Employee-owned businesses tend to be more financially stable than those with traditional ownership structures. Studies show that over the past five years, employee-owned businesses were significantly less likely to experience profit declines (14% compared to 25% for non-employee-owned businesses). For business owners who view their company as a legacy, this paired with the continued success of their creation can be a major motivator to transition ownership to their employees.
If an employee ownership trust (EOT) is one of the options you are considering, we have compiled six questions you should ask yourself to help you determine if an EOT is the right path for you.
Contents:
- Why are you interested in an employee ownership trust?
- Are you a limited company and do you qualify as a trading company?
- How many employees, shareholders and directors does your business have?
- How do you plan on financing your EOT?
- Are you looking to pass control over to your employees?
- Are you happy that an EOT will benefit all employees in your business on similar terms and that the trustee of the EOT will be the principal shareholder?
Why are you interested in an employee ownership trust?
It would be helpful for you to understand your motivations for creating an EOT. Are you primarily interested in succession planning and/or do you wish to transition the ownership of the company into broad-based employee ownership?
How does an EOT compare to other options like selling your business through a trade sale, a management buy-out or sale to private equity? What are the key factors driving your interest in the EOT approach?
Are you a limited company and do you qualify as a trading company?
EOT tax benefits are only available in relation to sales of shares in limited companies and they are not available to corporate shareholders. If you operate as a partnership, limited liability partnership, or sole trader, you will need to incorporate your business first. Here's what EOTs have to offer:
- You can sell your shares to the EOT without paying capital gains tax on an uncapped basis; and
- Companies owned by EOTs can pay annual bonuses to employees of up to £3,600, and those bonuses are exempt from income tax.
While most businesses qualify as ‘trading companies’ under EOT rules, there are exceptions. If your company holds investments like buildings or stocks in other companies to a substantial extent, you may need to re-organise pre-transaction as unfortunately, EOT tax reliefs are not available for such companies.
How many employees, shareholders and directors does your business have?
To qualify for the EOT capital gains tax exemption, there is a limit on the number of shareholders who can also be employees and own a large stake (5% or more) in the company. This limit is a ratio of two shareholders (maximum) to every five total employees.
For example, a company with four employee-owners, each holding 25% of the shares would need at least 10 employees to qualify for an EOT. This is to ensure that the transition is to a broad-based employee class.
There's a similar rule for tax-free bonuses under EOT ownership. A company cannot have too many directors who are also employees compared to the total number of employees or directors.
How do you plan on financing your EOT?
Unlike a trade sale or sale to private equity, there is no third party to fund the purchase of your shares. This means that available cash in the business and future cash flow will fund the purchase of your shares over a period of time and/or the company or EOT would need to borrow from a bank or specialist lender to fund the transaction.
The higher the sale value, potentially the longer it will take for you to receive the full payment for your shares.
Are you looking to pass control over to your employees?
When you implement an EOT, your employees will not directly hold shares in the business and therefore they do not have a direct ownership interest which provides them with voting or economic rights such as dividends.
There is no requirement to appoint an employee director to your company board. Neither is there any requirement for any other employee representation in the structure. However it is common and important to consider the appointment of an employee trustee director and/or to constitute an employee council or committee to act as a channel of communication between your company board, the employees and the EOT.
Are you happy that an EOT will benefit all employees in your business on similar terms and that the trustee of the EOT will be the principal shareholder?
EOTs are designed to give all employees a stake in the company's ownership – meaning any financial benefits from the EOT must be shared fairly among all employees. This could be an equal amount for everyone, or it can be based on factors like salary, service, or hours worked.
To qualify for EOT tax breaks, the EOT needs to own more than 50% of the company's shares. While operational control and day to day management of the company continue to be the role of the company board, the EOT will control the constitution of the board and will have voting control in relation to shareholder matters.
If an EOT seems like the right fit for your business, we recommend speaking with a specialist employee ownership trusts solicitor to discuss your specific situation and explore the process in more detail. We can guide you through the legalities and ensure a smooth transition for your business and your employees. If you’re still undecided about your business’ succession plan, see our five reasons to sell your business to an EOT.
