Behind the growing popularity of Employee Ownership Trusts (EOTs)

In the current economic climate, it can sometimes be difficult for owners to execute partial or full exit strategies to their satisfaction. Amid soaring inflation, tight M&A financing conditions, falling valuations and general economic uncertainty, owners looking to secure a satisfactory exit that reflects an accurate value for their company can face considerable challenges.

These conditions have arguably been a central contributor to the increasing popularity of deals in which a business is sold to an Employee Ownership Trust (EOT). Historically something of a rarity, with the notable exception of the John Lewis Partnership, EOTs are rapidly becoming a useful solution for owners looking to exit their businesses.

According to the Employee Ownership Association, 2022 was a record year for the growth of employee-owned businesses (EOBs). 332 new businesses became employee-owned during 2022, with the number of EOBs standing at more than 1,400 in June 2023 – an increase of 37 per cent in 12 months. The calendar year 2022 saw particularly strong growth, with 332 new EOBs.

The Employee Ownership Association credits much of this growth in EOBs to the success of EOTs, which were set up as a government initiative in 2014. According to the EOA’s stats, 90 per cent of companies that are currently employee-owned moved to this ownership model following EOTs being enshrined in legislation.

What is an EOT?
EOTs, which were set up by the government in 2014 to encourage businesses to sell controlling stakes to their employees, are an ownership model in which shares in a business are held in a trust on behalf of employees who collectively own more than 50 per cent of the company. The firm must be a trading company, or, in the case of a group, the principal company of the group. A company cannot be classed as a trading company if it has significant investments, such as cash or land.

Trusts must meet certain other criteria in order to be established, which includes the exclusion of any employees with shares in the business worth more than five per cent, the inclusion of all other employees (the “all-employee benefit requirement”) and the equal treatment of all employees in the trust (the “equality requirement”).

The benefits of the EOT cannot, therefore, be to the advantage of particular employees, although benefits of greater amounts can be allocated based on factors such as length of service, hours worked and salary.

The government hoped that establishing a clear framework through which owners can sell to employees fairly, might increase employee ownership in the UK. And it worked, as a growing number of businesses are realising that selling to employees carries many benefits

According to the EOA, employee-owned businesses contribute 4 per cent to the country’s GDP. They are better-placed to withstand economic turbulence thanks partly to higher levels of employee engagement and loyalty, and they achieve superior productivity.

A brief step-by-step to selling your business through an EOT
Firstly, your business will need to set up the EOT. An external private company is then often appointed to act as the EOT’s corporate trustee. Once the EOT is set up, shareholders in the company can sell their shares to the trust through a share purchase agreement.

A fair market price for the business will typically be worked out alongside an independent professional, with the sale price agreed in advance. This helps to avoid the long, drawn-out and often costly negotiation processes that are frequently involved in conventional business sales.

An EOT will typically only pay a portion of the full consideration up front, with the remainder taken on as a debt, which is then paid off over time from the business’ post-sale profits.

What are the advantages of selling to an EOT?
EOTs offer numerous benefits to both owners seeking to make an exit and the employees who ultimately take over the running of the business. Primarily for owners, selling to an EOT offers major tax advantages that can help to make it a more lucrative exit strategy.

When selling to an EOT, owners benefit from an effective rate of 0 per cent Capital Gains Tax (CGT). This can make selling to an EOT an extremely attractive option to shareholders in a business, who might otherwise pay a CGT rate of 10 per cent, or even 20 per cent, of the profits generated from the sale.

This offers a clear advantage over other types of business sales (such as management buyouts), which might be subject to CGT. EOTs are also exempt from inheritance tax and income tax and are eligible for a corporation tax deduction when bonuses are paid to employees.

David Alcock, Partner at Anthony Collins Solicitors says: “Transfer to an employee ownership trust is free of capital gains tax. Whether this is the best option for every owner will depend on whether they can find a buyer for the business, and whether a sale to a third party is really what they want to do. There are other options, but the tax advantages mean that any owner should look very carefully at employee ownership.”

One of the main concerns facing owners looking to sell their businesses during economic downturns is that they may dispose of their business at a time when its profits and valuation are comparatively low, running the risk that they lose out should the business perform strongly and become more profitable during a subsequent economic upswing.

An EOT offers owners the chance of retaining an ongoing stake and role in the business. As with a sale structured with a lengthy earnout period, this enables owners to not only continue profiting from the business as it grows, but also means that they can help to drive that growth, potentially enabling them to increase the return they see from the sale.

As with an earnout, this scenario also offers an upside to the employees taking over the business, giving them a sense of continuity and stability while they acclimatise to ownership and helping to reduce the likelihood of the business suffering from the change in ownership.

Furthermore, as the employees have already spent years working with the outgoing management, there is likely to be a strong existing working relationship, helping to potentially reduce the chance of the type of post-sale disputes that often affect earnout sales to third parties.

Something that might prove particularly attractive to owners navigating the current challenges around business sales is the fact that a sale to an EOT can prove far smoother, less disruptive and less costly than going to market and attempting to find a third-party buyer.

If the company’s employees are interested in taking over the business, then the seller has an interested party immediately and may decide that, while there may be potential buyers out there with greater cash reserves, a sale to an EOT offers a more logical, quicker and easier solution. Given the moderate decline of business valuations over recent months, this is likely to be particularly attractive when compared with the prospect of spending a significant amount of time seeking an outside buyer willing to meet their valuation, with no guarantee that they will.

Given this selling environment, a likely option for owners who do turn to a third-party sale is that their business will be swallowed up by a well-capitalised larger counterpart or competitor, something that might lead to the business being merged into another operation, with jobs potentially put at risk.

This may not be of the utmost concern to some owners, but for others (particularly founders), seeing their business be taken over in this way and knowing that it could lead to long-term colleagues losing their jobs might give them pause for thought.

As Chris Maslin, founder of EOT consultancy Go EO, explains: “Typically, a founder’s main option for exiting is to sell to a bigger competitor. That tends to mean their business is absorbed into the bigger entity. Their brand disappears, and half the staff are made redundant. Hence whilst the founder might get a big financial payoff, it often leaves a sour taste in their mouth.”

A sale to an EOT can help to avoid this, ensuring that the business is not snapped up by a rival, or a larger operation that will simply absorb the business into its own, preserving jobs and keeping the business and brand that the owner has built over the years intact.

Tough Construction is a Glasgow-based construction firm founded in 1974, generating nearly £68 million in revenue and comprising more than 500 staff. In July 2023, the company was acquired by an EOT following the decision of owners Bob Leishman, George Duncan and Kenny MacKenzie, who took over the company in 2007, to retire.

The deal saw the firm become Scotland’s largest employee-owned business and outgoing owner Bob Leishman said it was a reflection of the contribution that staff had made to the company’s success. Leishman asserted that the opportunities, training and development that the company offered to its employees had been key to keeping staff turnover low and driving Tough’s growth.

He added: "A sale to a third party may have disrupted that. This move to employee ownership allows the company to continue to offer excellent service to our clients, and secure employment for our people.”

“A sale to an employee ownership trust lets us have our exit, knowing that the company is in safe hands. We have a talented leadership team ready to take over and it’s time for the old guard to step aside. So far, the news has been well received by staff and clients.”

Finally, a succession plan built around an EOT can be a great way to motivate staff and build the value of the business prior to completing the transaction. Ordinarily, if employees know that a business is up for sale, this can spread a sense of uncertainty among the workforce, who are worried that a new owner will come in and make seismic changes to the business and, potentially, significant redundancies.

On the other hand, selling to an EOT can help to incentivise and engage employees, offering them the opportunity to work towards a point where they ultimately take control of the business, work for themselves and share ownership equally. This could feasibly have a transformative effect on morale and, ultimately, productivity.

Langcliffe International is a leading buy-side M&A acquisitions originator based in West Yorkshire. Founded in 2012, the company has grown rapidly across Europe thanks to strong relationships with vendor advisors, private equity firms and corporates.

The company, which introduces deal opportunities in the £3m-£100m value range, has attributed its success to its strong relationships with vendor advisors, its bespoke operating systems and the rapid growth it has seen in Europe, which accounts for more than 50 per cent of its revenue.

In March of this year, the company transitioned to an employee-ownership model, signifying its commitment to empowering its workforce and driving a more inclusive, equitable corporate culture.

The deal saw Managing Director Mark Eardley transfer 73 per cent of his shares to the company’s EOT. The structure also saw an Employee Stock Ownership Plan (ESOP) established, enabling employees to acquire shares in the company.

According to the company, the move to employee ownership is expected to bring significant benefits in terms of improved employee engagement, attracting and retaining talent, alignment of interests in decision-making and strategic planning, wealth creation for employee and an enhanced corporate reputation.

Commenting on the deal, Mark Eardley said: "Selling the company to our employees through the creation of the EOT ensures the stability of the business for the long-term and supports our desire for further international growth.”

“This move recognises the value that our fantastic team has delivered over the years, and it is a very exciting opportunity for each individual to take a pivotal role as the business progresses. Creating a great place to work is fundamental to our business principles, and we’re very excited about the next stage of the journey."

As Dave Alcock explains: “You know that if the business makes a profit, you’re entitled to a share of it. Employee Ownership Trusts don’t particularly reward individual brilliance/hard work, the fruits of success are spread. It encourages staff to work together for the greater good. The staff know that if they slack, they hurt themselves and their colleagues, not some rich fat cat at the top. Therefore, productivity tends to increase, staff turnover reduces, the number of sick days drops, etc.”

Alcock points out that there is also a significant financial incentive for staff in an EOT: “Each year staff can get a tax-fee share in the profits of up to £3,600, but also because they are the collective owners of the business, the underlying value belongs to them through the trust.”

Why are EOTs proving especially popular now?
As outlined in the introduction, the M&A market is currently in a state of tension. Activity has slowed from the post-COVID surge seen during 2021 and, amid widespread global economic uncertainty, valuations are falling.

M&A appetite has also declined considerably as businesses instead focus on shoring up their operations and attempt to navigate the numerous economic headwinds that are impacting many UK industries. At the same time, the state of the economy means that, even where there is appetite to conduct acquisitions, buyers may struggle to secure the necessary financing, with traditional backers such as banks and even private equity firms increasingly cautious about how they deploy their funds.

All of these factors mean that many owners that are eyeing an exit from their business over the next few years may have to think more creatively if they wish to achieve this and, ultimately, attain a fair valuation for their company. This might mean that sellers are more willing to pursue deals with alternative structures that widen the pool of potential buyers, such as through earn-outs, or by selling to an EOT.

Another factor that has been suggested as contributing to the increasing popularity of EOTs in the current economic climate is the growing financial strain on younger professionals in management positions, who might – ordinarily – seek to acquire the businesses they work for from their senior counterparts.

According to Chris Maslin: “Management buy-outs used to be popular, where the up-and-coming 30–40-year-olds would buy out the share-owning 60+-year-olds. However, with house prices as they are relative to wages, your average 30-40 year old simply can’t raise the cash to buy their seniors out. Hence these aren’t as common as they used to be.”

Maslin adds that EOTs can solve this problem, with staff paying far less to take over the business, with the bulk of the consideration typically paid out of future profits.

EOTs are also increasingly being regarded as a more ethical means of exiting a business, something that is of growing importance as factors such as ESG become more prominent. As we outlined in another recent insight, ESG is one of the core considerations that investors factor in when they are assessing which companies to deploy their funds into and there are indications that exit strategies involving EOTs can help companies to boost a company’s credentials in this regard.

According to recent research from EOA research partners Professors Andrew Robinson and Andrew Pendleton of the White Rose Centre for Employee Ownership, EOBs are highly socially responsible, with 71 per cent of EOBs having a statement of purpose built around making positive contributions to the environment or society.

97 per cent of EOBs, meanwhile, have at least one form of employee governance, while 74 per cent have two or more. The research also found that employees have “some or a lot of say” in decisions regarding working conditions at 90 per cent of EOBs and 85 per cent have a say in new working methods.

EOBs are also largely more transparent regarding their finances, with 75 per cent of EOBs sharing financial information several times each year and a further 21 per cent sharing financial information at least on an annual basis.

With ESG so high on the agenda for investors such as private equity firms and banks, a succession plan built around a business becoming employee owned through an EOT could prove valuable in attracting the financing needed to fund an upfront portion of the deal or to secure working capital for the business.

What are the disadvantages of selling to an EOT?
While sales to EOTs offer numerous advantages to both owners and employees, there are drawbacks that will need to be considered before committing to exiting a business in this way, as well as considerable risks inherent in a succession plan based around a business becoming employee-owned.

Perhaps the most salient drawback in the current environment is that owners are unlikely to receive the full consideration for the business up front. Typically, in an EOT acquisition, a small proportion of the valuation will be paid up front, with the remainder paid out based upon the company’s future profitability.

This makes an EOT exit a less tantalising option for business owners who are seeking an immediate windfall from their business sale, perhaps if they planning on using the funds to embark on a new venture or investment or to finance immediate retirement plans.

The drawn-out nature of the consideration for a sale to an EOT also poses a considerable financial risk to the outgoing owner, particularly amid the kind of tough trading conditions that many UK businesses are currently facing. The likelihood is that much of the sale value – perhaps a significant majority – will be tied into the business’ ongoing success and future profitability.

This means that the owner is in danger of missing out if the company underperforms post-sale, which is a distinct possibility in a scenario in which employees with no previous experience running a business become the company owners.

This raises a few potential concerns for outgoing owners. Firstly, the uncertainty around gaining the full purchase price may mean that owners choose to remain involved in the business to a significant degree in order to ensure that the company is performing to a level that will enable them to achieve the full consideration (which can raise further problems both for the outgoing and incoming owners). This could be problematic for owners looking to make a full exit from their business.

Secondly, owners may be discouraged from seeking a high valuation for their business, due to the possibility that the firm may struggle to pay it back and that the need to furnish the debt could impact its cashflow later if trading remains slow. While this is a good incentive for owners to not seek an unrealistic valuation, there is a possibility that it may lead to the business being undervalued, especially if its performance improves significantly in the post-deal period.

Committing to selling a business to an EOT can also mean that sellers are limiting their pool of potential buyers and possibly missing out on attracting an outside buyer that could pay a higher valuation. Selling to a third party could also prove more lucrative for an outgoing owner if they sell to an experienced industry operator and tie a portion of the consideration into the business’ future performance, with an experienced buyer potentially more likely to drive significant growth in the post-sale period.

In terms of the problems that can arise from owners remaining involved in the business post-sale, the biggest concern is probably the possibility of tensions arising between the former owner and the new employee-led ownership. Owners who give up control of their business but remain involved in the day-to-day operations may struggle to adapt to the loss of control and the fact that they no longer have the ultimate say in the strategic direction of the business, even though this relinquishing of control may have been something they’ve been working towards for years.

From the point of view of the new owners, having the former owner remaining involved in the business could make it more difficult for employees to impress their own plans on the company, particularly as the former owner (even though they have given up control of the company) is likely to still command a significant degree of authority.

While this may prove useful in helping employees adjust to ownership of the business and facilitate a smoother transition, in some cases it could be difficult for the right balance to be struck, for former owners not to retain too tight a grip on the business and for employees not to cede too much control to their former boss.

Despite the drawbacks inherent in selling to an EOT, the significant upsides that this kind of exit offers clearly makes it an increasingly attractive option in the current climate, offering a solution to many of the issues that owners may face when selling their businesses.

The increasing attractiveness of EOTs is demonstrated by the growth in EOBs during 2022 and this is a trend that seems to be continuing during 2023 and could be set to carry on for the foreseeable future as owners seek smoother, simpler and more ethical exits.

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