Employee Ownership Trusts (EOTs) are increasing in popularity, with many business owners now looking at this succession route. 

In particular, family-owned businesses are opting for this exit path. At a stage where family members are considering exiting the business, it can often be a challenge finding a suitable buyer, not least one who is able to uphold the continued employment, core values, culture and identity in the business. 

In this article, we explore what EOTs are, their qualifying criteria, and why the model is growing in popularity as a way for shareholders to sell their companies for the best value and in a more tax-efficient way than a traditional trade sale.

What is an EOT?

An EOT is a special form of trust that purchases the shareholding in a trading company and then hold it on behalf of the employees as a whole. The shareholders of a company (i.e. the owners) sell shares representing at least a majority stake (51%) of the equity of the company to the EOT, which will then hold the shares for the employees. 

EOTs were introduced by the Government in 2014 to encourage founders and other shareholders to pass ownership of their company on for the benefit of its employees. The EOT model provides for every employee to be a part-owner of the business – a model famously adopted by The John Lewis Partnership. 

Whilst EOTs were slow to take off in the UK, they are now increasing in popularity. In June 2022, the UK Employee Ownership sector recorded the milestone of 1,000 employee-owned businesses. 

The growth in Employee Ownership has been attributed, in part, to the increasing realisation by family-owned businesses that EOTs offer an ideal solution to business succession. By acknowledging the role employees play in establishing the success of the business, owners can ensure their legacy is protected by the very people that helped develop it. 

What are the benefits of EOTs?

For the selling shareholders, the benefits of Employee Ownership include: 

• Tax advantages: No capital gains tax is payable on a qualifying sale of shares to an EOT (this does not apply to corporate shareholders). This provides a tax saving of up to 20% of the tax that may otherwise arise on the gain. 
• A straightforward sale: From a sellers’ perspective it should be a relatively friendly transaction as it is to an internal buyer and this can make the deal process quicker and allow management to focus on the business.
• A certain sale: There is no need to find a buyer to facilitate an exit (whether a trade buyer or private equity investor) so there is more certainty of completing a sale.
• The owners also do not need to sell all of their shares and can continue to hold their position as directors of the business.

For the company and its employees, the benefits include: 

• Bonuses: After the transaction, the company can pay eligible employees bonuses of up to £3,600 per year, free of income tax (these remain subject to national insurance). The company can take a corporation tax deduction for these bonuses.
• Retention: By owning part of the business, employees have a personal interest in its performance and growth. Such an enhanced employee engagement results in improved retention.
• Preservation of values: There is more certainty and stability for employees when the values and culture of an organisation are not disrupted through a third-party acquisition.
• Drives success – Employees are encouraged to be more entrepreneurial and motivated to contribute to business growth. 

How does an EOT work?

An EOT is established through the following steps: 

1. A qualifying EOT is set up. The EOT is a form of trust, that must have a trustee which is responsible for controlling the assets on behalf of the beneficiaries of the trust. The EOT will adopt a set of trust rules which must be complied with by the trustee; and 

2. The owners (i.e., existing shareholders) will then sell their shares (at a jointly obtained independent market evaluation) to the EOT by way of a share purchase agreement. The selling shareholders will usually sell their shares on day 1, but receive payments over a period of time (known as an “earn-out period”) and remain involved in the running of the business during that earn-out period. Upfront cash is funded either from an excess cash in the business or by a third-party lender. A substantial part of the consideration is often deferred and funded from future profits and cash of the business. 

What criteria must be met?

There are certain key qualifying criteria which must be met in order to benefit from the associated tax reliefs, including: 

• The target company must be a trading company or holding company of a trading company.
• The EOT must own more than 50% of the share capital and be entitled to the majority of the voting rights and more than 50% of the company’s profits and assets on a return of capital.
• Any distributions made by the trust or bonus payments must be made to all employees on the same terms. The trustees can distinguish between employees based on their remuneration, length of service and hours worked.
• The number of employees holding more than 5% of the company (or more than 5% of any class of share of the company) cannot exceed 40% of total employees. This may pose a problem for companies with a small employee base or those with multiple share classes held by small groups. 

We have experience at stevensdrake of advising companies and shareholders who are looking to transition to an EOT structure and have dedicated specialist lawyers and qualified tax advisors to cover the various aspects of legal and tax advice required.

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