A crackdown that will crush the sector or reforms required to protect it? Supporters of employee ownership trusts (EOTs) are awaiting the detail of the UK government’s plans for an overhaul of the rules governing these schemes with some anxiety. While many in the sector believe certain changes are justified, there are fears that the strong growth of EOTs seen in recent years could be curtailed by over-zealous regulation. It is worth noting that the UK does lead the world in EOT legislation and take-up. EOTs are now available in the US and Australia, and the European Federation of Employee Share Ownership is working with British and EU lawyers to transpose the EOT model into EU laws. All the more so given the pressures facing the sector from tighter credit market conditions, on which EOT structures completely rely.

First introduced in 2015, EOTs are specialist structures through which business owners can sell companies to the workforce in a tax-efficient manner. It took some time for understanding of EOTs to build, but the concept has become increasingly popular. Over the year to June 2023, there was a 37% rise in EOT transactions, according to the Employee Ownership Association (EOA), taking the total number of businesses owned by an EOT to more than 1,400. 

The use of EOTs by well-known companies including Riverford Organic, Aardman Animations and Richer Sounds has helped boost awareness. And James de le Vingne, chief executive of the EOA, thinks there is more growth to come. “This small section of the economy is punching above its weight across multiple dimensions of impact on individuals, businesses, communities and the wider economy,” he says.

The EOA points to recent research suggesting that 31% of business owners have plans to sell all or part of their companies in the next five years. That means 54,000 small and medium-sized enterprises will go through some sort of transaction by 2029, if the owners keep to their plans. “There is a compelling case for policymakers to ensure that these businesses are supported to better plan for succession, including to explore employee ownership as part of the process,” de le Vingne insists.

Regulatory balance

However, policymakers have several reservations. One is regarding the governance of EOTs. These transactions see a trust buy the business on behalf of the employees at a price agreed in an independent valuation. But ministers are concerned that some business owners are seeking to maintain significant control of the company following the sale, installing themselves as trustees on the EOT board, as well as on the board of the business itself. The government has suggested rules to prevent this – perhaps legislation that limits the vendor and its representatives to having only a minority of trustees on the EOT board.

There’s another concern about the generous tax break that EOTs offer owners. The sale of a business usually attracts capital gains tax on the proceeds – typically at 20%, although with a 10% rate on the first £1m of gains thanks to business asset disposal relief (BADR). However, owners who sell to an EOT pay no capital gains tax (CGT) at all. Instead, liability for the tax rolls over to the trust, which pays CGT on any secondary sale. And secondary sales have been thin on the ground. It’s fair to say that the options for selling an EOT are not fully developed as yet. Ministers worry that unscrupulous business owners and tax advisers have spotted a loophole. EOTs set up offshore can escape the CGT liability, potentially enabling business owners to pursue a second sale but to avoid CGT altogether. The UK government has therefore floated the possibility of banning overseas structures altogether.

What worries some in the sector is that a heavy-handed approach to reform could – perhaps unwittingly – cause problems. For example, vendors may retain a stake in the businesses they sell and expect a say on the EOT and the company’s board, so pushing back too strongly on that right could put some off. Overseas trusts are rarely anything other than a tax avoidance strategy, but if ministers choose a broader approach – perhaps capping CGT relief just as BADR is only available on £1m of proceeds – that would hit all transactions.

“It all depends on where the regulation goes,” says Harry Knight, corporate finance director of Corbett Keeling. “Successive governments have supported the concept of EOTs so we have to hope we get tweaks designed to ensure the spirit of the original concept is respected, rather than anything more drastic.”

De le Vingne professes himself unconcerned. “We strongly welcomed the government’s EOT consultation and the relevance of the associated proposals,” he says of the initial views expressed by ministers last year. “It was encouraging to see recognition of the success of employee ownership as a business model over the past decade, and the importance that EOTs have had in unlocking this success.”

Indeed, the EOA believes that nipping potential abuses in the bud now will protect EOTs in the medium to longer term. The danger, otherwise, is that a high-profile case in the future will give rise to a tougher crackdown. It’s a view shared by Anna-Louise Shipley, an associate director at accountants Buzzacott. “There will be some people attracted to the ‘no tax’ headline, but an EOT is not for everyone – this is about engaging employees and creating goals that are aligned through offering proportionate reward,” she says.

The counter argument is that new rules could kickstart a direction of travel towards a tougher regime. “There are limited commercial reasons to go down the overseas trust route, so we recognise why this is an area of attention,” says Stuart Goodman, a partner in the corporate finance division of Evelyn Partners. “And I suspect that, at some stage, there may well be a move towards considering caps on EOT reliefs, as there was with BADR and entrepreneurs’ relief.”

Deal leverage

Such setbacks would come at a difficult time for the sector, with EOTs currently also facing headwinds from the debt markets. In a typical EOT arrangement, the business owner agrees to a deferred consideration, with the EOT paying the agreed price in tranches over a number of years. But in some transactions, the EOT takes on debt in order to fund a larger upfront payment to the vendor; however, the rising cost of credit undermines the viability of this model. And even in deals where no debt is involved, vendors are now being asked to settle for lower discounted rates of return on deferred considerations, given today’s higher interest rates.

“It’s already difficult to raise finance for an EOT deal given the complications of these transactions,” says Gerry Young, founding director of RVE Corporate Finance. Many businesses are relatively small with limited real assets, making them less attractive to lenders. Banks also worry about businesses’ ability to repay loans while also making good on any additional commitments to the vendor.

A related problem, adds Young, is that companies with existing lending could see their banks demand a renegotiation of existing credit arrangements. “Most credit agreements include change of control clauses requiring the business to seek agreement from the lender,” he points out. “A sale to an EOT would constitute a change of control and could give the bank an opportunity to impose inferior terms.”

Tougher tax rules, moreover, would exacerbate these problems. In the worst-case scenario, lenders know they can pursue the sale of a struggling business to limit their losses. But such a sale would crystallise the original CGT liability, reducing the funds available.

The good news, says Corbett Keeling’s Knight, is that he has seen more debt-backed EOT deals in recent times. “Banks and debt funds have become more familiar with the concept, and some are actively seeking out EOTs,” he says. “Lenders are attracted by this idea of aligning the interests of the employees and the business.”

However, Evelyn Partners’ Goodman says he always advises EOT trustees to tread carefully in this regard. “If you’re going down the EOT route, over-leveraging is a bad idea,” he warns. This is another reason to emphasise the importance of good governance in EOT structures – former owners sitting as trustees of an EOT may take different views of the desirability of debt, depending on which hat they’re wearing. “The role of the trustees is to protect and serve the interests of employees,” Goodman says.

Still, it doesn’t have to be all or nothing. For example, EOT-owned firms can choose to make use of existing debt facilities to provide vendors with at least some upfront consideration. One option is to draw down on an existing asset-backed finance facility.

In the end, however, vendors will need to be realistic, particularly in tougher credit conditions. “The way we approach debt discussions with clients is to remind them that a sensible level may help accelerate the receipt of some of their consideration; it won’t change the valuation or the total consideration, and it may well extend the overall repayment period,” says Goodman. Debt servicing costs, meanwhile, will impinge on the company’s ability to build up reserves and pay the remaining balance in a timely fashion.