Succession planning for business owners often gives rise to the question of how to pass on what they have created. Particularly so when the case for sale is driven by retirement. Where family succession isn’t an option, historically trade sales or a traditional management buy-out have been the default.
With the advent of high-profile businesses such as Richer Sounds taking advantage of the route and the Government support for employee ownership, more business owners are considering a sale to an Employee Ownership Trust instead.
In this article, we look at the logistics and tax advantages of setting up an EOT and how an EOT sale compares to a traditional trade sale.
Contents:
Logistics of setting up an EOT
he logistics of setting up an EOT are relatively straightforward and the tax advantages of selling to one can be considerable.
- An independent valuation of the Company is undertaken.
- Tax clearance is submitted to HMRC to ensure that tax advantages for the selling shareholders will be available (a decision within 30 days is the norm).
- To give clearance HMRC should be satisfied the EOT is for the benefit of employees (subject to qualifying conditions).
- The EOT can hold 100% of the shares in the company or 51% in combination with other investors or shareholders.
The tax advantages of selling to an EOT
In general, the sale of shares in a company is subject to Capital Gains Tax (24% for higher and additional rate taxpayers with effect from 30 October 2024) but potentially subject to Business Asset Disposal Relief (BADR) (formerly Entrepreneurs’ Relief), which currently provides for 10% tax on qualifying assets up to a lifetime limit of £1M. Further to the October 2024 Budget, the rate of BADR will increase to 14% from April 2025 and 18% from April 2026. In contrast where an EOT is correctly structured:
- The business owner must transfer more than 50% of the shares to the EOT.
- The business owner pays no Capital Gains Tax on the sale.
- Employees may receive an income tax-free bonus each year (2024/25 = £3,600).
There will be some changes to the structure and implementation of EOTs for EOT disposals on and after 30 October 2024. These are expected to provide easements to the transaction and to implement guardrails to encourage a long-term transition into employee ownership.
What delivers the highest value?
Employee Ownership Trust
A valuation for an EOT is handled by an independent specialist using industry standards and reaching a valuation range commonly based on multiples of EBITDA or discounted cash flow. Business owners maybe conservative when striking a decision on the value within the range and also might be reluctant to set the value too high as the business will need to fund the business owner’s payment for the sale of their shares from future profits. Also, HMRC could subsequently deem it above market value and tax the excess as employment income through PAYE.
Trade sale
A trade sale generally carries with it an element of competition between buyers which assists valuation. There is also a keen focus on financials which tend to drive valuation methods such as EBITDA. In essence market competition tends to deliver the price and the PAYE tax risk should not arise.
Conclusion
In a straight race, a trade sale tends to deliver a higher value but of course the highest value is not always the main priority of a seller, particularly given the tax comparison. Taking into account CGT rate changes announced in the Budget on 30 October and ignoring BADR, the tax differential means that the pre-tax value of a trade sale would need to be 31.5% higher to achieve the same deal value.
How are payments handled?
Employee Ownership Trust
In an EOT sale the transaction normally gives rise to a debt from the EOT to a business owner. This is then typically repaid from profits made by the business each year which it contributes to the EOT to repay the seller. It is common to see time periods of 5-7 years and of course repayments depend on continued profit generation. For sellers who want to extract the majority of the sale value at completion, the lag in getting fully paid out and the risk of a default on the debt (which is typically unsecured) can be unattractive.
Trade sale
Most trade sales tend to deliver most of the consideration upfront subject to deferred consideration, earn-outs and retentions. This tends to be the market norm, the focus of advisors and the result of pre-sale housekeeping and subsequent due diligence giving confidence to the buyer.
Conclusion
Again, in a straight race a trade sale tends to deliver more of the consideration upfront with a shorter overall timescale on the balance. Bear in mind however that if a business owner is not yet ready to retire or leave but wishes to remain with the business the speed of payment may be less of an issue.
What about employee engagement and business sustainability?
Employee Ownership Trust
One of the key drivers behind EOTs is increasing employee engagement and driving business sustainability. In theory it should lead to improved business performance as employees have a stake.
Recent research by the employee ownership sector has shown employee owners are 8-12% more productive. In addition, employee-owned businesses tend to be making more money and doing more to recycle that money into the economy by creating more jobs and investing in improving their products and services than their non-employee owned counterparts.
Trade sale
It could equally be said of trade sales that they encourage employee engagement through share ownership schemes and the need for new owners to engage with the team within. However, there is also a risk of redundancies after a trade sale as often trade buyers are seeking synergies and cost-savings.
Conclusion
In this race it is fair to say that EOTs tend to fair better albeit with a limited track record.
What about contention, negotiation, and complexity?
Employee Ownership Trusts
Handing over the reins of a company you’ve poured your heart and soul into is already a challenging process, and a competitive sale can add even more stress. In most cases, EOT sales are quicker and less contentious than trade sales as there is no third party involved. This means there is low risk of process failure.
Trade sale
Third parties will undertake detailed due diligence on a trade sale looking at financial, commercial legal and tax risks in order that the deal is priced to reflect these risks. This can absorb significant management time and significant adviser deal fees and the risk of process failure is high.
Conclusion
Once the business owner decides the EOT route is the right succession route, the implementation time and deal fees will generally be significantly less than a trade sale.
What is the best route?
Trade sales and sales to an EOT are both viable routes for sale for a business owner and both should be considered on their own merits considering the circumstances. An EOT may be more appropriate for a business owner who can take advantage of the tax benefit whilst remaining engaged with a safe custodian of the business and is willing to sacrifice an element of value and payment time. What is without doubt is that the EOT route is becoming increasingly considered alongside trade sales in more and more sale scenarios, fueled by several factors, including the simplicity of the process and the appealing tax benefits for both sellers and employees, with the number of EOT formations up to 6% of business transfers in 2024.
If an EOT seems like a good fit for your business, we recommend consulting with a specialist Employee Ownership Trusts solicitor to discuss your unique situation and explore the process further. We can guide you through the legalities and ensure a smooth transition for both your business and employees. If you’re considering a trade sale instead, we can also provide expert advice and support to help you navigate that process smoothly.
Contact us on 0800 689 1700 or fill out the short contact form below and a member of our team will be in contact.
