Webinar: Three reasons why EOTs are booming in uncertain times

Posted by rosa.burnley at 12:21 on 9 Oct 2020

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We hope you enjoyed our Webinar on 7th October. There were lots of questions asked and in case you missed them here are the answers:

1. For staff who currently have shares or share options, they could be 'participators' and thereby excluded from being beneficiaries of the EOT. Could you comment on any implications of this?

Any employee who is or was in the last 10 years a 5% or more shareholder, or any employee related to such a person, is a “participator” and therefore an excluded beneficiary of the EOT. This means they cannot be included in any distributions directly from the EOT, e.g. the distribution of any sale proceeds if ever the EOT were to sell its stake. Incidentally, such employees must be included in any all-employee bonus pool if that bonus is to qualify for income tax relief, so the “participator” restriction applies only to direct distributions from the EOT. This restriction can seem harsh on people unrelated to the majority shareholders and who want to remain long term employees of the company. A common solution is to allow such employees to sell to the EOT alongside the controlling shareholders and be granted options in the new EOT-controlled company if the new board judges that to be commercially justified.

2. If a combination of EOT (51%) and private purchase from an existing employee (49%) was done, what exit options would the 49% share owner have in the future? Would they be constrained because the other 51% was owned by EOT?

The 49% shareholder could sell to the EOT, or to another person acceptable to the EOT, or could wait for the whole company to be sold. Note that a 49% stake is likely to be valued at a discount to a controlling stake and, if sold to the EOT, would not qualify for CGT relief as this is only available in the tax year when control first passes to the EOT. There are probably better ways of achieving the same economic effect as the one you describe, so please get in touch if you would like to discuss further.

3. Does RM2 have any evidence of the EOT model being exploited to permit structures and/or cultures not in the spirit of employee ownership?

No, but that’s not to say that all companies are completely culturally attuned to employee ownership when an EOT is established. It can take years to change a company’s culture and it’s not without risk. There are two schools of thought on the best approach: either work on changing the culture before an EOT (but be prepared for a long haul and for the possibility that the EOT might not happen after all) or convert to employee ownership and then gradually change the culture to get the very best out of that structure.

4. Is there a single reform you would advocate to the EOT regulation to increase its effectiveness?

I’m happy that the current legislation achieves the right balance of incentives for business owners to sell to EOTs and safeguards against abuse. I’m more worried about the long term effect of EOTs accumulating value that can’t easily be shared with employees. I’ve always felt that employee ownership should mean sharing wealth as well as empowering employees. My worry is that perfectly healthy EOTs will be dissolved unnecessarily to liquidate value for employees. So I would like to see EOTs being allowed to allocate capital stakes to employees, as in the American ESOP. I wrote about this in a paper called “Equity for All” which you can download free from Ownership at Work, a think tank connected to the EOA.

5. What steps would do most to build owner awareness of the EOT option?

Owner awareness is building already as more advisers realise it would be negligent not to include the EOT as a plausible exit option. I think the current pace of growth is fine: it’s sustainable and ensures high standards. I’d worry if EOTs became the next big thing.

6. What are the minimum transaction fees for a small company?

The best way to find out is to test the market. There are many good EOT advisers out there, some of them specialising in smaller companies. My advice would be: insist on experience (as you would for a heart surgeon!) and don’t skimp on the financial planning. You only sell your business once.

7. Could you touch on benefits to employees, new shares etc?

Employees become beneficiaries of a majority equity stake in a business, can receive income tax free bonuses of up to £3,600 per year, may be invited to become shareholders alongside the EOT and will almost certainly have the chance for more involvement in the running of the company, whether at job level or more formal governance level. There is no other way in which employees end up owning a company without personal financial outlay.

8. I had heard of some concerns that the contributions from the company to the EOT could be a taxable dividend in the hands of the trustees. Is that just over thinking it or is it a legitimate concern?

Although a company’s contribution to an EOT is technically a distribution (though not a dividend), and as such must be covered by distributable reserves, HMRC has not sought to tax such contributions as dividends when received by trustees. For HMRC to do so would undermine the whole EOT structure. There are various steps that can be taken to minimise this theoretical risk: put a dividend waiver in the trust deed, seek a s701 clearance from HMRC and structure carefully in the share purchase agreement the company’s obligations to make contributions.

9. Have you heard anything about the CGT exemption for EOTs being changed as part of the new CGT review that is being undertaken?

Only speculation, not even rumours with sources. I would be surprised if EOTs were attacked. They are still in their infancy, they are fulfilling their policy purpose, there is no known abusive practice and they don’t cost much in tax relief. There are bigger fish to fry.

10. Who can act as trustees?

The legislation is silent on this point, so any competent, diligent person could be a trustee. It’s common to include one or more employee trustees, it’s quite common to have an independent person, and it’s very common for one or more vendors to be trustees, though they must be outnumbered by people who are unconnected to them. It’s even possible to have a single professional trustee for companies that love outsourcing, though outsourcing control of your company to a third party is a big step!

11. Is there an exit route for the EOT or is it a permanent structure?

Yes. An EOT-owned company can be sold at any time if the trustees are satisfied that it would be in the best interests of the beneficiaries. Having said that, EOTs are set up to be sustainable, meaning they don’t have to be sold to work, unlike a private equity investment for example. An EOT could even to sell to a second EOT, unlocking value for the first generation. See Q4 above.

12. Do all employees have an equal share in the benefit of the EOT? What happens when employees leave or join?

Effectively yes, though this can be moderated by reference to employees’ pay, length of service or hours worked, or some additive combination of those factors. This is relevant when benefits are distributed directly by the EOT trustees (e.g. the proceeds of a share sale) or when the company pays income tax free bonuses. When employees join a company, they become beneficiaries after a qualifying period of no longer than 12 months, and when they leave they cease to be beneficiaries.

13. Would it be possible to use an EOT as a mechanism of combining two similar privately-owned (and culturally aligned) businesses – i.e. a merger followed by creation of an EOT. Are there any examples?

Yes, and some corporate reorganisation work in advance of an EOT transaction is common. For example, we’ve done demergers of non-core subsidiaries that founders wanted to keep outside the EOT, and we’ve combined separate companies into a single group with share-for-share exchanges prior to a sale to an EOT. Please get in touch with us for examples.

14. Where can I obtain your paper “equity for all”?

This is available at https://www.rm2.co.uk/resources/policy

15. When will this video be made available?

It is now available on our YouTube Channel.

If you have any further questions about the Employee Ownership Trust and whether this may be an appropriate avenue for your Company please contact us at enquiries@rm2.co.uk