Should you sell your business to an Employee Ownership Trust?
Thinking of exiting your business but want to make sure its legacy lives on? Selling to an Employee Ownership Trust (EOT) might be the perfect solution. This increasingly popular exit strategy allows business owners to step away while keeping their company thriving, benefiting both the seller and the employees.
Big names like John Lewis and Aardman Animations have embraced EOTs, but this model isn’t just for industry giants. In this article, we’ll break down key advantages, considerations and potential drawbacks to help you decide whether it’s the right path for your business.
Why Employee Ownership Trusts are gaining popularity
Selling to an Employee Ownership Trust effectively transfers ownership to employees, bringing clear engagement benefits. It’s particularly attractive for companies that rely heavily on their people, such as professional services firms, multigenerational businesses with a family culture, and creative or technical firms where continuity and expertise are crucial.
EOT sales are a viable option for business owners looking to exit, particularly in uncertain market conditions or niche sectors with limited buyers. If structured correctly, an EOT sale allows the seller to avoid Capital Gains Tax (CGT), while employees benefit from annual tax-free bonuses of up to £3,600 per employee together with the advantages of being able to make long term business decisions.
Structuring the sale: Ensuring fair value for the selling shareholder
A critical issue in EOT transactions is ensuring the selling shareholder receives value for their shares. Typically, the company funds contributions to the EOT, which can be structured in two ways:
- The company secures financing to fund the EOT contribution, requiring confidence that it can meet repayment obligations.
- Contributions are made from trading profits over time, meaning the seller accepts a deferred consideration structure.
Each method presents challenges. If the company has existing secured debt, lender approval may be needed before further borrowing. Additionally, deferred payments shift financial risk onto the seller.
To qualify for the CGT exemption, the seller must transfer a controlling interest, relinquishing ownership of over 50% of the share capital, voting rights and dividend rights. This means they cannot retain decision-making powers via a shareholders' agreement or vendor security, although security granted by the company to third-party lenders is allowed.
Conflicts of interest also need to be considered carefully as selling shareholders often remain as directors, either of the company or the EOT trustee company.
How can a business qualify for an EOT?
When selling to an Employee Ownership Trust, several key criteria must be met to qualify for tax benefits and ensure compliance with legal requirements:
- The company must be a trading entity or the holding company of a trading entity.
- Sellers must surrender control over dividends, capital and voting rights. The change in control is immediate upon sale and HMRC scrutinises corporate governance to ensure compliance. If sellers still hold board majorities or veto rights, tax criteria will not be satisfied. HMRC also examines how decisions are made in practice and if the business doesn’t genuinely transfer control, it will lose the tax advantages.
- Sellers who owned 5% or more of the shares within the last 10 years cannot benefit from any capital distribution by the EOT if they remain employees post-sale. However, they can still receive the tax-free bonus if they continue to work for the company as employees.
- Sellers and connected parties must not exceed two-fifths of the workforce in the 12 months leading up to the sale or during the tax year of the sale. This is known as the limited participation requirement and prevents substantial pre-sale shareholders who remain employees from exploiting EOT tax advantages. Businesses where the share ownership has been structured for tax efficiency, including where shares have been transferred to spouses, may need to restructure share ownership well in advance of any proposed sale.
Other considerations when selling to an Employee Ownership Trust
If you are considering selling to an EOT, keep in mind that:
- EOTs are not short-term solutions. Selling shareholders often wish to retain a minority interest for future sale benefits, but this presents challenges:
- Selling again is rarely in employees’ best interests. Once deferred payments are complete, profits typically go towards employee benefits.
- Retained minority shareholders may receive dividends but realising value from their stake is unclear. The EOT usually holds pre-emption rights and it is very likely that a minority shareholder discount would be applied to any valuation.
- Sellers enter a sale agreement with a trustee company whose only asset is shares in the trading business. Most transactions involve deferred payments, meaning sellers are unlikely to receive the full sale price upfront. While standard legal protections to protect sellers receiving deferred consideration can be included, enforcing them is difficult since the trustee company lacks liquid assets and relies on trading contributions to meet obligations. Sellers should carefully assess financial risks before proceeding.
Preparing for an EOT sale
For the right businesses, EOTs offer a sustainable succession plan but early planning is crucial. Sellers should seek expert advice well in advance - potentially 12 months before the intended sale - to restructure appropriately and meet necessary conditions. With the right preparation, an EOT can ensure a smooth transition, benefiting both business owners and employees in the long run.
How can we help?
Cathy Cook is a partner in our corporate team with niche expertise in EOT transactions. For further advice or assistance with selling to an Employee Ownership Trust, contact Cathy on 0113 238 4042 or email ku.oc1745075216.fcl@1745075216koocc1745075216.
You can read about some of the clients Cathy has advised on EOTs in the case studies below:
