Whilst the legislation governing EOTs was first introduced back in 2014, I’d say the term has only established itself in the modern M&A adviser’s lexicon over the last few years as EOTs have gained popularity. This is no doubt partly due to the significant reduction in (what was) the 10% Entrepreneur’s Relief lifetime limit from £10m to £1m back in March 2020, no doubt prompting business owners to look at alternative means of achieving a tax effective exit.
EOTs have become so popular as a means of exiting a business that specialist lenders are even advertising EOTs as a specific funding line.
We’ve advised on our fair share of sales of businesses to EOTs over the last few years and my key learning is that whilst they should definitely be part of the ‘exit’ conversation, alongside typical leveraged buyouts (MBOs and MBIs), Private Equity and trade sales, the tax savings arising from a sale to an EOT should not be the sole motivation.
The two obvious benefits of pursuing a sale to an EOT are a complete exemption from Capital Gains Tax (CGT) by the exiting shareholder(s) and the transition of beneficial ownership, in an equitable (and also tax efficient) manner, to the business’ employees.
So, what’s not to like I hear you say?
Unfortunately, like any tax incentive or relief that’s introduced, it seems to be just a matter of time before an ‘industrialised’ approach is taken to mass-marketing them – just look at the R&D tax credit industry that’s exploded as a prime example and the resultant ‘sledgehammer to crack a nut’ reaction The Chancellor of the Exchequer has taken to this regime in the recent Autumn Statement.
I was slightly dismayed to hear only recently that a business which had been passed to its employees via a sale to an EOT had been ‘bought back’ just after the two-year tax-clawback period, with the apparent sole motivation of the original EOT sale being nothing more than the owner’s wish to access the cash on the company’s balance sheet, free of tax. I’m not sure this was what was envisaged when the EOT legislation was first introduced!
On a similar note, I’ve repeatedly been approached both by clients and prospective sellers, saying they’ve been approached by another firm doing the hard-sell on EOTs. There are obviously a range of tried and tested exit options, from MBOs, MBI’s to Private Equity and trade sales, so having EOTs as an alternative is fantastic, but surely should just be part of the conversation as opposed to the ‘go to’ exit solution?
Like any tax relief, the EOT legislation is riddled with complexity and conditionality, so ensuring that every box is ticked from a tax (and legal) perspective is absolutely critical and sometimes a deal-breaker. You’ll thank me for not running through these conditions in detail, but joking aside, an upfront feasibility exercise, considering the pros and cons of pursuing a sale to an EOT is highly recommended before signing on the dotted line.
Outside of tax, the two questions I often get asked are “Is this the right move for my employees?” and “Could this be an intermediary step towards a full exit”?
Two quite different questions and not often asked in the same breath!
On the first, my answer would typically be that there would often have been a prior motivation towards transferring the ownership of the business to its employees, so an EOT can be a very tax-efficient way to facilitate it. The employee ownership model is much more prevalent on the European continent and collective ownership can work extremely well, dependent upon the facts and circumstances. Equality across the employee base though is fundamental, so it’s difficult to discriminate in terms of ownership and reward, solely based on an owner’s choice of who should benefit.
On the latter question, my answer hedges towards a “not really” on the basis that the spirit of the legislation is very much centred around long-term employee ownership as opposed to short-term gain. That said, I’m starting to see the first few employee-owned businesses (those that have previously been transferred / sold to an EOT) being taken to market. Whilst a subsequent sale is possible, any sale would need the approval of the trustees acting in the interest of the employees, who will ultimately benefit from it. This dynamic will inevitably make things more complicated than one or two founder shareholders deciding to sell, but it’s not insurmountable.
In addition, the return of proceeds to employees by the Trustees is likely to attract PAYE and NIC, resulting in HMRC taking a large chunk of the value realised.
So, whilst I’m not intentionally a doom monger when it comes to EOTs as an exit option, I would always advocate ‘more haste’ less speed’ when making such a decision – it’s not one that can easily be reversed.
