An EOT is a form of employee benefit trust, which acts as a collective vehicle to purchase a controlling interest (share capital) in a company. The shares are then held on trust for the long-term benefit of the employees as a whole.
EOTs provide a purpose-built exit plan for business owners and have been proven to consistently improve employee engagement and efficiency. However, choosing to convert to an EOT should reflect a business’ culture, ambitions, corporate structure and long-term strategy.
Some well-known examples of employee-owned businesses include John Lewis, Richer Sounds and Arup.
How does conversion to an EOT work?
Firstly, a trust is created (the EOT itself) which is settled in favour of the company’s employees. The EOT will have a single “corporate trustee” and this will take the form of a separate newly incorporated company.
The board of directors of the corporate trustee will usually begin by reflecting those directors of the target company. However, over time the EOT may choose to add further positions to the corporate trustee’s board, such as an employee representative or a professional trustee.
The sellers will sell their shares (this must be more than 50% of the target company’s share capital, see below) to the EOT, usually with some of the consideration being paid on completion and the majority of it being paid over a number of years on a deferred basis.
The EOT will continue to fund the purchase of the shares from the seller through profits generated by the target company.
In order for a business to qualify for an EOT conversion, there are a number of requirements which must be met both before and after the sale of the shares. These include: –
- Employee Benefit Requirement: The EOT must benefit all eligible employees. The seller cannot “cherry pick” employees to be eligible, though they can set certain limits on how much employees benefit from the EOT (see below).
- Equality Requirement: All of the eligible employees must benefit on the same terms. This doesn’t mean that each employee benefits to the same extent at any one time. For example, the seller may wish to set limits to the extent an employee will benefit from the EOT based on reference to their salary, length of service or hours worked.
- Controlling Interest Requirement: The EOT must acquire a “controlling interest” in the target company. This equates to the EOT holding more than 50% of the ordinary issued share capital, voting rights and profits available for distribution.
- Limited Participator Requirement: No more than 2/5ths of the company’s employees can individually hold 5% of the company’s issued shareholding. This might cause an issue for smaller companies with a smaller workforce.
- Trading Requirement: The target company must be a trading company or the holding company of a trading group.
Advantages of an EOT
Possible Tax Advantages:
- The seller may benefit from a capital gains tax (CGT) relief on the sale of their shares to an EOT. This is one of the most attractive incentives for a seller, especially in light of the reduced CGT relief now available from Business Asset Disposal Relief (formerly Entrepreneurs Relief).
- EOTs are able to provide their employees with a £3,600 tax free (income tax) bonus each financial year.
- Possible inheritance tax reliefs (IHT) (subject to appropriate IHT advice).
An EOT conversion, if delivered and presented correctly, can motivate a workforce to be more productive as they are “working for themselves” rather than for a separate owner of the business.
The company will be effectively purchasing itself from the seller as a shareholder. This limits the negotiation process which might occur in an “standard” share sale and will more than likely lead to the EOT (as buyer) agreeing to a reduced list of warranties in the Share Purchase Agreement (meaning reduced liability for the seller).
Purpose-built exit strategy:
An EOT provides the seller with a purpose-built exit route from their business. It also means the seller doesn’t need to sell to a competitor and the business can retain its identity.
Greater return on share capital:
Because of the tax benefits, overall, an EOT conversion may lead to a far greater return on a seller’s capital. However, the obvious threat to this is the length of time over which the seller is paid (possibly 7 years or more) and the risk that the target company may not remain profitable during this period.
Can combine with sub-management incentives:
Following conversion, second tier/sub management teams can be incentivised to ensure the company remains profitable during the period of deferred consideration using employee share schemes such as EMI Schemes or Growth Share Schemes.
Disadvantages of an EOT
It is often the case that the full extent of the consideration will not be paid to the seller for a significant amount of time (possibly upwards of 7/8 years) and this is further reliant on the target company continuing to generate profits.
Loss of control:
Unavoidably, the seller will also lose control. The conversion process is still very much based around a share sale and while the seller will be able to retain some control at board level throughout the duration of the deferred consideration period, ultimately, they will no longer be a shareholder and the company will operate for the benefit of its employees from completion.
The tax benefits are reliant on the company not committing a disqualifying event. This would usually result in the company no longer meeting the qualifying conditions mentioned above and, as such, it would require the EOT knowingly making a significant decision for it to no longer qualify (i.e., selling more than 50% of the issued share capital, the trust no longer benefiting all employees or the company ceasing to trade).