A sale of your business to all the employees via an Employee Ownership Trust (EOT) is a relatively simple, advisor and vendor-driven exit strategy and therefore more immediate than a trade sale. What’s more, to encourage such sales, they are currently subject to 0% Capital Gains Tax, provided they meet the qualifying rules. This means they can be more lucrative than some trade sales where multiples of earnings valuations are low or high earn-outs are likely. An EOT also enables you to continue working in the business, if you wish, as an employee and they offer great rewards to the team which helps to protect your company culture.
When the employees can’t pay and the management doesn’t want to raise funds for a buy-out, where does the money come from for an EOT sale and how are they valued? The short answer is the money must come from the company and only from distributable reserves. The company provides the funding so it can be sold into the trust company for the benefit of the employees. Meaning the value comes from spare cash or future cash flow over a period of time, often with some initial proceeds accelerated at completion by third-party debt on a cash flow loan from banks and/or other lenders. Most main retail banks are interested in funding EOT sales when they are structured correctly and there is sufficient profit and cash flow.
EOT Value and Funding
The valuation should not be entirely driven by traditional price-earnings (PE) multiples of historic profits. Historic profits have been spent but the future cash flow provides a meaningful forecast of the company’s potential performance going forward and therefore so should the valuation. The company’s reserves, forecasts, and cash flow over a period of time will drive the target value, more than an arbitrary PE multiple. The valuation is subject to HMRC approval, which is mainly to confirm that the sale is not structured for tax avoidance purposes.
The funding for an employee ownership sale must only come from distributable reserves. This is to ensure that the trust, and therefore the employees, are not saddled with a valuation or debt burden that can’t be achieved. The funding on completion is usually comprised of any initial distributable reserves (spare cash) in the business together with any initial third-party debt (bank borrowing) – typically up to 2 x 2.5 times earnings before interest, tax, depreciation, and amortisation (EBITDA).
Additionally, there is usually a vendor loan sitting alongside any third-party debt, which is ongoing and funds the EOT structure for a period of 5 to 10 years to help maximise the cash flow for funding and the value. This is a downside of an EOT sale as it means that the shareholders are usually taking a credit risk on the valuation for some time into the future. The upside, however, is that forecasts and growth can be factored into the value and on the basis that, subject to cashflow, the employees are getting the business for free, there should be no compulsion to discount the sale for the employees, although some sellers choose to do so on an altruistic basis.
Third-party debt works well for EOTs where people either don’t want to take the credit risk, perhaps not trusting the business model or employees or because they are not involved on a day-to-day basis or simply because they need the money upfront to buy houses or pressing alternative investments. There is an adage that 85p today is worth more than £1 tomorrow, but this relies on inflation and good investment opportunities.
Stagflation and high-interest rates on debt do, perhaps, change the balance today meaning that many choose to fund via vendor loans and bank any interest earned. Where third-party debt is used, the lender will take security for its loan over the company’s assets and will require priority for its repayment over any other funding, including any vendor loans. Typically, bank borrowing for employee ownership is structured over 5 years.
The EOT funds the debt service for the vendor loans by gifts or contributions from the company out of after-tax funds. Total annual contributions made by the company to the EOT can be no greater than the annual amount of distributable reserves. Due to this constraint, it is critical to ensure that the projected debt service on an annual basis is no greater than the projected after-tax profits for the year. A ‘letter of wishes’ commitment by the company to make contributions to the EOT is always contingent upon it having the available funds.
Many EOT advisors still use a traditional PE valuation model, but this is flawed and does not bring the depth of strategic planning and modelling to align cash flow to value and protect both the seller and employee. The analysis may sound complex, and it does require financial modelling to establish the value and funding options for each EOT structure. However good forecasts and modelling at a feasibility stage can usually demonstrate to sellers the estimated level of proceeds that are CGT-free. The company is buying itself using its current and future reserves within the given period, thereby, contributing to the valuation factor.
Time may be running out to take advantage of the 0% CGT, so it is important to act now and not miss out. The clock is ticking on the 0% CGT as people generally support an increase in CGT and a change of Government. With an election likely in the first half of 2024, this may be the stimulus to further review CGT concerning EOTs.
The specific financing structure of an EOT will depend on a range of factors, including the size and nature of the business, the availability of financing options, and the preferences of the former owner. EOTs are typically financed through a variety of sources, including:
- Bank loans- usually secured by the assets of the business with the EOT making regular repayments, including interest, over a fixed period.
- Seller financing – by accepting deferred payments as part of the purchase price.
- Grant and contributions – some governments and non-profit organisations provide grants to support employee ownership. These grants can be used to finance the establishment of the EOT or to provide working capital for the business. Schemes can also be established where employees contribute.
- Retained earnings – the EOT can also be financed through the retention of profits creating distributable reserves to create initial sale proceeds.
Contact Avondale Corporate
Avondale is a leading Mergers & Acquisitions strategy consultancy. We have been working with the best entrepreneurs and companies operating both locally and globally for more than 20 years. Our firm provides a fully integrated service from business sales and acquisitions to business growth and strategy to corporate funding opportunities.
With an election and potential change of Government during the first half of 2024, time may be running out to take advantage of the 0% CGT, so it is important to act now and not miss out. If you would be interested in learning more, please contact Avondale on +44 (0)1737 240888, our Contact Us page or email email@example.com to speak to one of our EOT specialists. You can also visit our website at www.avondale.co.uk to learn more about our services.