What do you need to know about leadership succession and benefits of an Employee Ownership Trust?

This article is by Grant Thornton

Every business needs to have a succession plan in place. But what if the traditional strategies of either family succession or a trade or private equity sale are not desired or unavailable?

What if it is important to both continue to engage a loyal workforce in the long term as well as preserve the integrity and continuity of the business, whilst enabling current shareholders to exit?

The COVID-19 pandemic has amplified these questions and has led to many entrepreneurs and business owners reassessing their succession planning strategies. An Employee Ownership Trust (EOT) could provide an attractive alternative for business owners and is now often included in the range of exit options available.

An EOT allows a business owner to dispose of the majority of their shares and realise gains free from Capital Gains Tax (CGT), whilst also allowing their business to retain its authenticity.

At the same time, employees will share in the future success of the business and be incentivised to grow long-term value. Creating or enhancing a strong culture of employee engagement can provide an engine for growth, without external investors.

What is an EOT?

An EOT is a special statutory trust established by a trading company for the benefit of its employees. The owner can sell between 51% (i.e. more than 50%) and 100% of their shareholding to the EOT. Following their disposal, the original owners can choose to remain involved or step back from the business immediately or over time. This enables owners to control the timing and nature of their succession.

Why consider selling to an EOT?

EOTs profit from two key tax benefits. Firstly, shareholders selling more than a 50% shareholding in the business can do so without paying any CGT. And each year, employees of a business owned by an EOT can receive cash bonuses of up to £3,600 per employee, free of income tax. In addition to the tax benefits, there are a number of commercial reasons to consider an EOT:

(1) Leadership succession

Without formal ownership planning, businesses run the risk of not being sustainable. Some owners do not want to plan or think about their withdrawal from the business. This reluctance typically arises from a strong sense of attachment; an aversion to letting go of control; fear of retirement; and, also, the inability to make succession choices between their children. Financial factors also often play a part.

However, successful succession plans can take years to evolve and an EOT can give the flexibility to realise value now whilst allowing the time to develop or identify future leaders of the business. After the sale to an EOT, the original owner can remain significantly involved with the business to help develop the new leadership team and, at the same time, retire on gradual terms.

(2) Growth Planning

Employee-ownership structures engage employees in a more meaningful way which can result in increased efficiency and lower cost, producing higher growth. In the UK, productivity levels have been relatively flat since the last recession and had taken a further hit at the start of the year due to the pandemic. In contrast, research conducted by the Employee Ownership Association (EOA) in 2020 reported that UK productivity rose by 5% in Q3.

The EOA research indicates that employee-owned businesses are more resilient in difficult economic periods and are more productive overall. It is thought that this is in part due to increased employee engagement brought about by involvement in decision making and the financial rewards of ownership. According to the EOA, in the last recession non-employee owned businesses grew sales by 0.6%, employee owned businesses grew by 11% over the same period.

(3) Employee Engagement

The evidence shows that productivity within a business is predominately impacted by how engaged its staff are. According to research by Jacob Morgan, covered in the Harvard Business Review, those businesses that invest in their employee experience are four times more profitable than those that don’t.

If implemented correctly, EOTs can create a culture of employee ownership and shared endeavor. The dynamic of the relationship will change from ‘what can my employer do for me’ to ‘what can I do for the business’.

Typically, employee owned businesses offer a high level of transparency and sharing of information so that employees can take more responsibility in helping drive performance and ultimately benefit from the reward. This increased feeling of responsibility will also often lead to improved decision making, improved all round performance and an increase in innovation.

Most innovation in today’s economy is stifled because employees are not encouraged to think this way, as the overall success of the company is not relevant to their direct reward. Employee ownership can change that.

Trust in UK business has been in decline since the last recession, yet employee owned businesses are nurturing a permanent and strong relationship of trust. “Almost 60% think that EOBs are more trustworthy than businesses not owned by their employees at a time when diminishing trust in UK institutions has recorded an historic low of 29% and trust in business is at 33%.” (Deb Oakley Chief Executive of EOA, 2019)

How is the disposal funded?

If the business has sufficient cash reserves, gifts of post-tax profits can be made to the EOT to fund a proportion of the sale consideration up-front. The balance of the consideration is typically owed on deferred terms structured through loan notes issued by the EOT and either repaid from future profits of the business (contributed to the EOT) or from the proceeds of a future sale of shares by the EOT.

Loan notes issued by the EOT will typically carry a rate of interest that is both acceptable to the selling owners and affordable for the business. Upfront cash consideration can also be funded from debt raised by the business and/or the EOT.

Common misconceptions around EOTs

Original owners need to step away completely

Not necessarily the case. The original owners are only required to sell 51% of the voting shares in their company and can remain as minority shareholders and as directors of the company fully involved in the day to day operations. It could also be used as part of a gradual retirement plan while developing a new leadership team to take the business forward.

Banks will not lend to an EOT structure

Based on our experience, where third party debt is required to finance an EOT transaction, the same due diligence and risk measures that would apply to a debt financed management buy-out, also apply to an EOT transaction. Where new management is untested, a bank might be more confident in lending to an EOT owned business where existing owners remain involved and it is moving into a more stable and sustainable ownership structure.

EOTs introduce an extra layer of complexity

Day to day, the EOT is a passive investor so the way the business is run, and management and operational decisions are made, does not need to change. All that changes is the identity of the majority shareholder. Over the longer term, to have the best chance of succeeding, a corporate governance structure that encourages employee participation could be introduced.

All employees are shareholders

The majority shareholder will be the trustee of the EOT and not the employees. The EOT will hold the shares on behalf of the employees, as its beneficiaries. As with any majority or sole shareholder of the business, the trustee will be involved in any significant strategic decisions and any decision relating to its share ownership, such as an offer to sell. In making these decisions the trustee must consider the interests of the employees and maximising both short and long-term value.

Further information and why Grant Thornton?

We would be happy to talk through whether the EOT approach could help majority shareholders exit as part of their succession planning and as part of a wider business strategy discussion. We provide a complete advisory and implementation service which includes advice on strategic exit planning, employee engagement, tax structuring, all documentation and valuation services.

Author and Contact Details
Dominic Merlin-Cone | Partner | Employer Solutions | Tax
For Grant Thornton UK LLP
T (direct) +44 (0)117 305 7667 |
E Dominic.Merlin-Cone@uk.gt.com

Andrew D Morgan Jones | Senior Manager, Employer Solutions | Tax
For Grant Thornton UK LLP
T (direct) +44 (0)29 2034 7561
E Andrew.D.Morgan.Jones@uk.gt.com

Monique Bealieu | Partner, Employer Solutions | Tax
For Grant Thornton UK LLP
T (direct) +44 (0)20 7728 2621
E Monique.Beaulieu@uk.gt.com