The increasing popularity of employee ownership trusts

An employee ownership trust (EOT) is a structure whereby employees have an indirect controlling stake in the shares of their employing company, or its group's parent company, via a trust formed specifically for that purpose. John Lewis & Partners is probably the most widely known employee-owned company in the UK, but it has been joined by many more businesses over the past few years.

A number of years ago, the government undertook research into the performance of employee-owned companies, and found that they tended to outperform other businesses in similar industries and were more resilient in times of economic downturn. The government therefore introduced generous tax reliefs in 2014 to encourage companies to move towards employee ownership. There are two key reliefs available and, subject to all of the conditions being met:

shareholders selling to an EOT can benefit from a 0% tax rate on the entire amount of any capital gain arising on disposal; and
employees of an EOT-controlled company can benefit from tax-free bonuses of up to £3,600 per year.
Employee ownership is still only commonplace in a relatively small part of the UK economy, but the number of companies moving to employee ownership has rapidly increased in the last couple of years, perhaps in part due to the reduction in the maximum lifetime relief available under business asset disposal relief (formerly entrepreneurs’ relief) from £10m to just £1m. An RSM freedom of information request to HMRC last year found that, in 2019, a total of 38 companies made clearance applications to HMRC relating to sales to EOTs, increasing to 100 companies in 2020, 383 companies in 2021 and, in the first four months of 2022, 123 companies.

How is an EOT structured?

In an EOT transaction, the shareholders of a company sell some or all of their shares to a trust, the EOT. In order to qualify for the available tax reliefs, the EOT must obtain control of the company, so it must acquire more than 50 per cent of the company’s ordinary share capital, voting rights and rights to dividends or similar distributions.

The EOT holds the shares in the company for the benefit of the trust beneficiaries, who are the current employees of the company or group at any time. It is important to note that the employees do not directly hold shares in the company: their ownership is indirect via the EOT. Upon ceasing employment with the company or group, individuals lose entitlement to any rights or value in the EOT. Subject to specific limited exceptions, all current employees must be included as beneficiaries of the EOT and the ‘equality requirement’ must be satisfied, which means that benefits provided by the EOT must follow the strict requirements in the legislation for how they are distributed; EOTs cannot be used to selectively benefit only senior employees for example.
There are various conditions that must be met in order for the tax reliefs to be available, so it is important that a full analysis of the conditions is undertaken prior to an EOT transaction, and it is always recommended that advance clearance is sought from HMRC. HMRC looks closely at transactions for which EOT tax relief is claimed, and so it is critical that all aspects of the legislation are complied with, or relief could be denied.

Why are EOTs becoming increasingly popular?

Moving to employee ownership can have many benefits for the selling shareholders, the employees and the business itself. Some of the main drivers behind many EOT transactions are listed below.

The benefits for selling shareholders are that:

• their legacy, being the business they have built, is preserved;
• they are able to continue working in the business to the extent that they choose to do so;
• time and money does not have to be invested in trying to find a suitable buyer; and,
• they can benefit from a 0% tax rate on any gain on disposal (provided all of the conditions required to qualify for EOT tax reliefs are met).

The benefits for employees are that:

• they are able to remain in their current jobs and operate within essentially the same structure with minimal disruption, in contrast to the outcome of many other types of major share transaction which often result in significant change and, in some cases, job cuts;
• they often feel more valued by their employer and feel they have a voice in terms of the direction of the business;
• they are eligible to receive bonuses of up to £3,600 per year tax (but not National Insurance contributions (NICs) free, provided all of the conditions for EOT tax reliefs are met; and,
• they are potentially able to share in the success of the business going forwards.

The benefits for the company are that:

• staff are more invested in the profitability of the business, and the business may therefore benefit from increased resilience and productivity;
• employee retention is often higher as employees are more incentivised to stay with the business; and,
• it can be more attractive from a recruitment perspective, given both the ethos of employee-ownership and the potential benefits arising, and this can often differentiate it from its competitors. 

EOTs are proving extremely popular at present. Given the current economic landscape, some buyers are unusually nervous about making acquisitions, meaning it is more difficult for some companies to find an appropriate buyer, leaving the shareholders with fewer options to exit the company or find a succession route. In addition, third party transactions are often subject to significant earn-outs which some sellers are concerned about in the current market.

Rumours of increasing tax rates are also causing more shareholders to consider EOT transactions when disposing of qualifying shareholdings.

How is the transaction funded?

EOT transactions are often funded, in part, through the company’s, or its wider group’s, existing cash and reserves at the time of a transaction, and in part by way of its future profits. It is therefore important that the company has the ability to generate the necessary profits and cash, in order to pay both any initial and any deferred consideration, which usually means ensuring a trusted management team are in place. It is possible to directly incentivise selected key employees with directly held equity alongside the EOT, to encourage them to remain with the business and drive it forwards.

Many companies pursuing employee ownership also look to obtain bank funding, which can increase the amount of consideration that can be paid upfront to exiting shareholders.

Could an EOT be a potential disposal route?

EOTs can be a successful structure where the selling shareholders are keen on the employee ownership philosophy, and are genuinely willing to relinquish control. EOTs do not tend to work well where selling shareholders are only interested in the tax reliefs and the structure does not align with their personal or commercial objectives.

Employee ownership is not right for every business, and shareholders will want to consider a range of alternatives when taking such an important decision, including perhaps a trade sale, private equity investment or a management buyout. There are a few key questions that can help to identify if EOT ownership is likely to be a successful route for a company to follow. These include the following.

• Are the shareholders looking to retire or step back? This is not a requirement for an EOT, but an EOT is often used as a way to facilitate succession.
• Is the company profitable and cash generative? If not, an EOT is unlikely to be attractive to a selling shareholder.
• Does the company have key individuals remaining with the business after the transaction, who can drive it forwards to continue generating profits?
• Are the shareholders willing to wait for some of their sale proceeds, and accept the risk that deferred consideration inherently brings? If not, an alternative route with all of the proceeds received upfront may be preferable, notwithstanding the higher tax charges that may apply.
• Is the company struggling to sell to a third party, or do the shareholders want to ensure the business continues in its current state going forwards?
• Are the shareholders willing to embrace the ethos of employee ownership?

For more information, please get in touch with Martin Cooper or your usual RSM contact.