Daniel Sawyerr and Samantha Lenox from Alvarez & Marshal Taxand UK investigate the growth in the Employee Ownership Trust Sector and the benefits of selling to one.
Macro-Economic Context:
2022 to date has been particularly challenging for public market investors. Central banks are increasingly determined to rein in inflation at a point where several factors (including the Ukraine conflict) have presented persistent pressures in this respect.
In the US, stocks had the worst start to a year in in more than 50 years (between the start of year and mid-June, S&P500 Index was down 23%) and global bonds had the worst start to year on record.
In the UK inflation has hit double digits for the first time in 40 years, and a breakdown of CPI components shows a striking breadth of categories experiencing price gains.
Though the UK’s household energy price guarantee should see CPI settle at a lower level than first expected, the recently announced fiscal package from the Chancellor will likely be inflationary for the economy and puts pressure on the Bank of England to hike interest rates at a faster pace than previously indicated. Thus, sovereign (gilt) yields have risen more than their US counterparts. Credit spreads have also widened in the UK fixed income market, leaving year-to date bond returns in significantly negative territory and investment grade and speculative grade corporate bond yields at levels not seen for at least a decade.
However, despite these apparent headwinds, UK M&A activity remained robust over the second quarter 2022. Perhaps unsurprisingly, the Office of National Statistics did report a reduction in the number of transactions when contrasted to a bumper 2021, but overall deal volume remains broadly in line with long term, pre-pandemic averages[i].
Growth in the Employee Ownership Trust sector
Moreover, we continue to see significant growth in the employee ownership trust sector. Through January 2021, one in twenty business exits was to an employee ownership trust (EOT) and 2021 more broadly saw record growth in the sector with the creation of 285 new EO businesses. Up to and including May 2022, 118 new employee-owned businesses were created.
There is also evidence of transaction deal values growing in the employee ownership space. For example, TTP Group Ltd, a Cambridge technology company was sold to an EOT in December 2021 at a reported transaction value of £276m.
In this briefing, we look at why a sale to an EOT may be the right strategic option for a succession and the importance of planning and taking advice to ensure a successful transaction.
What do we mean by an exit to an EOT?
This is the sale of a controlling shareholding (i.e. 51% or more) in a trading company to an employee ownership trust (EOT) which is structured to benefit from statutory HMRC tax reliefs. Employees of the company will become beneficiaries of the EOT and may receive tax free payments from the EOT.
What are the benefits of selling to an EOT?
Some of the benefits are as follows:
- From a tax perspective, the owners can sell their shares free of Capital Gains Tax and on an uncapped basis provided the legislative criteria are respected. In addition, the employee-owned company can award income tax free bonuses to employees of up to £3,600 per year.
- The transaction can be structured to enable a gradual succession and relinquishment of the business owner’s influence. This may be particularly beneficial where there is vendor finance as part of the sale consideration and the owners are dependent on the successor management team to generate profits to pay this down. The owners may continue in executive or non-executive roles and/or can be given veto rights in relation to key decisions without putting tax reliefs at risk.
- For many business owners selling to an EOT, employees will be the business’s biggest asset. Employee retention and job security will often be important criteria to owners who have built personal relationships with employees and will wish to preserve their legacy. As a sale to an EOT does not involve a third party, or a combination with an existing business, employment levels can be retained.
- There is evidence that EO businesses are more resilient than non-employee owned businesses during an economic downturn. Research shows that EO businesses are better at maintaining top-line performance and employment levels during recession[ii].
This success might be attributed to the “ownership dividend” and the higher levels of employee engagement where employees have an ownership interest in an employee-owned company.
Importance of taking professional advice and planning for a successful sale to an EOT
For the majority of business owners, an exit is a once in a life-time event and has often taken a number of years to achieve. With a liquidity event comes financial intricacies and complications, which means that professional advice and guidance become essential.
In the most successful transitions, entrepreneurs seek out professional advice in a variety of areas well in advance of the sale, as meeting the time demands of continuing to run a business, managing the transition process and optimising the sellers’ personal financial position simultaneously can be a real challenge.
As an example, from both a wealth management and a personal tax perspective, whilst a sale of shares to an EOT is free of Capital Gains Tax if correctly structured, understanding the Inheritance Tax (IHT) exposures post disposal is key. An EOT structured exit exhibits certain nuances in this respect with vendor finance in the form of loan notes yet to be received is typically within the scope of IHT.
Alvarez & Marsal provides a full-service advisory and implementation EOT offering. This includes tax structuring and advice to ensure the transaction benefits from the HMRC tax reliefs available, valuation services to value the business being sold to the EOT, documentation services for the sale of the business to the EOT and debt advisory services for funding the sale.
London & Capital supports its clients by working with them to organise their wealth into a coherent strategy that is fit for purpose in the context of clients’ objectives and priorities. Both in the run up to & beyond an EOT exit.
[i] https://www.ons.gov.uk/businessindustryandtrade/changestobusiness/mergersandacquisitions#:~:text=There%20were%20333%20completed%20M%26A,Quarter%202%202021%20(500).
[ii] Page 8 – “Does Employee Ownership Confer Long-Term Resilience” – January 14, 2014, Cass Business School and Newcastle Business School, Northumbria University, the Employee Ownership Association.”
