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Partner Piece: The Rise and Rise of Employee Ownership Trusts by Kingsley Napley LLP

December 2, 2024

 

The Rise and Rise of Employee Ownership Trusts

 

Roughly ten years ago, the UK government legislated for employee ownership trusts (“EOTs”). Initially there was not much fanfare, but in the last few years their popularity has grown.

 

What is an Employee Ownership Trust?

Put simply, it’s the John Lewis business model. A company is sold to an EOT, which exists for the benefit of the employees of the company. All employees benefit equally, subject to some fairly limited powers to differentiate.

 

This has a number of positive effects. Generally, I think many would agree the employees of John Lewis tend to be impressive, and that is, in no small part, driven by the fact they all benefit if John Lewis does well – they effectively all own a small piece of the business. Their hard work is not for the benefit of a faceless shareholder, it benefits them personally, and all their colleagues. When all employees push for their employer to succeed, that business is more likely to succeed.

 

What are the benefits?

Capital gains tax (“CGT”) is the tax you pay when you sell shares – the main rate was increased to 24% in the recent budget.  A large part of the government’s CGT revenue comes from founders and other shareholders selling their shares to trade buyers / private equity / etc. One material benefit of an EOT is that shareholders who sell to an EOT (provided the legislative conditions are met) pay no tax. This can be a very substantial benefit for a seller, greatly increasing their net proceeds of sale.

 

Once the EOT owns the company, it is then able to pay bonuses to employees free of income tax (up to £3,600 per year). This can save the company significant amounts of tax, while also rewarding its employees. In our experience, most EOT owned companies pay these bonuses (why wouldn’t they?). Note national insurance is still payable.

 

Selling to an EOT can keep the business from falling into the hands of those who might damage it. Many founders are not just interested in money, they care about the employees they’ve often spent half a lifetime working alongside. What’s to prevent a third-party buyer “streamlining” the business by firing half the employees after sale? Or implementing “efficiencies” which might destroy the previous culture? With an EOT, that can be fairly easily protected against.

 

As touched on above, the likelihood of the company flourishing increases. A common question put to me is “how can I incentivise my employees?” This is one answer to that question – let them share in the profits going forwards.

 

How does it work in practice?

It is a little more complicated than a standard sale. First, the EOT is created. Typically its trustee will be a company limited by guarantee, with its members typically including a combination of employees, independent persons and founders.

 

Next, the Articles of Association of the company to be sold are tailored to cater for the EOT and protect its status.  The EOT needs to acquire a controlling stake in the company, and keep that control. The Articles of Association assist with this.

 

A specialist is engaged to value the company (typically an accountant). They will advise what is a fair sale price.

 

A sale agreement will be agreed between the selling shareholders and the EOT.

 

The shareholders will sell to the EOT. Typically, an initial payment is gifted by the company being sold to the EOT, which pays it in turn to the sellers. Invariably, this will be a relatively small percentage of the total consideration.

 

The remainder of the consideration is often paid out over time. As the company generates profits, a fraction of those profits is gifted by the company to the EOT, which continues to pay out the sellers until they have received their full share payment. This can take several years. It can be accelerated by the EOT or company taking bank debt (but the interest costs of such debt may make this unappealing – inhibiting company growth).

 

It’s worth making it clear that the full benefit to employees doesn’t begin until the sellers have been fully paid. They may receive their bonuses, but more material payments will rank behind paying the selling shareholders.

 

The members of the EOT trustee may, to some degree, rotate. Sometimes there may be a process to allow employees to vote in their representatives, for example.

 

Key points to be aware of

Given the material tax advantages, EOTs have a number of conditions they must meet at different times. Some are set out below:

  • The company must be a trading company.
  • The company must have sufficient employees unconnected to shareholders.
  • The EOT must control the company after its purchase, and must continue to control it to ensure the CGT saved does not come back into charge (this charge can arise to either the selling shareholders, or the EOT itself).
  • Care needs to be taken over implementation. Many errors cannot be “fixed” later, and can cause the tax advantages to fail.

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