Employee Ownership Trusts – selling your company to its employees

Good morning. Welcome to our webinar this morning introducing the employee ownership trust. Thank you for joining us. We appreciate your time.

My name is Garry Karch. I am the head of the EOT Services practice group at Doyle Clayton. We are a London and Reading-based workplace legal and advisory firm, and one of the services we provide is helping business owners transition into an employee ownership trust as an alternative to a third-party sale.

The presentation this morning, the formal portion, will last about 45 minutes, and then we will leave time after that for questions and answers.

If you look at the control panel on the right side of your screen, and I believe it should be on the right side of the screen, whether you’re using a Mac, PC, or portable device, you’ll see there is an area down there toward the bottom where you can actually type in your questions.

And if you have something you’d like us to address for the group, you can go ahead and enter your question in that area, and we will deal with that at the end of the formal part of the presentation.
And if you do have more specific questions that you’d like to talk about, please feel free to send me an email, give me a call, and we can talk about your specific circumstances offline. Happy to spend that time.
If you would like a copy of the presentation after we’re done, please send me your contact information. I’ll be happy to email you a copy of the presentation itself.
If you would like to learn more about employee ownership trusts, you can visit our website. You’ll find a heading there for employee ownership trust services, and that should help you if you have any additional questions that we may not have addressed.
And finally, from a housekeeping perspective, we will be putting a recording of this webinar online. You can access that through doyleclayton.co.uk, which is our website, and also through the Doyle Clayton YouTube channel.
It will probably take us a day or two to get this actually up online, but it will be there if you’d like to take another look through this or share the content with some of your colleagues.
So with that, let’s go ahead and get into the main part of the presentation.
So let’s start out general, and then we’ll work our way a little more specifically on what the EOT is, how it works, what the requirements are.
So the EOT has been around for almost six years now. It was introduced during the Lib Dem Conservative government back in 2014 in the fall budget or the Finance Act.
And it’s basically a special type of trust that just holds the shares in a company on behalf of its employees.
And it was really put into place, as you can see here on the slide, to try to provide business owners with an alternative to a third-party sale.
And there are a lot of reasons that that would be more attractive to both the vendor, to the employees as well.
But the key to this, and what had been missing in terms of incentivising vendors, is when you sell to an EOT, the sale of a controlling interest, and we’ll talk a little bit more about what that means as we go through the presentation, but the sale of a controlling interest in a company to the employee ownership trust is exempt from capital gains tax.
This is even more meaningful now because in the recent budget speech, the Chancellor of the Exchequer actually changed the lifetime allowance for entrepreneurs relief from £10 million to £1 million.
So there is a much greater benefit now to a business owner who would look at a sale to an EOT than to either a trade buyer or a private equity firm.
So there is a major incentive now, even greater, for the business owner who is looking to sell to an EOT.
The reason this is an important structure from the government’s perspective and basically from, I think, a societal perspective as well, not to sound too presumptuous there, but you create long-term stable ownership.
And along with preserving company independence, it’s been shown in numerous studies over the years, both in the UK and in the US, that employee ownership helps retain jobs, it helps create jobs, and it tends to be tied to an increase in company performance.
You can debate whether it’s cause and effect or correlation, but it has been shown consistently to be beneficial for a business to be employee-owned, and you can compare that, again, as I mentioned, in numerous studies over the years, both here and in the US.
The other key, and this is important to a lot of vendors, because even though somebody may be looking at transition and succession planning, they don’t necessarily want to step away from the business that they may have founded or that they may have purchased and grown over the years.
They don’t want to necessarily step away tomorrow.
So what the EOT does is let the vendor plan their exit on their own terms.
If the company is ever sold, the qualifying employees will share in those sale proceeds.
So if you have a business that is sold, and let’s just pick a number here, for £5 million at some point down the road, the order of the waterfall in which cash would be distributed would be to pay off any remaining debt.
It would be to pay any taxes due to revenue from a capital gains tax perspective.
And then after that, the employees, based on a fair and non-discriminatory formula, would share in those proceeds.
So this can be a significant windfall for the employees as a result of the hard work they’ve put in to help build the company and continue to make it successful over the years.
One of the other unique aspects of the employee ownership trust is that employees in a company owned by an EOT may also qualify for tax advantage share schemes.
Typically, when you have a company owned by a company, and that’s what we really have here, you’ve got the trust, which is a limited company, owning the controlling interest in another limited company.
Typically, that structure would not allow for tax advantage share schemes such as the enterprise management incentive or EMI option, or share incentive plans, or the SIP as it’s referred to.
But with the EOT structure, you’re permitted to do that.
So it allows you to further align the interests of the employees by providing them with tax advantage share schemes that provide even more economics of ownership to employees going forward with the business’s continued success.
So there are a number of potential benefits to employees that are provided through the EOT structure.
It’s not just the capital gains tax relief for the vendor, although that is a very important incentive for someone to sell to an EOT.
So throughout the rest of the presentation then, we’re going to walk through more details about how you qualify, what’s involved, how you finance the structure, and why it’s something you should take a look at if you are interested in potentially transitioning your business.
So as I mentioned before, this has been around for almost six years now.
It was introduced in October of 2014 to encourage greater employee ownership for a lot of the reasons I mentioned previously.
The real key, and this is the main criteria here, is that the EOT has to acquire what’s called a controlling interest, and that means more than 50% of the company’s share capital.
This is an absolute bright line, must occur for the vendor to be able to take advantage of the capital gains tax relief, and for the employees to be eligible for the income tax-free bonuses.
This is generally not an issue.
If someone is looking at selling their business, they are generally going to sell a controlling interest, and in our experience, most business owners end up selling 100% of their company rather than just a controlling interest.
And we’ll go into this in some of our other webinars going forward as to why that’s the case.
But selling 100% actually provides the company with more flexibility to provide incentive shares to employees going forward, whether it’s from a recruitment perspective, whether it’s from an incentive perspective.
But you do get a lot more flexibility once the trust owns 100% of the shares.
Because what’s unique with the EOT structure is the trust can buy 100% of the business, and then you can dilute its ownership interest or reduce its ownership interest from that 100%, and if you take it to the extreme, down to 50% plus a share.
We would never encourage anybody to go to that extreme, but what it means is you can provide EMI options for employees equal to 10 or 20% of the company and then reduce the EOT’s ownership stake from that 100% down to, say, 80%.
So you’ve got a lot of flexibility once the trust owns the 100% that you wouldn’t necessarily have without taking shares out of the vendor or the staff pocket, so to speak, if the trust acquired less than 100%.
The EOT also has to be entitled to more than 50% of the profits of the company.
But as you can see here on the slide, we make note that it will generally waive its dividend rights.
And the reason for that is that it is very tax inefficient and restricts flexibility if you were to try to pay dividends to the trust, and then it would try to get those funds out to the employees.
In that particular case, what you would have would be a tax at the corporation tax level for the business.
The EOT, if it received a dividend, would then have to pay tax on that, and then if it distributes proceeds to the employees, they would then have to pay income tax on what they receive.
So there would be three levels of taxation, if the dividends were paid to the trust and with the objective of getting that money out to the beneficiary employees.
You’re better off if you want to get additional cash into the employees’ hands simply paying bonuses, whether it’s the income tax-free bonus, or whether it’s just normal discretionary bonuses or profit sharing that the company may provide its employees because then you only have two levels of taxation.
There would be corporation tax for the company, and then there would be income tax for the employees above and beyond any income tax-free bonuses that might be paid.
So the trust generally will waive its dividend rights for that reason.
This is an all-employee plan, so all employees must be included as beneficiaries of the trust.
But you can institute a qualifying period, and that qualifying period can go up to 12 months, although in our experience, most businesses don’t go all the way to that 12-month period.
We’ve had a number of clients who have actually used a six-month period.
We’ve had a number who have used no qualifying period.
Our view is that some kind of a qualifying period does make sense only in that you don’t want to find yourself obligated as a company to make any employees to someone who may have been there for two, three, four months between either their choice or the company’s choice, and they’re not a fit.
They leave, and then they would still potentially be included as an employee as defined for a period of time after their departure and therefore entitled to receive a bonus.
Or if the company happened to be sold at some point within a reasonably short period following their departure, they would still be eligible for a percentage of the sale proceeds.
So you generally would want to use some kind of a qualifying period.
It’s really a choice up to the management team and up to the vendor whether or not they want to have that go up to the full 12 months.
What’s key also is that the interest in the EOT, and when we talk about interest, we’re talking about basically calculating the income tax-free bonus amount, or we’re talking about calculating the sale proceeds that would be allocated to employees if the company is ever sold.
Those interests have to be allocated on what the legislation refers to as the same terms.
Basically what that means is a fair and non-discriminatory formula.
It definitely does not mean that everybody has to get the same interest.
So you can use a formula as long as it’s objective.
Typically, what you will see is a remuneration-based allocation mechanism.
You can include years of service.
You can use hours worked in a period of time, all of which are very objective measures of how you would allocate interest in the trust.
What you cannot do is use an employee’s rating from their annual evaluation.
You cannot use job title.
You cannot use education level.
Anything like that would be considered discriminatory from the Revenue’s perspective, and that would not be permitted in terms of allocating the interest in the trust.
You can use multiple factors, so if you wanted to set up a point system that incorporated years of service along with remuneration, that’s perfectly acceptable.
But what you have to do is basically set up two different pools of proceeds that would then be combined.
So what I mean when I say that is you could have one pool where the amount of the bonus payments or the amount of the sale proceed allocation would be determined by the employee’s time of service with the company.
You would have another one that could be determined by their remuneration over a period of time compared to remuneration for all employees.
And then you could add those two to come up with the total bonus, again, subject to the £3,600 maximum per year.
What you can’t do would be to use a multiplicative calculation.
So you couldn’t take years of service, multiply that by remuneration, and then come up with a calculation, because that would not be considered same terms.
It would be considered discriminatory in favour of longer-serving, higher-earning employees.
So you can factor both in, but the calculation has to be additive rather than multiplicative.
Technical aspect, but it’s a question we typically get after completion as a company is looking at how they’re going to allocate bonuses the first time around.
And we’re happy to work with people to come up with a formula that works.
Now, as I mentioned before, the EOT can be combined with tax advantage share schemes.
This really is useful to align the interests of the various parties.
So the EOT itself is an indirect ownership model.
The employees are beneficiaries of the trust that owns the shares.
They are not direct shareholders.
So from their own perspective, they might look at that and say, “This is great.
We know the company is going to be here.
It’s not going to be sold.
We’re not going to lose jobs, potentially.
But we don’t own shares.
We’re not real true owners of the company in terms of the ownership economics that come with share ownership.”
So being able to use these tax advantage share schemes can be very useful in aligning the interest of the employees and the staff with the company as a whole.
We’ve had clients that have actually provided EMI options for all of their employees.
That’s an extreme.
The company had about 40 employees, and everybody who worked at the business received EMI options post-completion.
It can get a little messy, a little complicated to administer at that point, but the vendor felt that it was very important to take care of the people that helped make the company successful.
A SIP, share incentive plan, can be probably a little bit more effective way of doing that, although it doesn’t have quite the same benefits that the EMI option may have for the employees.
But the key takeaway here is that you can provide direct ownership economics to your employees following completion that they might not otherwise have.
One of the other real significant questions that we have to deal with with a lot of our clients as they’re researching whether or not this makes sense is: What is the role of the trust and of the trustees?
Are they now going to be telling me how to manage my company?
And they do, and I say my company intentionally, because even though somebody is selling, if this is something that they’ve built or they’ve bought and grown, they still have that sense of protection and ownership of the company where they want to make sure that it can continue to be managed and run effectively.
So the real key here is that the EOT and the trustees are very passive investors.
They really have two major decisions that they need to make over the life of the company’s EOT ownership phase.
And that could be a permanent phase, it could be something that is, pick your number, 10 years, whatever it may be, because EOT companies can be sold.
The trust is a shareholder like any other shareholder, and if the trustees would get an offer, they would look at that and just say, “Is this in the best interest of the employees to sell, or is it in the best interest of the employees to continue to own it under the EOT structure?”
But the two decisions the trust really has to make that are key are to buy the shares initially and to enter into this phase of employee ownership, and then whether or not to potentially sell the company at some point in the future.
Those are those two key decisions that the trustees need to make.
On a regular day-to-day basis, the company is still going to be run by the management team and the company board of directors.
It will make sense, obviously, to keep your controlling shareholder up to date on what’s going on with the business.
So we recommend a couple times a year, a meeting with the trustee just to bring them up to speed on what’s going on with the business.
Not a requirement, but just a best practice, obviously.
You don’t want your controlling shareholder operating in the dark.
But the trust is going to let the management team and the board do what they need to do to manage the company.
And that’s a real key factor, because it’s a concern that a lot of vendors have going into this.
It’s like, are we giving up control to this sort of nebulous entity sitting out there that’s going to question every decision the company board makes and the company management team makes?
And the answer to that is it’s not going to.
It’s passive.
In fact, there is potential liability that can attach to the trustees as shadow directors if they get too involved in the management of the company.
So that’s really not an issue, but it’s a very common question that we have to deal with.
So from a tax incentive perspective, I’ve touched on these points before, but just to sort of summarize here from a tax incentive perspective, the shares you sell to the EOT, assuming you meet the requirements, controlling interest, fair non-discriminatory formula for bonus and trust interest allocation, et cetera, that’s going to be 100% capital gains tax-free to the seller.
And that’s going to be whether or not you sell 51% or whether you sell 100%, the proceeds of the sale of those shares, as long as it’s a controlling interest, will be 100% capital gains tax-free.
Now, the key factor here is that this is basically a one-time opportunity.
So let’s say the vendor decides to sell 60% to the trust.
The vendor or the vendors would qualify for capital gains tax relief on that 60%, but if they sold the other 40% in another tax year, the sale of that 40% would not be capital gains tax-free.
That would be subject to capital gains tax just like any other sale of shares.
So this really is a one-time, and I say one time meaning it has to occur in the same tax year.
So if you sold 60% in March and decided to sell another 40% in October, both of those transactions would be CGT-free because they’ve occurred within the same tax year.
If you cross into the next tax year, that 40% again would be subject to capital gains tax, and you would be able to take advantage of, again, they’ve changed the name, but I still in my own mind think of it as entrepreneur’s relief.
You would still be able to take advantage of entrepreneur’s relief on that 40%, assuming you’ve remained an employee of the business and qualify from a shareholding perspective.
But this is really significant now.
The lifetime allowance for entrepreneur’s relief has been reduced from £10 million to £1 million.
What that does, just to give you an example, and there’s a short white paper on our website that goes through this, if you have a business valued at £5 million, that takes the capital gains tax on the sale from £500,000, which would be the 10% entrepreneur’s relief, up to £900,000 with the reduction in the lifetime allowance down to £1 million.
So at that price level, that value level, it almost doubles the capital gains tax that would be paid on a third-party sale.
So the CGT relief available with the EOT structure can potentially save you almost 20% of the proceeds on a £5 million transaction, which we believe is very significant.
Again, the beneficiaries from a tax incentive perspective can receive £3,600 annual income tax-free bonuses with the proviso that you do want to make sure that you manage expectations.
So structurally, I’ll just sort of walk you through what a transaction will typically look like.
So in this case, you start with the shareholders in the upper right-hand corner.
They’re going to sell to the EOT, which is obviously the red box in the centre.
And then when you look at how the payments are made here, obviously the shareholders want to get paid for their shares.
They’re not going to just contribute these to the trust out of the goodness of their heart in most cases, although it has happened.
So the trust itself then needs to find the money to pay the shareholder for the shares that it’s acquiring.
So that will typically come from a couple of areas.
One, the trust can borrow from a third party if the company is large enough and profitable enough.
And typically, to get the interest of a lender, you should have operating cash flow or EBITDA, which is earnings before interest, taxes, depreciation, and amortization, of at least £1 million to access third-party financing.
Or the vendor can, in effect, service the lender by taking back vendor notes from the trust.
The company will guarantee the debt because that’s where all of the cash originates.
The trust has no other way of accessing funds other than with the assistance of the company, whether it’s through a guarantee to a third-party lender by the company, or whether it’s providing a charge over its assets to that third-party lender.
But all of the cash starts at the company level and then in one way, shape, or form, makes its way through the EOT to the shareholders.
The repayment of the loans, again, whether it’s to the third party or whether it’s to the vendor, is basically made through a contribution made by the company to the trust, which will then pay the principal and interest on the loans, either to a third-party lender, to the shareholder vendors, or to both.
Because you will not be able to borrow enough from a third-party lender, even if you’re large enough to access the third-party capital markets, to pay 100% of the purchase price.
So there will be, in virtually every transaction, the need for some kind of vendor support to allow the trust to buy its controlling interest.
So the company will make an after-tax contribution, and this is a gift.
A contribution, it’s not a dividend for the reasons that we talked about earlier.
There are just tremendous tax inefficiencies with dividends.
So it’s a contribution made from distributable reserves, and that’s key.
You can only distribute a gift to the trust up to the amount of the distributable reserves the company has on its balance sheet.
So the company will make that gift to the trust.
The trust will then turn around and make that payment to the lender, again, whether it’s the vendor or whether it’s a third-party lender.
There is a little bit of a disadvantage to this structure from an interest deduction perspective in that a third-party buyer is able to deduct a portion of the interest expense on the loans that it uses to purchase a company.
With the EOT structure, that’s not possible because the company makes a contribution, again, after tax, equal to the principal and interest due by the trust to its lender, so there is no deductibility of the interest.
And that’s something that we have brought up numerous times, along with many other people who do the type of work we do, to the government saying, “It’s time to level the playing field and allow for some interest deductibility on these EOT loans.”
But at this point, that hasn’t happened, unfortunately.
So that’s the core structure.
And then over on the left-hand side, and this again, I know there’s a lot on this slide, so it’s something I’m sure you’ll want to spend some time with in trying to understand a little bit more.
But as you can see, number seven over there, going from the company to the employee, that’s the income tax-free bonus payment that’s permitted with the EOT ownership structure.
And then item number eight over there would be the tax-advantaged share schemes that we’ve talked about already.
So that’s the general structure, and there are variations on the theme.
But in general, all of these have to occur in some way, shape, or form for a structure to work.
So why would you look at an EOT versus a third-party sale?
I think the first point here is that these are probably the most flexible transactions you could undertake.
Subject to the requirements to qualify as an EOT, there’s very little structurally you can’t do with these.
You basically are in control of all of the major aspects of the transaction and basically can make this work based on your particular circumstances, particularly if you’re going to look at a vendor finance transaction.
There’s really nothing in the entire transaction process in that case that you don’t control.
So if you want to ensure that you’re going to be able to complete this transaction, complete it quickly, and complete it at a lower cost than you might see with a third-party transaction, a vendor-financed EOT transaction is certainly going to be the most inexpensive, efficient transaction you could undertake.
If you’re looking at a 100% vendor finance deal, we tell clients to expect eight to 12 weeks from start to finish.
If you’re looking to raise third-party capital to support the transaction, you can add significant time to that because it takes time, if you’re running a full process, to try to find the best financing in the marketplace.
It does take time to do that, and we tell our clients to expect probably two months in addition to the core transaction to source the capital, run that process, bring lenders in, have meetings, let them do their due diligence, get their credit approvals, and document the transactions.
So there is a significant increase in time.
One of the things you can do, and we actually had a client do this a couple of years ago, was to complete based upon vendor financing and then turn around once you’ve got that in place and your transaction is seasoned a little bit, then go back out to the market to try to refinance some of that vendor debt with third-party debt.
That’s perfectly acceptable.
There’s no reason you can’t do that, particularly if there is a compelling reason you’d like to complete sooner rather than later as a vendor.
So you’ve got some options, you’ve got some flexibility here.
One of the real keys, we think, as well is if you look historically, when you talk to a business owner about selling to the employees, you could almost see their eyes roll.
“That means I have to sell at a discount.
It means that I’m not going to necessarily know when I’m going to get paid out.
I’m just not sure that works for me.”
But with the EOT, you can sell at fair market value.
So there’s nothing that says you have to take a discount.
You can look at this just like you would look at any other type of a sale transaction.
Get a business valuation done, which we think is basically a mandatory requirement even though it’s not a legal requirement.
You want to give the trustees a basis for their decision to buy the company, and that third-party independent valuation does that.
And then when you factor in the financing structure, you can make this transaction work economically at a level very similar to a trade sale, and certainly over time exceed at least the gross proceeds of a private equity transaction if the transaction is structured properly.
One of the other keys is that if you look at excess cash on the balance sheet, and in this case we’re talking about what is really excess cash.
It’s not something that you look at and say, “I’ve got this cash sitting here now, but then I’ve got corporation tax payments due. I have other things that are obligations going forward.”
This is cash that’s been built up over the years.
Tax has been paid on from a corporation perspective.
But you haven’t paid dividends because the tax rate on dividends for an additional rate taxpayer is over 38%.
So it’s just one of those things where you’ve let the cash sit in the company and haven’t been able to access it.
Excess cash with an EOT transaction comes out to the vendors tax free, and that’s critical because we’ve had clients in the past that have had several million pounds of cash on the balance sheet that has just been sitting there.
It’s not used in the operation of the business, but they haven’t distributed anything out because of the heavy tax bite that occurs if they do that.
So when you think about how you value a company, basically what you do is you would take a valuation based upon a multiple of some kind of cash flow measurement.
So one of the most common is EBITDA, which I referenced earlier, operating cash flow or earnings before interest, taxes, depreciation, and amortization.
And let’s say the multiple might be five times your EBITDA or your operating cash flow.
What you then do is you add any excess cash on the balance sheet and you subtract any debt, and that gives you the equity value of the company.
So it’s basic valuation theory.
There’s nothing nefarious or underhanded about it.
It’s just how you value a company.
So it’s the core value of the company based upon some kind of an earnings measurement and a multiple, plus excess cash, minus debt.
So that excess cash that comes out now becomes part of purchase price, and with the EOT structure, is not subject to tax.
So if you compare paying 38% on a couple million pounds versus paying nothing on a couple million pounds, that can be pretty attractive for most vendors.
I think on a more subjective basis as well, selling to an EOT eliminates the need to go through what is usually a pretty adversarial sale process if you’re looking at selling to a third party, particularly to a trade buyer.
There’s going to be a lot of back and forth on value.
There’s going to be a lot of back and forth on how you allocate the efficiencies of the new company, who gets the benefit of that.
Is it the buyer?
Is it the seller?
What’s going to happen with jobs at the target company, which would be your company, post-completion?
Because if there is a need to rationalise the workforce, the job cuts typically don’t come from the acquiring company.
They come from the acquired company.
So you eliminate those integration issues after completion with the EOT transaction.
The day after completion is going to be just like the day prior to completion in most regards that the employees are going to care about.
There’s not going to be a concern about job losses or anything else.
It’s just going to be a new ownership structure where they now, through the trust, are the controlling owners of the company.
So a lot of reasons to look at an EOT versus a third-party sale, and our next webinar in a couple of weeks is going to go into more detail on the EOT as a business sale alternative.
Again, we’ve talked about these points for the most part already, but there’s long-term stable ownership, job preservation, and legacy.
You can’t underestimate the importance of legacies from business owners and communities where they’ve long played an important role.
And this allows the company and the vendor to fulfil that legacy and create something that’s lasting as they move on after they sell the company.
One of the other points, we talk about the proceeds being equal to or greater than some of the third-party sale alternatives.
When you structure the transaction on commercial terms, that means vendor loans, whether it’s 100% of the financing or a portion, are going to be done on commercial terms.
Which means they’re going to have an interest rate that’s a market interest rate, and there’s going to be, if it’s a subordinated piece of financing, which means it comes behind a third-party lender, there’s going to be an additional incentive that the vendor gets down the road that brings that return up to a market-level return.
So if you look at what a subordinated return would be for a third-party lender, you’re probably talking somewhere in the 12% range.
So you don’t pay 12% cash interest.
Companies can’t afford to do that for the most part.
So you pay a lower level of cash interest, and there’s an additional payment, we refer to it here as an equity kicker, that’s paid at the end of the subordinated loan term to bring the overall return up from, say, that 7% or 8% cash interest up to that 12% overall return.
So when you look at that and compare the gross proceeds, this can be very competitive with third-party sales.
The other point, and again, I mentioned this earlier, the trust is a shareholder.
And there’s nothing that says that a shareholder with the right offer can’t sell the company.
So if there is a great offer that comes in, the trust will more than likely hire its own advisor, have the business valued, and then it will have to make a determination as to whether or not the sale is in the best interest of the employees.
If a company was sold initially for £5 million and a trade buyer comes in three years later and says, “I’ll pay you £10 million for this company,” the trust would have to give some serious consideration to that.
Although it doesn’t necessarily have to take the offer, but it would certainly need to justify why it turned that offer down, particularly if the management team and the company board recommended the transaction.
So for the most part, the trustees are not going to question the judgment of the company board, unless it’s something that just on the surface appears to be really out of line with what’s in the interest of the employees.
But it’s key that the trust document its deliberations, how it makes a decision with respect to that potential future sale point, and if that situation ever occurs.
And as I mentioned earlier, when you look at the sale structure, 100% sale creates the ability to use share incentives to a greater degree to both retain current staff and to attract key employees going forward that are going to help grow the business.
So if you sell 100%, you basically have 49% of the shares that can be used as incentive shares going forward.
Again, you wouldn’t necessarily want to go to that extent, but you do have the ability to do so.
Again, just to summarize the benefits to the vendors.
Fair value, you exit in a way that you want to exit.
What’s key from a documentation perspective is that in a third-party sale, the company and the management team/vendors are typically required to make a large number of representations and warranties regarding the company performance, its financials, its compliance with laws, regulations, licence requirements, et cetera.
With an EOT transaction, that list is significantly smaller.
There’s a presumption made that the trust, because it will have typically employees and a vendor or two on the trust board, is familiar with the company.
It knows the company’s business and doesn’t require the same type of protections that a third-party buyer would.
Along with that, when you talk about vendors serving on the board of the trustee, it’s important to know that the vendors cannot constitute the majority of the trustee board.
There’s a clear conflict of interest in that case.
So if you had a five-person board, maximum you could have two vendors, two shareholders on that board.
If you had a three-person board, you could have one vendor serving on that board, but you cannot have control, again, because you basically would be making the decision to buy your own shares if you had control.
So you will have probably some management representation.
You may have third-party representation on the trustee board.
But regardless, there’s an assumption, presumption made that there’s a better understanding of the company and its operations with the EOT than there would be with a third-party sale.
The other key here is that when you look at going into a transaction like this, you want to make sure that there aren’t going to be any issues with respect to the Revenue and tax obligations.
So what you can do is apply for a transactions and securities clearance from the Revenue, and you provide them with an overview of your transaction, how it’s going to be structured.
And then they will come back within 30 days, in normal circumstances, within 30 days, and give you a letter that says, “Based upon the transaction as outlined, we are confirming that we will take no counteraction for tax based upon this transaction.”
So you have something in writing that says that they are not going to come after you as the vendor for capital gains tax, income tax, looking at this as a deemed dividend, disguised remuneration, whatever.
So, again, this is not a legal requirement.
It is a mandatory part of the process from our perspective because it costs nothing, and you get this back in usually two to four weeks.
So why you would not want that kind of clarity, it’s kind of beyond our understanding.
So we do look at that as mandatory.
I think I already made the point with the last two bullet points here that on an overall proceeds basis, the EOT, when structured appropriately, can provide proceeds that are equal to or greater than those you would often see with private equity or trade sales.
So if your perception has been that you have to take a discount to sell to the employees and, I’ll put this in quotation marks, “do the right thing,” that is most definitely not the case.
So financing the transaction, again, here are basically the four alternatives to financing the transaction, and other than the private equity, the vendor can provide the financing on the same commercial terms.
So you’d start with free cash on the balance sheet, get that out of the company with no tax.
Senior debt, banks, debt funds typically provide this on a three to five-year initial term with pricing generally 3% to 7%, 7% is toward the high end.
If you figure 3% to 5%, that’s probably a good pricing range.
Sub-debt, this is what you use to fill in the capital structure.
So after you’ve borrowed from the cheap source of capital, you then fill in the gap.
And in most cases, this would be the vendor for an SME, because the third-party sub-debt providers typically look at a little bit larger transactions.
A million to a million and a half pounds of operating cash flow would start to get their interest.
Something smaller than that, you’re talking about the vendor taking this piece of the capital structure.
Typically interest only, and then it’s refinanced over time with third-party debt.
There are a couple of private equity firms that will invest in a minority stake in an EOT company.
They’re a little more difficult to find because it doesn’t fit their model.
They typically want a control stake.
They want to be able to sell the company down the road, and that is somewhat contrary to the objective of the EOT structure, but there are a few minority investors who will invest in these.
But they look for a very high return, and their exit is much more difficult from a minority stake in that they would still probably push for a sale of the company.
But their only other buyer really would be the company or the trust buying their stake back, because an outside party is typically not going to buy a 10% or 20% stake in an SME.
But those are your capital sources.
So other elements, other aspects to the EOT.
I’ve already mentioned the issue with the trustees.
Vendors, as they should not, cannot constitute a majority of the trustee directors because of the conflict.
And again, the company board and the trustee board should not materially overlap, again, because you’ve got that potential conflict.
If you have the company board and the trustee board comprised of the same individuals, there’s a serious question of independence in that regard.
We do require a valuation opinion because we believe the trustee directors should have the support they need to make the decision to buy the company rather than just taking someone’s opinion that the company’s worth X amount.
This clarifies that, and it gives them the ability to rely on something if there ever is a question of value.
The transactions and securities clearance, again, we require this as part of our transaction.
There’s no reason not to.
And I think finally, key is the more soft side, subjective side of the structure.
We believe it’s really important to communicate with the employees as part of this process.
We have dealt with clients who basically have not done any communication.
In fact, we had one that said, it’s kind of dark, shock may be a little bit strong of a word, but, “Do I have to tell the employees we’ve done this?”
And it’s like, well, yes, legally, probably not, but you’re missing the boat if you don’t do that because the whole benefit of this structure is to get people motivated, to get them excited about the company, to get them to feel like an owner, where they put that additional effort in and help foster continued success.
But maximising the benefit of the trust and the employee ownership structure really does require providing your employees with a better understanding as to how what they do really impacts the business as a whole.
You tend to see with these types of transactions that employees do take a greater interest in how they’re doing their job, how others are doing their job.
You’ll often see employee councils that are formed to help support the transaction of the company with its new ownership structure.
They can serve as an interface with the management team, with the trustee at times.
So this is an important part of the process that goes beyond just getting the deal complete, but it helps set the company up for further success going forward.
So in conclusion then, when you look at all of these, we feel the EOT sale is very compelling.
And it’s been a little disappointing to see the rate of uptake of the EOT structure over the last six years in the UK.
The growth rate is accelerating, so there are more of these being done.
There are probably, based on the latest count, somewhere between 375 and 400 EOT-owned companies in the UK.
There are more advisors who are now talking to their clients about these structures.
But there are two constraints, I think, to why this hasn’t grown a little faster.
One, the number of advisors who are comfortable with it and are going to bring this up to their clients has been relatively small.
It is increasing now.
And the other aspect is really a lack of third-party capital, particularly for companies at the lower end of the SME range.
So from that perspective, as we get more comfort with the lending market, as we get more advisors who are going to bring this up to their clients, we should see that growth rate continue to accelerate.
From a financing perspective, financial perspective, you don’t have to give up value to look at this as an alternative for selling your company.
It is definitely a structure that allows you to be very competitive with a third-party sale, and you control the transaction variables.
And for anybody that may have gone through an aborted third-party sale process, you understand what I’m talking about.
You go through this process, you open your books up.
Basically, you go, as we call it, open kimono to competitors.
And there’s only going to be one buyer if the process is successful, but you’ve shown a lot more than that, all of your confidential information.
So there’s some real considerations along those lines to keep in mind.
You complete more quickly at a lower cost in most cases.
And once you get through the current tax year and the next tax year, there is no risk of the capital gains tax clawback to the vendors.
Anything that would happen in terms of a disqualifying event, which is usually going to be the trust owning less than 50%, and that typically would come from a sale of the company.
After this tax year and the next tax year, that obligation passes to the trust.
So the vendor doesn’t ever have to worry about that clawback again.
And then finally, I mentioned this to start.
Employee-owned firms tend to perform at least as well as non-employee-owned firms based on numerous studies both in the UK and in the US.
So with that, that’s the end of the formal part of the presentation.
So appreciate it if you would follow this webinar, respond to the follow-up survey you’ll get.
We do read those.
We do take into account comments we receive and want to make these as useful as we can for you.
If you’d like a copy of this, please email me with your contact info, and our next webinar will be at 11:00 a.m. on the 21st.
And in that webinar, we will talk about the EOT as a business sale transaction or sale alternative.
And as I said before, for more information on the employee ownership trust, you can visit our website.
Please feel free to reach out to me with any questions you may have.
Be happy to spend time talking with you about your particular circumstances.
And with that, let me just see if we have any questions that have been submitted here.
And it looks like we do not today.
So at that point then, I say thank you very much for your time and for your attendance this morning, and we look forward to speaking with you on our next webinar.
Have a great day.

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