There are not many exit options you can say this about, but employee ownership trusts (EOTs) are booming. Data from the Employee Ownership Association (EOA) shows there was a 37% increase in the number of UK companies fully or partially owned by their employees over the year to June 2023. Just over 1,400 companies are now owned through an EOT structure, almost three times as many as three years ago.

A cynical analysis of this data would conclude that as potential buyers of businesses – whether trade or private equity – have become more risk-averse over the past 18 months, sellers have begun looking to their workforces to fill the gap. “Trade buyers and financial buyers are more cautious, given the higher cost of debt funding and weaker economic prospects in the UK,” points out Gerry Young, executive director at RVE Corporate Finance. “By contrast, a sale to an EOT can be executed without counter-party risk. And there is now a critical mass of business owners and professional advisers who have successfully carried out EOT transactions – more than 1,000 between 2015 and 2022 – so a sale to an EOT is no longer considered an ‘unusual’ exit when owners and advisers are considering the exit options.” 

However, James de le Vingne, CEO of the EOA, believes that while the narrowing of the exit options for vendors may have had an effect at the margins, there are more sustainable positive forces at play. “We’ve built momentum as the evidence has increased that employee ownership works,” he says. “The adviser community is also better informed, so there is much more support available to owners considering going down this route.”

Several high-profile transactions have also helped raise awareness of the EOT option. The launch of EOTs by well-known businesses including Riverford Organic Farmers, Aardman Animations and, in particular, Richer Sounds, has caught the attention of business owners, de le Vingne adds.

Change of control

First introduced in 2014 following the recommendations of the government-commissioned Nuttall Review of Employee Ownership (which was launched at ICAEW), EOTs offer various tax exemptions to encourage take-up (see box, All about tax?). To qualify, business owners must set up EOTs in a certain way. The basic principle is that the owner must sell a controlling interest in the business – at least 51% of the shares – to employees. Although EOTs aren’t required to buy a majority stake, the tax benefits won’t be there if they don’t. The sale is done by setting up a trust, run by a corporate trustee. The trust commissions an independent third-party specialist to value the business. Once a fair sale price is agreed between trust and vendor, the trust purchases the business on behalf of the employees.

Some trusts arrange debt finance to buy out the vendor in one go upfront, but the more common model is for payments to fall due in tranches over an agreed period. Either way, the business then makes payments to the trust from its ongoing profits, so its debt – to vendor and/or lender – can be settled.

As the new owner, the trust is responsible for the business from the point of purchase. It must appoint a board of trustees that will work with the management team responsible for running the business. Board members typically include non-executive directors or independent trustees, employee representatives and a representative of the seller if it has retained some shares in the company.

Getting the legal documentation on an EOT transaction right is a key factor, says Neil Palmer, partner at law firm Fieldfisher: “There will be a share purchase agreement (SPA) governing the terms of the sale itself, but it will also be important to document the arrangements that sustain employee ownership over the longer term.”

The SPA will need to set out the payment arrangements – for example, when the vendor will be paid and in how many tranches; whether the schedule is fixed in time or dependent on business performance; and what happens in the event of a breach. It may also include warranties and indemnities from the buyer, as well as non-compete provisions the vendor must comply with.

New structure

Separately, documents such as the trust deed and the articles and constitution of the now employee-owned business set the stage for how the company will be run under its new ownership structure. “You’re effectively embedding a whole new governance structure,” Palmer adds, “and this is where the hard work really starts. Keeping the energy and momentum going once the transaction is completed, and building a framework to sustain this over the long term, present much bigger challenges than getting the deal done in the first place.”

This is an important point. The promise of employee ownership is that businesses run by their workforces benefit from increased engagement. Staff with a stake in the company are ready to share ideas, to go the extra mile and stay with the business, rather than accepting a job elsewhere. But those benefits – and the superior business performance they can drive – will only materialise if employees feel they have genuine agency. 

There is no one-size-fits-all model for governance. Many companies operate with an elected member of the trustee board, or they may have employee directors on the management board. But they also need mechanisms for working with the rest of the workforce – ‘voice groups’ and works councils are commonplace.

Get it right and there can be real dividends, says Fieldfisher partner Graeme Nuttall, author of the aforementioned Nuttall review. “There is a growing body of evidence that employee-owned companies outperform commercially and financially,” he says. “They also tend to have happier and more engaged workforces with much lower rates of staff turnover.”

Indeed, the evidence is compelling enough that many other countries are now looking at the UK EOT model. Nuttall has talked to officials in the US, Australia, Canada, Denmark and Ireland about how they might introduce similar arrangements. “Employee ownership is becoming a great UK export success story,” says Nuttall.

Of course, back in April, John Lewis, long-lauded for its partnership model, announced that was under review.

Stumbling blocks

Still, there are hurdles to overcome. In particular, says Matthew Emms, a tax partner and head of share plans and incentives at BDO, vendors must show patience. “With a trade sale or a sale to a private equity investor, the vendors usually get paid a proportion of their consideration upfront with some of the deferred consideration subject to an earn-out or rollover or reinvestment,” he points out. 

“By contrast, selling to an EOT, the vendors typically receive lower upfront consideration, with the balance of the consideration paid in tranches over a number of years.”

For sellers unable to wait – because of poor health, or a planned new venture, for example – the EOT may be able to secure finance to fund the deal at the outset. But with some technical complexities around that funding – such as the issue of the company’s deferred capital gains tax liability – not many lenders will be comfortable with that idea, says de le Vingne: “We would like to see more lenders active in this market. There may also be a role for a group such as the British Business Bank.”

Another issue is valuation. The EOT has a fiduciary duty not to pay more than a fair market value for the business, points out Anna-Louise Shipley, an associate director at Buzzacott: “There may be a gap between what the EOT is able to pay and what another bidder is prepared to offer.”

With valuations across the M&A market under pressure, the fact that such gaps may be narrower today than 18 months ago could be one reason why EOT deals have become more numerous. Still, getting the valuation right, even in these uncertain market conditions, is especially important for an EOT. “The business has to be able to pay the agreed price,” says Shipley. “The future of the business and value for employees could be jeopardised by an over-generous valuation.”

Best of intentions?

It’s also important that business owners consider EOTs for the right reasons. Many are drawn to the idea because they’re conscious of their legacy – they’ve built a business in their community, working with staff, and want to ensure the organisation endures. However, there is a suspicion that a minority of owners are simply focused on the tax incentives. In July, the government launched a consultation on plans to tweak some of the legislation on EOTs amid conjecture that a few owners have been attempting to play the system. Ministers propose that vendors should not be allowed to exercise control over an EOT once the sale is completed – vendors and connected persons should therefore not account for more than half the trustees. They also want to prevent EOTs setting up offshore.

The first proposal is designed to ensure sales to EOTs are genuine disposals. The second protects the principle that the initial capital gains tax break is a deferral, rather than an exemption from liability; trusts set up offshore may be able to avoid CGT altogether on a subsequent sale, ministers point out. “Advisers and vendors may have valid reasons for using offshore structures, but HMRC is keen to ensure that with substantial tax breaks on offer, EOT transactions are structured in line with the spirit and the letter of the EOT legislation,” adds BDO’s Emms.

The EOA is broadly supportive of the government’s proposals. “Ultimately, we’d be concerned about any arrangement where the employee ownership isn’t properly embedded,” says de le Vingne. “That would undermine the integrity of the concept – and prevent the company from realising the full potential of employees owning the business.”