Employee ownership of a company is not a new concept. It has been around for a while, with employees enjoying direct ownership as shareholders, often receiving dividends that supplement salary, or indirectly as beneficiaries of an employee benefit trust with proceeds extracted as taxable bonuses.
Increased engagement
Jamie Crawford, Partner at Stevens & Bolton LLP explains that the rationale for increasing employee ownership is clear and well-documented: employees feel more engaged in businesses they have a stake in and that engagement tends to translate into increased productivity and greater profitability.
Selling to an employee ownership trust (EOT) is increasingly considered as an option in many business succession plan discussions. It can achieve a transition to a stable and independent ownership for the benefit of employees at the same time as it provides an attractive “exit route” to the selling shareholder both financially and in terms of protecting a legacy.
Headline requirements
An EOT can be set up to acquire a controlling stake in a trading company (or the holding company of a trading group) which it holds for the benefit of a company’s eligible employees over the longer-term. The size of the company or sector it trades in does not matter, but the EOT must acquire a stake greater than 51%.
There are additional requirements, but they are comparatively minor – the main one being to show a significant change of company ownership before and after the process (by reference to the proportion continuing employee and director shareholders bear to employees overall). The trust, for completeness, can be in the UK or offshore, but the trustee will almost certainly need to be a corporate.
Transaction process
Not only does the EOT provide a ready-made purchaser for the shares, it is generally considered a friendlier purchaser. The sale process should reflect this, as an EOT sale is usually a quicker transaction than a trade sale or private equity investment and should incur less in professional costs.
Crucially, however, the price offered by an EOT is no less competitive. An independent third-party valuation will be commissioned to arrive at a defensible market value for the shares – ensuring the trustee acted in the best interest of beneficiaries, without paying over the odds and, if the company funds the price, the directors have discharged their duties, which include considering the position of shareholders.
Funding the acquisition price
Where funding for the shares comes from is also an important consideration. In the US, there is an established market for lending to EOTs that acquire controlling stakes in underlying cash-generative businesses. Debt-finance, whilst available, is less common in the UK.
Here it remains normal practice for the bulk of the purchase price to come from the company’s own resources. The selling shareholder’s determination is therefore the amount of company cash to receive for their shares initially and the outstanding balance to be repaid from the company’s future earnings.
The flip side is that the price the shares are sold for is being fixed now. The selling shareholder therefore needs to be comfortable in any element of equity upside foregone. It naturally also needs confidence that the employees are able to drive the company’s performance, especially where that performance dictates the level of company funds available to repay consideration outstanding from the EOT to the shareholder.
Business as usual
That said, a company’s day-to-day operations can continue largely unchanged following ownership by an EOT. The main difference is corporate governance, where new processes will need to be adopted given the potential for conflicts of interest to arise.
This includes where the selling shareholder remains a director of the company controlled by the trust whose debt obligation outstanding to the shareholder is serviced by the company’s performance.
A number of solutions are available – from appointing independent non-executives and employee representatives to the board of the company and/or trustee to establishing an employee council.
However, the strongest draw of an EOT is really the choice it provides when compared to the alternatives of a management buyout, selling to trade or a private equity-backed deal. In those cases, deal terms will dictate whether selling shareholders roll equity value into a new structure (to partially finance the acquisition) or divest themselves of their shares entirely.
They will also determine whether a management team is replaced, whether investor directors are appointed to a board, what stretching financial performance targets should apply and what commercial matters require shareholder or investor consent. Purchase by an EOT is a longer-term arrangement that should not give rise to these considerations.
Tax advantages
Tax, whilst never the driver in any commercial transaction, can play a role in a decision to sell a controlling interest to the EOT. The obvious attraction is complete exemption from Capital Gains Tax (CGT) for gains made by the selling shareholder on disposing of their shares to the trust. However, if entrepreneurs’ relief remains available at 10% on £10 million of lifetime gains, the complete exemption from CGT is not of itself a reason to sell to an EOT. The 20% saving were entrepreneurs’ relief not for any reason available may be more a compelling argument.
For employees, the tax sweetener in moving to an EOT-controlled structure is the ability to receive annual bonuses from the employing company of up to £3,600 per employee free of employment income tax but subject to NICs. Trustees are entitled to distinguish between employees in determining the amount of a tax-free bonus by reference to remuneration levels, length of service and hours worked.
Senior management
Although, there is one important point not to overlook. Whilst the EOT stands to benefit the selling shareholder and the wider employee group, its implications for senior management need careful consideration.
That group risks feeling disincentivised by the EOT if it leaves them without any real prospect of direct equity ownership. They can also grow to resent the extraction of cash reserves to repay the EOT’s debt to the shareholder.
The EOT legislation has been drafted with this in mind – employees can sit alongside an EOT as direct shareholders, and it is possible to create a market for their shares, plus tax advantaged incentive arrangements (such as EMI options) are available to an EOT-controlled company where they would not otherwise be due to the corporate trustee’s control.
