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Is it time to sell your business to its employees?

With rumours about imminent changes to capital gains tax again swirling, is it time to consider setting up an employee ownership trust (EOT) and selling the business to that instead of doing a deal with a VC?

Increasing the number of employee-owned businesses has been a government ambition for some time. It is now 10 years since Graeme Nuttall reported back to the then coalition government on possible ways to achieve this. That the issue was raised when in 2012 was partly as a reaction to the financial crisis of 2008, and the inevitable backlash that led to widespread calls for more responsible capitalism that looked after the interests of all stakeholders and not just shareholders. Employee-owned businesses were seen as a way to achieve a more balanced economy, with the commonly cited example being the John Lewis Partnership. In 2014, the government introduced new tax reliefs to encourage more use of Employee Ownership Trusts (EOT).

Things have hardly leapt ahead since. Figures from the Employee Ownership Association show that as of last summer there were 576 employee-owned businesses in the UK using an EOT. But demand is picking up. Of that 576, 139 were created in 2020, with another 72 having only launched in Q1 of 2021.

What's your motivation?

One driver behind this renewed interest is undoubtedly the continuing rumours of a potential increase to CGT. Done correctly, EOTs offer a CGT-free way for founders to sell their business, with further tax reliefs available for employees (who can get £3,600 a year in tax-free bonuses). But there are other advantages beyond the cold, hard cash and tax benefits. Some founders are looking at it as a tax-efficient and relatively simple way to share the rewards of growth with all staff.

This is typically where the business is long-established and where many staff have been with the company for a long time. Often this is also tied in with a sense of wanting to exit the business in a way that secures a legacy and offers better security for employees. For others, an EOT offers a way of boosting employee engagement and further enhancing the performance of the business.

At a recent Supper Club expert-led discussion, John Manis, tax director at Smith & Williamson and one of the UK’s leading authorities on the interplay between taxation and employee incentives, explained the advantages of EOTs and highlighted some of the common pitfalls and mistakes founders make when setting one up. As with most of our digital meetings, members can watch a recording of the entire session in the on-demand group on the membership platform.

He explained that, while in the past many such trusts had been non-resident, which offered further tax advantages, there was a major move away from this. “Most people now recognise that the resident route is the better option. Setting up the Trust offshore isn’t really something that we’d advise anymore.”

In the simplest terms an EOT is a discretionary trust set up as an employee ownership vehicle. Manis highlighted some of the most important aspects of such an arrangement:

  • The trustee is usually a company limited by guarantee.

  • There is flexibility on who the members and directors of this trustee company are. They can be the previous company owners.

  • The beneficiaries are employees of the company.

  • Company owners who sell or gift shares to an EOT get full relief from CGT.

  • Relief operates as a “rollover,” not an exemption.

  • There is exemption from income tax for bonuses of up to £3,600 per tax year paid to employees of companies owned by an EOT

  • Inheritance tax reliefs allow company to be sold to EOT without IHT issues.

As attractive as the tax advantages are, there are several other reasons to consider an EOT. These include the benefits for and positive impact on the employees, especially issues such as greater employee engagement, higher retention rates, lower absenteeism and higher higher productivity, all of which can have a big impact on the bottom line and value of a business.

While EOTs are usually relatively straight forward to set up - and the transaction costs will be notably lower than for most other kinds of business sale or exit event, partly due to the fact that there is rarely any need for a due diligence process -there are. key areas that need to be carefully weighed up. These include:

  • The continued role of the founders, owners and directors in the trust company.

  • Any conflict of interest that. may arise as a result of the above

  • Whether it is necessary or desirable to use an independent trustee or to use a third party trustee company

  • How to get a fair valuation

  • How much of the business to sell (given that a controlling majority has to go the the EOT)

  • How much of the business to sell (again it has to be 51% minimum to qualify)

  • The ongoing running of the business and what say, if any, existing owners and directors might have in future.

There are huge benefits that may accrue to society and to individual businesses from the wider adoption of employee ownership and EOTs offer a relatively safe and easy way to move to this kind of model. But they are not for everyone and founders need to tread with care. But as a way to engage employees, or to share the rewards of growth with all employees (and equality rules for EOTs require it to be open to all employees), and as a way to take some or all your equity out of a business without paying CGT, it is an approach worth considering.