Employee Ownership Trust as an Exit Vehicle
I’ve been helping a couple of Business owners exit their business via a sale to an Employee Ownership Trust (EOT), rather than the traditional Trade sale route.
Although the concept has been around for ages (eg. John Lewis), it was the 2014 Finance Act that introduced a range of incentives to make this something really interesting.
In simple terms it’s a sale of the Company to the Employees, but without the key employees having to take on any personal debt.
Also, from a business owner’s perspective the sale is tax free – no CGT / Entrepreneurs Relief is payable.
Plus having been involved in lots of traditional M&A over the years, the things I like for the private company are:
- It can be arranged gradually at a pace that suits the business owners and the employees
- It keeps the company independent and preserves the founder’s legacy
- It is non-adversarial, saving on time, money and stress
- Successor management and key employees can still receive differential rewards as they would in a management buy-out
- It rewards employees for their loyalty
In essence it works as follows:
- Business is valued at say £10m and is then sold to the new EOT
- To finance this, the EOT borrows typically 40% from a Bank, and passes this £4m straight to the owner as an initial payment
- The remaining £6m is given as an “IOU” to the owner
- The bank debt is then repaid typically over 5 years from the future profits
- The IOU is then repaid typically from Years 3 to 10, although in practice the external bank debt is normally refinanced after 3 years to release another lump sum payment to the owners from the IOU
- The Bank debt is typically ca. 4% interest rate, the IOU is 7% (and this can also be rolled up if early year profits are not sufficient)
But the bit which is really powerful in my mind is how we then align the employee’s interests to the Owner’s interests.
This is key, as ultimately the Owner is taking quite a risk that the Company will continue to be profitable at a rate to pay down both the Bank debt as well as their IOU.
And it’s done by recognising that the EOT can issue new shares to key employees, providing it always holds at least 51%.
So what this means is that at Day 1 we issue, typically 30-45% of new shares (can be up to 49%, but always best to hold some back for future new key employees).
In simple terms these shares can be valued close to £1, as:
- Company Value is £10m, but from this we must deduct
- Bank Debt £4m
- IOU £6m
So effectively £1!
But then roll this forward and as the Bank Debt is paid off, and then the IOU is paid off, the 45% shareholding will be worth £4.5m even if the profits haven’t grown and the company is still only valued at £10m – in reality it should be considerably more. For which the employees have paid nothing!
So we have a brilliant alignment, in that the employees will want to increase the profits as fast as possible to pay off the debts, which in turn is exactly what the original Owner wants so they can be paid their IOU. To use the cliché – a true win-win.
The transaction mechanisms can be a bit complex, and there are all sorts of extra protections / safeguards that need to be built in. However, we at FD4 together with some very experienced advisors, will manage all the steps, and sort out the Financing, Tax clearances, Legal stuff etc.
If you are considering a Sale of a business, and would like a genuine alternative to a Trade sale, then please don’t hesitate to get in touch.