give the employee forum or council proper rights to appoint directors to the board or trustees. Some don’t. They keep it consultative, but it’s a real opportunity to get engaged with staff.

When a client comes to you for advice initially prior to committing to an EOT, what are the most common concerns that they raise? I’m sure we’ve probably touched on a few, but what would be the most typical things they would ask or be concerned about?

One of them, like you mentioned, Sean, is loss of control. We’re very clear with the owners of the business that when you do any EOT, you do have to give up a certain amount of control. You can stay involved in the business, but effectively, decisions need to be made for the benefit of the trust and the beneficiaries. One of the things that they often look at, and we get involved in, is the makeup and changes of the board of directors of the company and the trustee board to ensure there’s a proper and more mixed representation on those boards.

That’s something that people give a lot of thought to and rightly so, because you want the right mix of people with the right experience and roles involved in those boards. There’s also one other thing that we talk to people about and that is there’s an additional potential risk with EOTs that isn’t present necessarily on some other possible sale routes. They are for tax reasons we don’t recommend having security over the shares that have been sold, or a guarantee clause so that the main company guarantees to the owners that it will pay money for the sale.

We understand that some advisors do suggest a guarantee clause, but it’s not something that we suggest for tax reasons. So there are additional risks with an EOT sale that might not be there on a traditional management buyout structure, for example.

I’m interested in what happens when a company decides that they want to go ahead with an EOT. They’ve considered everything, sought advice from you, and your accountants, and said “Right,  Andrew, we’d like to go ahead with this.”

In terms of you being instructed, can you outline the key steps required in order to go from start to finish and complete successfully on the EOT?

We’d start with an initial meeting with the client to confirm instructions and any key goals that they want to achieve. Due to our multidisciplinary approach, we have all the relevant kinds of advisor there. We provide lawyers, accountants, and tax advisors so that we can help them with getting to those answers in an efficient manner.

Once we’ve had that initial meeting, our tax team will prepare their tax advisory report. They’ll apply to HMRC for various tax clearances and also perform a formal valuation.

While that’s going on, our legal team will set up a new company to act as trustee of the EOT. We’ll start drafting the main legal documents and then have a meeting with the clients to review and discuss the key terms of those.

When that’s happened, that’s often a stage when people feel ready to start getting involved with employee engagement. It only makes sense to do it once you’re almost certain it’s definitely going to happen because otherwise, you don’t want to waste staff time with it before you know it’s going to happen.

Then when all the documents have been approved, we get them signed. Then there are various filings to make with HMRC and there is some tax to pay because there’s stamp duty to be paid at 0.5% (correct at the time of the interview) on the value of the consideration.

Who are the trustees of an EOT? How are the trustees of an EOT selected? Who selects them?

In most cases, we recommend having a corporate trustee. We’d set up a new company that acts as trustee of the trust, and there’d be a board of directors on that trust company.

We always recommend that the board of directors consist of a different makeup compared to the main company board. We usually advise that there would be at least one employee director on the board, someone who wasn’t previously a shareholder, and one independent director externally, and if you were having a three-person board, you might have one of the selling founders on the board, but you’d have that sort of a balance of an employee and independent and maybe one of the founders.

This is for information only and sort of a general overview. What are the key tax areas that would need to be considered by businesses and business owners when contemplating an EOT?

I think two of the main points that you want to be sure of is firstly, that the owners are going to get the sale free of capital gains tax, because that’s one of the key things for our Tax team to check and that the income-tax-free bonus payments, the £3600 to staff are going to be paid in a way that will guarantee that they are tax-free because there are requirements for that as well if they’re not complied with the tax to be chargeable.

Also, it’s important to do that valuation I mentioned so that you can justify to HMRC that the price, that an excessive price, isn’t being paid for the shares in order to make sure you secure those CGT benefits.

I was reading that there are potentially some key tax considerations that might change in the future for EOTs. I read in April 2023 that entrepreneurs who give away their companies to their employees might be faced with a tax crackdown in the future. I read that HM Treasury has launched a consultation on EOTs after it emerged that some people might have been using them for unintended tax planning, or certainly that’s what may or may not have happened.

Under an EOT, those distributing the shares are exempt from capital gain tax, whilst the company can pay its employees the bonuses without incurring income tax. But the Treasury’s consultation, which I think is out later this year, for transparency, could see the tax benefits either restricted or potentially removed entirely.

The Treasury said the consultation would aim to, and I quote here, “ensure that the reliefs are targeted closely at incentivizing EOTs as an employee ownership business model, whilst preventing the relief from being used for unintended tax planning.” Do you think this will come out this year? How likely do you think it is there’ll be changes to this?

There’s a consultation running at the moment which expires actually on the 25 September, so it is really current. There are various proposals that HMRC is looking at, as you say, to look at possible abuse of the rules and to ensure that EOTs work as they intended.

As far as we’re aware, there are no plans to change the CGT or income tax benefits. However some of the key proposals are as follows:

a) they want to ensure that more than half of the trustees are neither former owners nor people connected with them. We’re not entirely sure how that would apply to a corporate trustee or whether it would directly translate to directors, but that’s one point.

b) The EOT must be a tax resident in the UK. That’s intended to remove the possibility that the EOT might sell in the future without any CGT arising on a future sale.

c) Regarding the tax-free bonuses, there might be an increase in the flexibility of those, so that the bonuses don’t necessarily have to be paid to directors who are employed, because at the moment that is one of the requirements. That would actually help the bonuses being distributed to staff.

d) There’s also the possibility of confirmation in the legislation that contributions to an EOT to be paid deferred consideration won’t be treated as taxable distributions. At the moment that’s something that our tax team always obtains specific clearance on, so that would hopefully be a helpful simplification.

So we don’t expect there to be an end to EOTs, but as you said, it is possible HMRC will close some loopholes where they think people haven’t been structuring them in the right way.

How long does it take to set up an EOT?

Usually about two to three months. We did do one in about six weeks that was a bit complicated and we had some late-night pizza deliveries to help get that one over the line.

Normally we say to people about two to three months.

How can you work with the business owners to try and either completely prevent issues occurring in the future or worst case, mitigate against issues coming up in the future?

I think it’s important to have regular engagement with staff so their expectations are met. The employee-owned business is only going to be a success if the staff feel engaged and motivated.

It’s also important to consult with specialist advisors to make sure that the ongoing corporate governance is appropriate. People have to remember, that once an EOT sale has happened, it’s not the founder’s company anymore and it needs to be run differently. I’d say those are some of the main points to consider.

Do you think we’re going to see an increase in EOTs over the coming months and years?

Well, they’re certainly popular amongst our clients at the moment and we’ve been busy and getting increasingly busy with them for the past few years. The feedback we receive from networking events we go to through organisations, such as the Employee Ownership Association, are that they are increasingly popular, so that does seem to continue.

 

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