Stories of company founders selling their shares Employee Ownership Trusts (EOTs) are starting to appear more regularly in the media, and we are seeing an increasing number of clients considering their use. High profile examples of businesses where owners have sold to EOTs include Aardman Animations and Richer Sounds.
But what are EOTs, and what are the benefits and downsides of using them?
What is an EOT?
An EOT is a specific type of “employee benefit trust”. Essentially, it is a trust which holds more than 50% of the shares in a company for the benefit of the employees of that company. The employees therefore become the ultimate owners of the company.
What are the benefits of an EOT?
If a company owner sells his or her shares to the EOT, they will not pay any capital gains tax on the sale proceeds. This is compared to the case where the owner sells to the management team, or to a third party buyer, where the owner will pay capital gains tax (currently at 20% of profits, or 10% where Entrepreneur’s Relief is available).
Employees can benefit financially too. As well as being able to receive a share of the profits of the business, they can receive up to £3,600 per year in tax free bonuses.
The EOT results in all of the employees having a stake in the company and benefiting from its profits, as opposed to control remaining in the hands of a few owners, or a new management team after a management buy-out. This can help to incentivise and engage the employee base, in turn driving performance and profitability.
Why are EOTs becoming more popular?
There are several reasons for this.
Firstly, general awareness is increasing, as more stories appear in local and national media.
Secondly, the restriction of the lifetime allowance for Entrepreneur’s Relief in the March 2020 budget means that, for some business owners, they may now pay 20% capital gains tax on all or a very significant proportion of the sale proceeds of their business, as opposed to 10% previously. That is incentivising owners to look at other ways of reducing their tax liabilities.
Thirdly, in the current economic climate, there may be less buyers for businesses, and fewer management teams willing to step forward and take on the financial risks of a traditional management buy-out. The EOT offers owners a way to exit the company without having to find a buyer, and without individual members of the management team having to take on financial liabilities.
Great – where do I sign up?
Few good things in life come for free, and EOTs are no exception. An EOT is not suitable for every business and every business owner, so careful thought and planning must go into the decision to form an EOT.
In particular, although the owner does not pay capital gains tax on selling to the EOT, if the EOT wishes to sell the company shares in the future, it will pay tax on the proceeds as if it had purchased the shares for the price paid by the original owner. For example, if the owner started the business from scratch for £1 and sells the business for £1m to the EOT, and the EOT then wants to sell for £2m, the EOT will pay tax on the full £2m proceeds of sale, rather than just the £1m gain in value from the price it paid to acquire the shares. That makes it very tax inefficient for the EOT to sell the company, and once an EOT is formed, it is difficult to go back. This means EOTs do not work well where the incentive for the management team to drive on the business is the prospect of a future exit.
In addition, the seller will also usually be reliant on the company to continue making a profit to be paid the full sale price, but the level of control that the seller is allowed to keep over the company is limited. And there can be significant administrative costs and burdens to maintain the EOT.
So whilst we expect to see EOTs becoming more popular, they are not for everyone.
We can advise business owners on the legal requirements for an EOT, and on the different considerations to take into account. The above is only a summary and is not specific legal advice. If you need any advice on EOTs, or other employee incentive schemes, please contact our Corporate Team.
Andrew Cooper ([email protected] – 01284 717511)
Simon Ratcliffe ([email protected] – 01284 717426)
Neil Walmsley ([email protected] – 01284 717416)
Mark Daly ([email protected] – 01284 717500)