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. Trade sales or a traditional management buy-out seem to be the default.
With the advent of high-profile businesses such as Richer Sounds taking advantage of the route and the Government push to encourage more employee models of ownership, more business owners are considering a sale to an Employee Ownership Trust (“EOT”) 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.
- Logistics of setting up an EOT
- The tax advantages of selling to an EOT
- What delivers the highest value?
- How are payments handled?
- What about employee engagement and business sustainability?
- What is the best route?
Logistics of setting up an EOT
The 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.
- The valuation is submitted for clearance to HMRC (a decision within 28 days is the norm).
- To give clearance HMRC must 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 less 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 (20% for higher and additional rate taxpayers) but potentially subject to Business Asset Disposal Relief (formerly Entrepreneurs Relief), which provides for 10% tax on qualifying assets up to a lifetime limit of £1M.
- 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 a tax-free bonus each year (2022/23 = £3,600).
What delivers the highest value?
Employee Ownership Trust
A valuation for an EOT is handled by an independent specialist using industry standards reaching a single value. This can be conservative as HMRC could subsequently deem it above market value and tax the excess as income.
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 rather than some objective measure or a business owner’s own opinion.
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.
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 not unusual to see time periods of over 3 years and of course repayments depend on continued profit generation.
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.
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 EOT’s is increasing employee engagement and driving business sustainability. In theory it should lead to improved business performance as employees have a stake. It should lead to lower levels of absence, loyalty and engagement. Something that over the years John Lewis has been a model for. It should also lead to a longer-term view being taken of the business rather than it being held by current owners driving it towards the next sale.
With relatively little track record of EOT ownership it is perhaps too early to say which model is better. Even John Lewis lost some of its luster in difficult economic circumstances, made some questionable expansion decisions and was criticised for treating its own partners rather better than sub-contract workers such as cleaners when they were not paid a living wage.
It could equally be said of trade sales that they encourage employee engagement through share option schemes and the need for new owners to engage with the team within.
In this race it is fair to say that EOT’s tend to fair better albeit with a limited track record.
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.