EOTs – Where can they go wrong?

Employee Ownership Trusts (EOTs) are a fantastic way to transition ownership, boost employee morale, and secure the future of a company.

Whilst EOTs have been around for several years after first being introduced into law in 2014, the tax advantageous exit option has continued to gain popularity in recent years as many business owners have become aware and find themselves asking themselves “Is an EOT suitable for me?”. Here, we explore some of the areas where EOTs can go wrong and, hopefully, aid you in avoiding these pitfalls.

Suitability, Suitability, Suitability

EOTs are not suitable for all businesses and choosing it as an exit option when it isn’t suitable will almost always lead to failure. Examples of when EOTs may not be suitable as an exit option include:

• Owners that are interested in an immediate exit. The structure of EOTs means that on completion, typically, only a percentage of the consideration is paid to the exiting owners, and this usually reflects the surplus cash and assets on the balance sheet, with the remaining balance being payable over several years (“deferred consideration”). The other factor that restricts an immediate exit of an EOT arrangement is that, in most cases, exiting owners will be required to stay on in the business post-completion to facilitate a sufficient handover to a new or promoted management team. It’s worth noting that this, to a certain extent, is also often the case in a trade sale.
• Due to the deferred consideration payment structure alluded to above, a business with inconsistent or volatile profits and cashflows would also not be suitable for an EOT transaction as it is unlikely to be able to meet the payment requirements reliably. This point is equally relevant when considering the market value of the business in relation to the expected future cashflows of the business. In short, the deferred payment plans must be reasonable and realistic

Valuations: A Delicate Dance

Another area of potential pitfalls of an EOT arrangement focuses on the key concept of determining the value of any business contemplating such a transaction. In order to achieve the lucrative tax treatment that is available to an EOT transaction, a business must be sold for “fair market value”. Determining this fair market value is typically the job of an independent advisor who will prepare a valuation report as well as obtaining HMRC tax clearance in most cases.

So, what if the owners of a business choose to ignore the valuation conclusion and decide to sell for an amount in excess of fair market value? Well, the consequences are twofold:

Firstly, any amounts received on sale in excess of fair market value are unlikely to get the advantageous and lucrative tax treatment. Instead, HMRC are likely to levy income tax charges on the excess consideration.

Secondly, there’s the potential to put the EOT transaction at risk. Ultimately, most EOTs are transacted on a “win, win” basis, where it is in the best interest of all parties involved. For the trust that acquires the shares on the employee’s behalf, it is unlikely to conclude that buying the shares of the company at a price that is above market value is in the best interests of the employees.

Avoid Burdening Employees with Debt

Exiting shareholders may be tempted to speed up their exit with the use of third-party debt, thus avoiding a lengthy deferral of consideration. Whilst this may be suitable in certain cases, this method should, however, be approached with extreme caution.

Most traditional high street lenders tend to shy away from funding EOT transactions, which has resulted in a rise in alternative lenders in the space. These lenders often match what is deemed to be riskier lending with higher interest rates, as we would expect. This means that debt servicing post transaction can often leave businesses struggling to keep up and can even impact employee motivation for the transaction, after all, who wants to take on a business with a significant debt burden?

The bottom line is that, for many, EOTs are a way of ensuring succession of the business is achieved and you want to give the new ownership model the best chance of success in  every way possible. One way of doing this is to avoid becoming over leveraged.

Staying In Line with Best Practice

There’s a plethora of guidance when it comes to best practice for EOTs, and failure to adhere to the best practices is likely to lead to either an unsuccessful transition or even disqualification from being treated as an EOT. The following points listed are all “disqualifying events” when it comes to EOTs:

• The company ceases to trade;
• The EOT ceasing to meet the all-employee benefit requirements or controlling interest requirements;
• A breach of the limited participation requirement; and
• The trustees not observing the rule of equality.

Of the above, the most common issue an EOT can fall foul of is not meeting the requirement to handover a controlling stake in the business. Not only must a business dispose of a controlling stake in the company shares (i.e., at least 51% of the shares), it must be able to demonstrate that the board of trustees isn’t controlled (either directly or indirectly) by the exiting shareholders. This is typically achieved by having an odd number of trustees appointed, typically three trustees, made up of an exiting shareholder, a new employee trustee, and an independent trustee. It’s of critical importance that any independent trustee is truly independent and is acting in the best interests of the employees. Yes, for exiting shareholders, that means the independent trustee shouldn’t be your best friend who is purely independent of the business!

Ultimately, failure to transfer control of the business to the EOT is likely to lead to detrimental tax implications and thus an increased tax bill for the sellers. I always find myself going back to a key accounting concept here…substance over form!

Maximise Employee Buy-in

Transitioning to an EOT model requires clear and consistent communication. If employees don’t understand the EOT structure, their rights, and the potential risks, it can breed mistrust and resentment. We therefore recommend that sufficient, dedicated time is allocated to ensure that the process is clearly explained to all employees and that any questions that may arise are answered in a timely fashion.

Why You Need Expert Guidance

 EOTs offer a compelling ownership model, but navigating the potential pitfalls requires expert advice. A qualified advisor or accountancy firm with experience in EOTs can help you:

• Prepare a fair and independent valuation.
• Structure a sustainable financing plan for the EOT.
• Develop clear communication strategies for employees.
• Review robust legal agreements prepared in conjunction with legal advisors to protect all parties.
• Establish a strong governance framework.

Don’t let your EOT dream turn into an EOT nightmare. By seeking professional guidance, you can ensure a smooth transition and unlock the full potential of employee ownership for your company.

For help and guidance with your own EOT transaction, please get in touch with our Corporate Finance team today for a free, no obligations, introductory meeting by calling 0330 058 6559 or email hello@scruttonbland.co.uk