The Employee Ownership Trust (or EOT) is becoming a more common exit option for founders. Current changes to the legislation regulating EOTs should help to cement the structure ensuring it has a permanent place as a strategic exit option for founders who wish to protect their legacy and provide the benefits of broad-based employee share ownership to employees.
In this article we explore what’s involved in a sale to an EOT and the current legislative changes which are going through Parliament, together with some of their practical implications for EOT transactions and structures.
Contents:
What is a sale to an EOT?
A sale to an EOT is a sale of at least a majority interest in a trading company or group to a statutory trust for the benefit of the employees.
The statutory trust is a legal arrangement whereby the EOT trustee will legally hold the trading company shares for the benefit of the trading company’s employees.
The sale is for market value and typically the deal is funded by a cash out of available company profits on Day 1 and the balance of the deal price is funded from future company profits over a deferral period. Third party debt may be used to allow the sellers to take more cash off the table more quickly.
In the ten years since the EOT was introduced in 2014, the structure has surged in popularity as an alternative to a trade sale or a sale to private equity because of the many benefits both to the selling founders and the staff. These include the retention and incentivisation of employees and the reduced transaction risk as there is no third-party buyer. Importantly the selling founders pay no capital gains tax on the sale of their shares to the EOT, and this tax relief remains uncapped.
What are the key current changes to EOTs?
The current Finance Bill which is going through Parliament is introducing changes to EOTs. These changes are generally effective from 30 October 2024. These changes do not fundamentally alter the EOT model but strengthen the role of the EOT trustee and introduce additional guardrails relating to the founder’s tax relief, which is a strong incentive for founders to sell to an EOT.
Trustee changes
There are three changes relating to the trustee of the EOT.
It is now no longer possible for an EOT to be tax resident outside the UK.
Further, founders and their close relations are no longer able to constitute 50% or more of the trustee body which is the EOT trustee. A very common model of trusteeship in EOT structures is the creation of a UK company limited by guarantee to act as a trustee and the appointment of individual directors of the company to constitute a trustee board. This change will mean that founders and their close relations may only constitute a minority of the trustee board directors.
The EOT trustee has a new duty not to overpay for the trading company shares nor pay a non-commercial rate of interest on a deferral and must have taken all reasonable steps to secure this position.
Seller/founder changes
From a seller perspective, for the seller to secure the capital gains tax relief on the sale of their shares, there must be no breach of the EOT legislative criteria in the tax year of sale and any of the four complete tax years following the tax year of sale. This clawback period used to be one complete tax year following the tax year of sale. This means that if an EOT transaction completes on 1 April 2025, the EOT legislative criteria must be met up to and including 5 April 2029 to ensure the sellers’ tax relief cannot be withdrawn. If a transaction completes on 6 April 2025, the wait period is another year, until 5 April 2030.
Other changes
HMRC has announced procedural changes which will ease pre-transaction clearance requirements.
There are also changes to how the payments made by the trading company to the trustee to pay the sellers their sale payment together with associated trustee acquisition costs will be characterised for tax purposes in the hands of the trustee. These payments will be characterised as distributions and there is a new tax relief which trustees will need to claim to prevent these payments being taxable on them.
What are the practical implications of these changes?
These changes are generally intended to encourage the transition to long-term employee ownership and prevent the use of EOTs in a manner which was not in the spirit of the legislation.
Impacts for sellers
For sellers, the extension of the clawback period during which CGT relief claims can be over-turned provides another tie to the business to ensure the EOT continues to meet the qualification requirements over this period. In practice deferred consideration is usually paid over a five – seven year period following the EOT transaction and sellers will generally wish to continue to have some involvement whilst the deferred consideration is outstanding in any event. This change will deter sellers from using an EOT as a stepping stone to a secondary exit. Therefore, it is critical that selling founders are ready to transition the business into longer-term employee ownership.
Impacts for trustees
The trustee changes strengthen the role of the trustee board. The selling founders will not be able to control the trustee board and will not, as trustee directors, be able to direct how payments are made from the EOT without the agreement of the other members of the trustee board.
The selection and appointment of independent trustees to the trustee board will become more important as part of the EOT transition process. It is current best practice to appoint an independent trustee director to the trustee board and the current changes will cement this and also support the appointment of professional trustees with EOT experience.
The duty to ensure that the sale consideration is reasonable including the interest component on deferred consideration will require the trustee board to take a more active role in scrutinising the valuation supporting the EOT transaction, including the repayment modelling of the deferred consideration to ensure this is reasonable.
The EOT trustee already has a fiduciary duty to the employee beneficiaries to ensure that it does not overpay for the shares. By requiring the trustee to secure the reasonableness of the valuation as a requirement of the selling founders tax relief, there will be greater alignment in the interests of all stakeholders as it will no longer be in the interest of the selling founder to seek an unreasonable and excessive valuation for their shares. In practice most sellers are not seeking to maximise sale value on a sale to an EOT so this change will weed out bad practice on the margins.
We are seeing a couple of approaches emerging to enable trustees to discharge their obligation to secure the reasonableness of the valuation and the interest on the deferred consideration. Trustee boards may instruct an independent review of the valuation commissioned by the trading company and trustee boards may jointly instruct the preparation of the valuation with the trading company.
Sue Lawrence, an experienced independent trustee and founder of Independent Directors and Trustees, welcomes the new legislation and the intentions of the changes. As an independent trustee the initial practical change she has seen is that independent trustees are being appointed at an earlier stage in the process when the valuation is being undertaken. This enables the trustee requirement to ensure the valuation is reasonable to be applied and documented with the independent trustee for future trustees to rely on.
The changes to the trust board composition and the restriction on having a seller majority provides clarity and a starting point for understanding the role of the trust versus that of the trading company board where the seller may still be in the majority.
Impacts for employees
The changes are in the interests of the employees as they support long-term broad-based employee ownership.
However, the government could have gone further to improve the tax benefits employees can access through EOT structures. The EOT income tax free employee bonus remains capped at £3,600 per tax year and there are employee and employer national insurance contributions (NIC) payable on this.
Considering exiting via an EOT?
The legislation is making its way through Parliament, and we expect final legislation in the Spring.
In the meantime, if you’re curious about how these changes could impact your business or your clients, join our upcoming free webinar on Thursday, 6 March, from 1 PM to 2 PM. We will walk you through everything you need to know about Employee Ownership Trusts (EOTs), including how they work, their key benefits and considerations, and the recent changes following the budget.