Luke Morris, Corporate Finance Partner examines the growing popularity of Employee Ownership Trusts (EOTs) and explains how they work.
Last month Julian Richer, the founder and sole owner of Richer Sounds, announced to staff that he was planning to transfer 60% of his shares to an EOT, a scheme like the one run by John Lewis.
The arrangement has been structured so that Richer Sounds – successful and cash rich – will essentially pay Julian £9.2m for the shares. On top of that, he says he will then give £3.5m of that back to his 522 staff (£1,000 for every year they have worked for the retailer, in case you were interested).
Now, as well as being a very successful and creative retailer (one of his London stores still holds the record for highest retail sales per square foot), Julian is an interesting character who you might have expected to go for this sort of thing: a serial entrepreneur, no children, author and animal rights campaigner with a fascinating and unique story. But what is more interesting, and what we are seeing in practice, is that use of EOTs is becoming far more common.
Should we all be thinking about becoming more like John Lewis?
The Employee Ownership Association says more than 350 businesses have now adopted the model, with at least 50 more preparing to follow suit. Other recent converts include Riverford, the organic vegetable box company and Aardman Animations, the Bristol-based film studio behind Wallace & Gromit. Closer to home, Scrutton Bland’s Corporate Finance team are also reporting a rise in enquiries regarding EOTs.
The idea of employee ownership, particularly ESOPs (Employee Share Ownership Plans) has been around for about 50 years. It originated in the United States where the principle is mainstream. My experience working with cross-Atlantic business negotiations is that many US corporations have some form of ESOP; involving employees over time is a common alternative in the US to selling a business to a third party.
The term “ESOP” is also sometimes used informally here in the UK, and for a number of years there has been an established Employee Benefit Trust (“EBT”) structure. However, the recent upward trend reported by the Employee Ownership Association can be traced back to the last coalition government when the idea of “inclusive capitalism” or the “John Lewis Economy” made good political headlines, and seemed based on data suggesting employee-owned businesses are more profitable in the long-term, create more jobs and are more productive and resilient than their traditionally-owned peers. Vince Cable in particular championed the EOT structure. For him the legislation met his political desire to increase employee ownership in the UK economy, by providing the “carrot” of generous and structured tax incentives to encourage uptake by entrepreneurs.
Greater employee engagement and commitment would, you think, also mean reduced absenteeism and more “hunger” from the workforce. Plus the legislation permits EOTs to pay tax-free cash bonuses to their employees of up to £3,600 per employee per year.
But for employees, perhaps the primary benefit in establishing a new long-term owner of the business (ie a trust for the benefit of the employees) is that the risk to the business and to employee security inherent in succession planning and transition is mitigated. No need for staff to fear “what will happen” if or when their boss sells the business. And all this without them having to use their own funds.
How it works
In order to qualify for the tax breaks, the EOT needs to be structured in a particular way. There are three key steps:
- A qualifying EOT will be established with a company as the trustee of the EOT (the Trustee Company).
- The divesting entrepreneur then sells his or her shares to the Trustee Company under a share purchase agreement (which must be more than 50%). The entrepreneur and the Trustee Company jointly engage a share valuation expert to value the company, and the Trustee Company uses this valuation as the basis for determining the purchase price. On the sale of the shares, the purchase price will create a debt owed by the Trustee Company to the entrepreneur which will be left outstanding.
- The underlying business will continue to generate trading profits each year and it will use these profits to make contributions to the EOT. The EOT will use these contributions to repay the outstanding purchase price that it owes to the entrepreneur.
Provided this is done correctly, no Capital Gains, Income or Inheritance Tax liabilities should arise on the disposal of a controlling interest in a company to an EOT, and directors can remain in post, receiving market-rate remuneration.
As with any transaction, it is crucial for shareholders contemplating an EOT consult with expert and experienced professionals. To qualify there are a set of conditions to meet, and there are legal, tax, financing, valuation and commercial considerations to be made. EOT may be a growing model and should be considered as part of a strategic review of succession options, but it will not be for everyone.