Employee Ownership Trusts: a Departure from Convention
In late October 2022, specialist tax consultancy firm, YesTax, transitioned to employee ownership through an employee ownership trust (EOT). The decision to become employee owned was driven by the desire to sustain the company’s unique culture and to recognise the fact that the business was built upon the hard work and commitment of its employees.
This article explores the journey to becoming employee-owned and also considers the experience of a tax advisory firm being the client and not the adviser in a tax-related transaction. The process of planning, communicating and finalising a change of company ownership is never a simple task – are things different when an EOT assumes control?
What is an EOT?
An EOT is a special type of employee benefit trust introduced in 2014 by the Cameron-Clegg coalition as an attempt to encourage more shareholders to set up a corporate structure similar to the John Lewis model. Championed by the coalition chancellor, George Osbourne, the aim of the legislation was to facilitate wider employee-ownership, albeit through an indirect holding.
By aligning the goals of stakeholders and employees, EOTs encourage employee retention and engagement while also ensuring the fruits of successful financial performance are shared equally amongst those who contribute to the business.
From a tax perspective, the benefits are generous and immediate. Disposals for UK individual shareholders are not subject to capital gains tax, giving a significant tax incentive over a third-party company sale which would normally be charged at 20% (or 10% if the individual has any business asset disposal relief (BADR) – formerly known as entrepreneurs’ relief – remaining). In addition, the EOT can pay bonuses of up to £3,600 to employees which are free of income tax. The bonuses are eligible for corporation tax relief, giving a further benefit to the company.
As of June 2022, the Employee Ownership Association (EOA) reported that 1,030 UK businesses were now in the hands of their employees. 2021 was a record year for EOT transactions, with 285 businesses making the transition. The UK EO sector has doubled since 2020, painting a very clear picture that EOTs are becoming an increasingly popular exit route for business owners.
YesTax’s EOT decision
The decision to transition to an EOT model can be prompted by several factors, both internal and external. YesTax had been approached by a third party in late 2021, who wanted to explore the possibility of an acquisition.
The offer was considered with interest, but after several months of negotiations, it was felt that a sale to a third party was not in the best interests of everyone involved in the business. The reasons to move away from a third-party sale prompted a discussion about the possibility of an EOT. Many staff had previously worked at an advisory firm which had been acquired by a large multinational and one of the key reasons for joining YesTax was the small, independent nature of the business. A sale to a third party went against the very reasons YesTax had been established.
An EOT provided the perfect exit route for the owners of the business and was very much in tune with YesTax’s culture. EOTs can be structured to facilitate a long-term exit for the business owners. The average age of the shareholders was a little over 40, so the desire to continue working in the business, while gradually allowing staff to assume more senior roles, seemed a perfect fit. The EOT would also allow the business owners to crystallise some of the value which had been created in the business since its formation in January 2019. By April 2022, the decision to move to employee ownership was unanimously agreed at the monthly board meeting.
Due diligence
The first formal task of an EOT transaction is to value the company. While self-valuations are possible, it is recommended that an independent valuation is sought to establish the true market value and avoid any tax complications on the sale of the shares for the shareholder. The valuation report and other justifications are then sent to HMRC, with clearance normally given within four weeks. In YesTax’s case, clearance was given within this stated timeframe.
A cursory glance at any EOT adviser website will often proclaim the quick, hassle-free nature of EOT transactions. While this may be true when compared to a third-party business sale, there are several factors which can increase the due diligence workload and the complexity of the sale.
One such complication is when a company opts to finance some or all of the sale consideration with third-party finance. As part of the sale transaction, it is often possible to arrange for a larger initial payment to be funded by a bank loan to the company. The bank loan is then paid back out of the company’s future profits over a period of time. In most cases, the bank loan will not cover the full sale consideration, so future profits will also be required to settle the remaining sale consideration not funded by the loan.
In the case of YesTax, the initial consideration was made up of a combination of cash held by the business and external finance. Understandably, the latter introduces a much greater degree of financial scrutiny, akin to a third-party business sale. The notion that an EOT can be a speedy, stress-free transaction is somewhat misleading when third-party finance is involved.
It’s an odd situation for any tax adviser to be on the receiving end of due diligence requests relating to their own business. All readers will have been on the receiving end of client frustrations where the client feels the request for information is unreasonable or unjustified. As tax advisers who understood why data was being requested, blood pressure levels were kept within safe medical parameters but it would be untruthful to state there wasn’t the odd expletive-laden initial reaction when certain requests came through.
While financial due diligence related to the EOT loan devoured much of the time spent on the transaction, consideration was also given to how the EOT would be structured. There are rules and regulations to be followed for the EOT to remain valid, and these have to be reflected in the trust documentation which underpins the ownership model.
Working with specialist EOT advisers, the trust documentation was prepared to ensure legislative compliance and to reflect how the owners wanted to reward staff.
Financial and legal considerations are not the only planning aspect to consider when transitioning to employee ownership. EOTs introduce a huge cultural shift within the firm and thought must be given to how the firm intends to transition, and over what time period. At YesTax, the key considerations were:
- What role do the current owners want to undertake, post completion?
- How long do the current owners wish to be involved with the business?
- What should the organisation structure look like after one, three and five years, post completion?
- How can we develop existing staff to become future leaders of the business?
- Do we need to recruit to fill any skill gaps?
- How and when will the EOT be communicated to staff?
The final point is worthy of further examination and was considered critical to the initial success of the transaction.
Communicating with staff
When and how to communicate EOT plans with staff is arguably the most difficult aspect of the whole planning process.
In a third-party sale, many owners opt to inform staff at the very last minute, with some not even disclosing the sale until completion has occurred. While this approach has its justifications, communicating EOT plans to staff moments before completion seems unfair, given that it’s the staff who will be material beneficiaries of the transaction. The pertinent question is clear: when is the right time to inform staff?
First, it’s worth noting that there is no right answer to the question. Having sought advice professionally, and having trawled through countless online EOT resources, the answers to the question varied wildly.
Communicate too early and there is a risk that the EOT falls through, leaving staff bewildered and confused, and possibly concerned that the business owners are looking for an exit at the next opportunity. Communicate too late, and staff may feel overwhelmed by the new ownership model, unsettled by their new-found status of indirect business owners.
YesTax opted for a ‘somewhere in the middle’ approach. The initial plan was to communicate to staff four weeks prior to completion, when there would be a high level of confidence that the deal would complete. Due to unforeseen due diligence delays, the plans were announced closer to eight weeks prior to completion, giving staff sufficient time to absorb the news and to ask questions about how things would work in the future.
The announcement was made in a team meeting, and a frequently asked questions document was prepared as a hand-out. A post-work social event was arranged immediately after the meeting and this proved an extremely useful forum for questions to be asked.
Thankfully, the EOT announcement was met with an overwhelmingly positive response. One justified concern was how long the current owners would be staying in the business. However, the transitional phase at YesTax had been set at five years, so staff were reassured that the speed of change would be kept to a reasonable level. One staff member summarised the mood at the post-work social event. Placing down his pint after a large swig, he commented ‘everyone’s a winner with this aren’t they?’. The communication plan had been a success.
Completion – YesTax as an employee-owned business
The delays in the due diligence process meant the target date of late September was no longer possible. Mild panic began to set in when the Bank of England announced a 0.5% base rate hike in late September, causing unease among lenders and borrowers across the country. However, YesTax’s lender agreed to honour the deal which had been set out a few weeks earlier on the condition that the transaction completed before the end of October. A sense of urgency was introduced into the deal and firm (but fair) emails were sent out to all those advising.
A further complicating factor was the fact that four of the five business owners were away from work in the last week of October. It soon became apparent that this would be a deal completed in Dubai, Portugal, the Lake District and from a caravan on the south coast of England.
As the final week of October arrived, it was clear that the deal was someway off schedule. However, monumental efforts from all advisers, business owners and even staff (one tax cConsultant was used as a delivery man to ferry documents from Sheffield to Nottingham) meant that the October deadline was met with one working day to spare. The speed of progress in the final week was an impressive feat, leading one director to comment, jokingly of course ‘I’ve absolutely no idea what I’ve signed this week!’
Final thoughts
Now the dust has settled on an eventful October 2022, it is satisfying to look back on the previous four years of the business. The EOT has provided an excellent framework to reward the staff who contribute to a business’s success. It has also provided an effective and relatively simple exit route for business owners who wished to crystallise the value of the business which had been created. Continuity is also a key benefit. In many ways, YesTax has been able to conduct business as usual.
There has been no major cultural shift, our commitment to give 2.5% of revenue to charity remains and our culture of rewarding staff for their efforts has been strengthened. These cultural ‘non-negotiables’ could not be guaranteed under a third-party sale. Of course, change will gradually be forthcoming, but a change which gives ownership and control of the business to those who contributed to its value can only be viewed as a success.
Article published in Taxation Magazine: https://www.taxation.co.uk/articles/employee-ownership-trusts-a-departure-from-convention
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