Employee Ownership Trusts: How do they work?

An EOT is a type of trust that a private business can set up with the aim of transferring all, or some, of ownership to its employees. Fundamentally, the employees must have a controlling interest (that is, 51% or more) but since they do not need to have complete ownership it has become more common for a co-ownership structure where the original founders or shareholders retain a direct personal interest, but transfer the majority of shares to a trust established for the purpose of benefitting employees.

This particular structure has been popularised in the recent years off of the back of the Finance Act 2014 which introduced various tax reliefs and incentives to support those engaging in this model.

Employee ownership trusts are an attractive ownership model for preserving the state and culture of a business during succession and exit, particularly for small and medium-sized enterprises (SMEs).

There are many stages involved in establishing the EOT including:-
1. Speaking with professional advisers to understand the requirements for an EOT and if this is the right model for you – this will include a tax advisor, valuer and solicitors with experience dealing with Employee Ownership Trusts
2. Getting a fair valuation undertaken for the business taking into consideration its profitability and level of success thus far, the market in which it operates, and the assets it holds
3. Applying for and receiving tax clearance from HMRC
4. Determining who will comprise the management and leadership of the company once its new structure is in place, as well as how existing payment structures will fit into the new ownership and whether remuneration needs to be restructured
5. Appointing trustees/directors of your new EOT which should include a representative for the employees as well as an independent person
6. Preparation and execution of the legal documents which may include incorporation of a new company as well as preparation of a Trust Deed and bespoke Articles of Association
7. Registration of the trust with HMRC

Setting up an EOT can be a protracted process considering all of the stages involved from consultation, to valuation, clearance and registration. The entire length of process for setting up an EOT typically takes 4-6 months

Like any other business trust, an EOT is managed by its trustees. However, it is common for a trustee company to be incorporated which would be managed by its directors. Careful consideration therefore needs to be had to who the trustees/directors will be of the EOT. Everything a trustee does in relation to the trust itself must be done in the best interests of the beneficiaries, i.e. the people who benefit from the trust. In the case of an EOT, these are the employees of the business.

It should be noted that a trustee’s role is solely in relation to the trust itself and not the business to which it is attached. It may be that a member of the business’s management team is also a trustee, but their two roles will be distinct and conducted separately albeit for the benefit of the same company and employees. Careful consideration therefore needs to be had on who will be a director/trustee of the EOT and who will be a director of the trading company.

An EOT is generally funded by the company. Money from its profits is paid out to the EOT over time, with the trust being upkept by the company’s future profits.
However, payments may also be aided—or funded entirely—by a bank loan. This is entirely feasible, but obviously not as preferable as the company funding the EOT and keeping the chain as short and simple as possible.

With the funding received from the company and/or loan, the EOT then pays the selling shareholders for their shares. This is commonly undertaken on a deferred basis with a portion of the sale proceeds being paid out on completion, and with the balance paid out over a period of time therefore relying on financial assistance from the target and ultimately profits of the trading company to fund the transaction. Unlike a normal management buy-out scenario, the Sellers will not be able to have security for their deferred consideration therefore it is not unusual to include additional ‘seller protections’ in the sale contract as well remaining on the board until the deferred consideration has been paid.

Once the EOT has paid its dues to the shareholders who sold their stakes in the company, the remaining profits can be distributed to the employees of the business.
There are strict rules guiding how the profits can be paid out to the various employees, and while the payments can vary according to an employee’s salary and contribution in terms of hours worked, it may not be adjusted according to performance and crucially it must be payable to all employees.

You cannot set up an EOT with payments established to benefit one specific team only. The reason for this is that the beneficiary meets the criteria by being an employee of the company—it is not a bonus or reward for good work, nor can it be withheld as a punishment for poor work. Of course, it is possible to require employment for a period of time before becoming a qualifying beneficiary, this is typically 6 months – 12 months service but cannot be longer than 12 months.

At the moment, bonuses paid to beneficiaries of an EOT are income tax-free up to £3,600 per UK tax year, after which point they will be subject to income tax. This is something to bear in mind for individuals, as it could make their personal tax situation more complex. It should also be noted that while bonuses are free from income tax (up to the above threshold), they are not exempt from National Insurance contributions.

During the process of setting up an EOT is the ideal time to make things like this clear to the intended beneficiaries, and an experienced solicitor can help by being an informative source on aspects such as these.

EOTs are generally a good thing for the employees who stand as its beneficiaries. It means a greater involvement and higher stake in the business than what would normally belong to an employee, and it can ultimately mean a more profitable time within a job role for the individual.

This feeds back into the job itself and levels of employee satisfaction. Having a stake and therefore an actual interest in the company gives employees a greater sense of commitment and can lower rates of staff turnover.

EOTs are good for giving staff a better means to identify with their roles and with the company they work for, giving them a sense of pride to be partly in ownership of the business even if only by a small piece.

The UK Employee Ownership Index has shown that even small-scale staff ownership confers benefits to employees that benefit the business itself as well as the individuals making up the workforce.

While EOTs aren’t necessarily right for every business, they can most certainly be positive for the staff running the business and grant plenty of benefits to make them worthy of consideration.

EOT schemes are not entirely perfect, and as such they have drawbacks as well as strengths.
Some of the advantages of EOTs include:

Profit

EOTs can be financially beneficial to both the business and the employees. The benefits begin early by applying to exiting shareholders, allowing them to sell their shares with exemption from Capital Gains tax. Meanwhile, employees can receive annual bonuses up to £3,600 without paying income tax.

Preservation

EOTs are an attractive option for owners who want to pass their business on without disrupting the culture and legacy that they’ve worked to build. By using the EOT, the business goes to no one person and enjoys a smooth transfer from its original owner to its new ownership under the trust.

Company image

A business that hands itself over to employees enjoys a favourable image from the public and from its staff, signalling a true intention to ‘give back’ to its workforce. This can be as much as useful PR tool as it is a direct benefit to the business’s structure, and is useful for business owners who don’t want to risk their company’s good image being destroyed by new owners.

Transaction Security and low risk

EOTs provide a great amount of transactional security. Given that they avoid selling the business to a third-party buyer, there’s no risk of the deal falling through so long as all controlling shareholders are content with the plan. Additionally, the process can be kept confidential in its early stages, minimising interference and speculation until the scheme’s setup is well progressed. It also means that the Sellers will not be required to deal with extensive due diligence or expected to give onerous commercial warranties as the buyer is an EOT, and the directors therefore intimately aware of the business already.

There are some potential cons to EOTs, including:

Employee ratios: EOTs have several requirements attached to them that dictate which businesses can transfer to EOT ownership. One of these stipulations is the ratio of directors to employees, which must be no more than 2/5, respectively.

Bear in mind that the ‘directors’ side of that ratio will include any of their relatives working within the business, which can skew the ratio even if only one relative of any director is employed. For this reason, small and/or family-run businesses may be outright unable to adopt the EOT structure.

Broad eligibility

As mentioned earlier, payments to beneficiaries are not performance bonuses. Every employee benefits from the scheme equally.
While this is arguably a big benefit to EOTs, it could also be seen by some as a drawback. Those who don’t work nearly as hard as others stand to profit from their part of ownership the same as others who made earnest effort all year round.

Limited deal security and options

Whilst you can still realise fair market value for the shares based on an independent valuation, to establish an EOT and get the various tax benefits there are strict requirements insofar as the deal structure is concerned. You are unlikely to get full market value on completion (unless the EOT has secured a commercial loan, which is less common) and are likely to rely on deferred consideration payments without security for these payments. Other options, such as an earn-out provision, may not be commercial viable or available when pursing the EOT route which you may be able to negotiate with a trade buyer.