The combined impact of the COVID-19 pandemic and the anticipated rise in UK capital gains tax has resulted in a substantial spike in the number of shareholders looking to sell their respective companies in the 2020/21 tax year.
Of those looking to sell, many have opted to sell to employee ownership trusts rather than a standard trade sale for numerous reasons. These include: (i) allowing shareholders and the directors to conclude a quick and smooth transition of the company to the employees, via an employee ownership trust, thus allowing management to focus on running the business rather than becoming embroiled in complex and time consuming sale negotiations; (ii) allowing shareholders to receive full value for their business without the need for earn-outs (a proportion of earn-out never pay out the extent expected by shareholders); (iii) utilising the power of employee-ownership to lock-in, engage and motivate the workforce to take the company to the next level; (iv) substantially lower transaction fees; and (v) allowing shareholders to claim a full UK capital gains tax exemption on the disposal.
The key sectors in which we are seeing a substantial movement towards employee-ownership, via employee ownership trusts, are in the marketing, architecture, construction, logistics and recruitment sectors.
If you own a trading company, you can now sell some, or all, of your shares to an employee ownership trust (EOT) (subject to satisfying certain conditions) for full market value without incurring any capital gains tax liability in a way which also benefits your employees.
What is an EOT?
An EOT is a special form of employee benefit trust introduced by the Government in September 2014 in an attempt to encourage more shareholders to set up a corporate structure similar to the John Lewis model. The aim is to facilitate wider employee-ownership, albeit via an indirect holding.
The incentive for owners is that the Government introduced very generous tax breaks to encourage shareholders to move to an employee-ownership model. However, in order to qualify for the tax incentives, the employee ownership needs to be structured in a particular way.
Although the tax breaks are aimed at companies, there is no reason why those businesses that are held by a partnership couldn’t be incorporated so that, when the time comes for exit, the shareholders (former partners) can sell their shares to an EOT.
How does a sale to an EOT work?
There are three key steps:
- A qualifying EOT will be established with a corporate as the trustee of the EOT (the Trustee Company).
- The shareholders sell their shares to the Trustee Company under a share purchase agreement. The shareholders and the Trustee Company will jointly engage a share valuation expert to value the company: the Trustee Company will use this value as the basis for determining the purchase price. On the sale of the shares, the purchase price will create a debt owed by the Trustee Company to the shareholders which will be left outstanding (see diagram).
- The company will continue to generate trading profits each year and it will use these profits to make contributions to the EOT. The EOT will use these contributions to repay the outstanding purchase price that it owes to the shareholders.
What are the advantages of selling to an EOT?
There are many advantages for shareholders, some of which we’ve highlighted below.
- It allows employees to indirectly buy the company from its shareholders without them having to use their own funds - thereby creating an immediate purchaser and addressing succession issues
- Shareholders can sell their shares for full market value (an independent valuation will be required)
- No capital gains, income or inheritance tax liabilities should arise on the disposal of a controlling interest in a company to an EOT (or on the subsequent receipt of the purchase price by the former shareholders)
- Not all shareholders are required to sell their shares to the EOT
- The directors can remain in situ post-disposal and can continue to receive market-competitive remuneration packages
- The EOT is generally seen as a “friendlier purchaser” which means the sale process may be quicker, with potentially lower fees.
What are the advantages for the company and employees?
As all employees get an indirect stake in the company there are substantial practical benefits associated with being owned by an EOT, such as:
- Greater employee engagement and commitment
- Reduced absenteeism
- Greater drive for innovation
- Improved business performance.
Companies controlled by EOTs are also able to pay tax-free cash bonuses to their employees of up to £3,600 per employee per year.
Key qualifying conditions
To carry out a qualify sale to an EOT there are five key conditions to meet:
- The company whose shares are transferred must be a trading company or the principal company of a trading group
- The trustees of the EOT must restrict the application of any settled property (the shares) for the benefit of all eligible employees on the “same terms”
- The trustees must retain, on an ongoing basis, at least a 51% controlling interest in the company
- The number of continuing shareholders (and any other 5% participators) who are directors or employees (and any persons connected with such employees or directors) must not exceed 40% of the total number of employees of the company or group
- Trust property must generally be applied for the benefit of all eligible employees on the same terms but the trustees may distinguish between employees on the basis of remuneration, length of service and hours worked.
EOTs are not just an option for traditional companies. Limited Liability Partnerships and companies that are part of a bigger group can also adopt an employee ownership structure. It is possible to find commercial and innovative ways to transition almost any type of business to employee ownership structures.
As different types of business examine how employee ownership trusts can be used, we are expanding our knowledge and expertise in this area.
Your next steps
In just the last year, BDO has worked with numerous companies, as well as LLPs and groups, on establishing employee ownership structures via Employee Ownership Trusts. They have ranged from companies with just 20 employees to over 1,800, with values from £1m to over £80m and from all sectors (including construction, architecture, recruitment, media, technology, marketing, professional services, corporate finance and manufacturing). We are helping shareholders sell their businesses while navigating the many pitfalls which can catch-out the unwary. Please let us know if we can help you.
Our team is the market leader in advising on EOT and employee-ownership and can provide you with free, practical and user friendly advice on the advantages and disadvantages of selling your business to an EOT.
For help and advice on selling your business to an EOT please contact Matthew Emms.
Read more on why you should now consider selling your business to an Employee Ownership Trust.
Read our client testimonials here.