An Introduction to Employee Ownership Trusts
Providing readers with an easy to understand overview of this compelling employee ownership structure. A 'must-read' for anyone considering a transition to employee ownership as an alternative to selling their business. It will also serve as an invaluable introduction to professional advisers and lenders interested in participating in this growing sector.
EOT vendor-financed transactions - "Baked In" or "Bake Off"
A question that has been raised with RM2 a number of times in the context of structuring vendor-funded Employee Ownership Trust (EOT) transactions is whether the better structure for a vendor would be for the vendor as part of their consideration (i.e. the purchase price) to not take a “loan note” from the target company but instead to structure the transaction so that the debt interest that would have been payable under the “loan note” is instead capitalised and added to the principal balance. The capitalised interest plus the principal would then form part of deferred consideration and would be documented in the share purchase agreement (SPA) itself.
The main reason put forward for adopting this approach appears to be one primarily of tax. Broadly speaking, the interest on the loan note instrument which would be taxable in the hands of the vendor is “rolled up” and treated as part of the deferred consideration in the SPA. This element of deferred consideration would then benefit from the capital gains tax relief afforded to vendors as part of EOT transactions (assuming that all the other legislative requirements have been met).
RM2’s view on this approach is that this could be the “tax tail” wagging the commercial dog. There is also a commercial imperative in these situations. The commercial reality is that if there is a loan note instrument in place, this will be a significant advantage in a situation where the vendor loan is refinanced with a bank lender part way into a ten year overall debt repayment programme. There is no need to modify any original transaction documents as the vendor loan would simply be refinanced and replaced with the bank loan. The EOT and the company may well wish to undertake this sort of refinancing to allow themselves to pay back more quickly the more expensive vendor loan.
In addition, we question whether the EOT trustees should accede to a position whereby the “reward” for the vendor (in terms of the loan interest) is effectively “baked in” to the position on the date of sale without sufficient regard to the “risk” inherent in the next following years of trading.
In conclusion, we note the rather aggressive tax planning nature of this suggested approach. However, RM2 consider that we should always be mindful of the concern in relation to EOT transactions that the EOT should not be overpaying to purchase the target company. If the EOT finds itself in the position that it cannot readily refinance its debt if desired, this will do nothing to assist the company and its employees going forward (and more generally the reputation of EOT transactions as a viable alternative to trade sales or private equity sales).