EOT - how much should a vendor sell?
One of the questions we get frequently from vendors is what percentage of the company’s shares should be sold to an Employee Ownership Trust (EOT). The answer will vary based upon the company profile and the vendors’ objectives. With only a few exceptions, our clients have elected to sell 100% of the shares to the EOT for the following reasons.
First, by selling 100%, the vendors are able to crystallise value and get Capital Gains Tax (CGT) relief on the full value of the business. They are able to diversify their wealth and de-risk.
Second, with a 100% sale, there will always be the need for subordinated debt to complement any third-party capital raised. For most SMEs, this subordinated debt will take the form of vendor loans. This means an opportunity to structure the subordinated vendor loans on commercial terms and provide the vendor with the ability to earn a 10-12% market return over time.
Third, if less than 100% is sold, the vendor will pay CGT on the sale of the remaining stake when it is sold. The minority shares will also be subject to a minority discount, unless the entire company is sold in the future, when selling the shares back to the company or the EOT.
Finally, there is more room for creating incentive shares for key staff when 100% is sold. The trust needs to maintain at least 50% plus one share. This means the company could issue new shares or Enterprise Management Incentive (EMI) share options for almost 50% of the business while retaining the benefits of the EOT structure. If the EOT only buys 55% of the shares, the amount of incentive shares or EMI options that could be created without further reducing the stake held by the vendors would be limited to just under 5%. This is the difference between the EOT’s ownership percentage and the level at which a disqualifying event would occur (50%).
For high growth businesses, it may make sense to retain a sizeable minority stake to try and maximise value. If growth is high enough, the value of the minority stake, even subject to CGT and a minority discount, may be significantly greater than the value of the retained stake had it been sold in the original transaction. Given projected performance, it would be relatively straightforward to perform an analysis that would indicate whether vendors would benefit more by selling 100% of retaining a stake in the business. The analysis would, of course, need to be based upon current tax structures and these could change over time.