Trade Sale versus Employee Ownership Trust
A Trade Sale versus an Employee Ownership Trust – what are the key differences?
For business owners without family and/or management succession planned, a trade sale is typically the solution when retirement beckons. But now, an increasing number of business owners are becoming aware of Employee Ownership Trusts – and the related tax advantages.
So, which is better – a trade sale, or a sale to an Employee Ownership Trust?
Before attempting to answer that question, let’s briefly touch on the definition of an Employee Ownership Trust.
An Employee Ownership Trust (“EOT”) is a tax incentivised mechanism that transfers control of the company for the long-term benefit of the employees. It basically allows owners to sell their shares to an EOT which offers generous tax breaks to the owner.
It was introduced by the Government in 2014 in an attempt to allow shareholders to set up similar models of ownership such as John Lewis. The sale of hi-fi retail business Richer Sounds to an EOT in 2019 was one of the more high-profile company stories of owners transferring the business to an employee-held Trust.
An EOT can take a few months to set-up and requires that the company is independently and expertly valued. It typically takes at least 4 weeks to gain clearance from HMRC. A useful overview of an Employee Ownership Trust is available from mid-market accountant BDO here.
Under EOT legislation, all employees are beneficiaries of the trust – but subject to a number of qualifying conditions. An EOT can own 100% of the shares in the company, or a proportion of the company (> 50%) alongside individual investors or shareholders.
To qualify for an EOT, HMRC has to be satisfied that it is for the benefit of the employees. The Employee Ownership Association states that there are more than 350 UK companies that have adopted the model, with more than 100 preparing to follow suit. With over 5 million SME’s in the UK alone, this represents a small proportion of companies – but one that is growing.
Under the current legislation, there are two key tax benefits to an EOT:
- Selling his / her shares to an EOT, the owner-shareholder does not pay any capital gains tax so long as control (i.e. more than 50%) of shares are transferred to the EOT.
- Employees can be granted a tax-free bonus up to £3,600 per annum.
An EOT is efficient because there is no tax to pay for the vendor. Whilst the tax advantage appears attractive, how does it stack up against a trade sale in the real world? Let’s find out…
A trade sale usually involves a professional intermediary (such as ourselves), marketing the company confidentially to a number of prospective buyers. At its best, the process is exhaustive and brings about real competitive interest amongst buyers with a view to maximising the price. The professional intermediary will prepare the financials of the company such that adjustments will be made to demonstrate underlying profitability together with future cashflows under new ownership. Handled by a skilled M&A professional, the structure of the deal and the timing of monies being paid will be negotiated to meet the needs of the seller.
A company sale to an EOT requires either a chartered accountant or corporate finance firm together with legal specialists to manage the process. So, either route, a company owner will need to engage professional services that will incur cost and time. The professional costs of a trade sale are likely to be greater than the costs of setting up an EOT, but this only makes up a small part of the picture.
Let’s compare the key deliverables.
Price (or ‘consideration’)
Price is one of the key elements that any business owner is focused on when considering an exit. Whilst most industries have leading indicators of value (e.g. EBITDA multiples), it is largely impossible to value a company without having a level of competitive interest. As anyone who has ever bought anything of value, it is rare indeed if the first price offered is the final price.
Simply put, a trade sale handled by an experienced intermediary, is far more likely to deliver the optimum value for the company.
How does that compare against an EOT valuation?
An EOT valuation has to be handled independently by a specialist. A valuation is reached using arms-length industry metrics, a final single value (as opposed to a range) being proposed. Whilst it may not be required to be cleared by HMRC, the valuation is at risk of being challenged. If HMRC considers the consideration paid to be above market value, then the excess will be taxed to income tax, which will be very expensive indeed for the recipients.
(There will perhaps be vendors who will attempt to game the system by attempting to influence a high market valuation, but given HMRC’s growing interest in EOT, it can only be a matter of time that unscrupulous valuations warrant HMRC attention).
As a head-to-head run-off, a trade sale is the more likely winner when it comes to delivering a higher valuation, simply because of the competitive element to bidding.
Timing of payment
Assuming professionally managed by an M&A professional, a trade sale usually results in a large proportion of the price (‘consideration’) being paid ‘in cash’ on completion. Any balancing payments can be split between deferred consideration, earn-out monies and / or monies held in escrow against potential warranty and indemnity claims. The split in payment is partly down to the level of competence of the professional intermediary (e.g. us), and partly down to either (a) the price aspiration of the vendor and (b) the cleanliness of the company as viewed by the due-diligence.
In short, the sale of a good and clean company handled by an experienced intermediary should deliver a significant proportion of the price at completion – i.e. the sale of the company.
In terms of an EOT, the mechanism for payment of monies is quite different. When a company shareholder sells his / her shares to an EOT, it creates a debt between the EOT (Trustee Company) and the shareholders – i.e. the EOT owes the shareholders for the value of the shares purchased – typically referred to as a vendor loan.
The company will aim to continue to generate trading profits each year and it will use these profits to make contributions to the EOT. The EOT will use these contributions to repay the outstanding purchase price (vendor loan) that it owes to the shareholders.
It is not unusual for repayment terms to be set between 3 – 10 years.
With an EOT, the exiting shareholder is therefore dependent on the trading company continuing to deliver sufficient profits in order to satisfy the vendor loan repayments over a medium-term period (e.g. 3 – 10 years).
As a direct to head-to-head run-off, a trade sale will usually deliver a much larger upfront ‘cash’ value to the business owner selling his / her shares. But – because an EOT allows shareholders / directors to remain employed by the company post-disposal, it may be attractive to business owners who are not ready to retire (or leave) and who are happy to stay with the company – and indeed who are happy to receive their monies in installments.
Subject to qualifying conditions, the proceeds of a sale of shares to an EOT are tax free under current legislation (May-21). This is a significant benefit.
Subject to (separate) qualifying conditions, the sale of shares in a company are subject to Capital Gains Tax at a rate of 20% for higher and additional rate taxpayers but subject potentially to Business Asset Disposal Relief (formerly Entrepreneurs Relief), which provides for 10% tax on qualifying assets up to a lifetime limit of £1M. Taxes are paid on gains and subject to personal allowances etc.
(Not covered here is an asset sale – e.g. when a trading company itself sells assets, trade and goodwill to a third party. This delivers an entirely different tax treatment – and hence this article will focus solely on the sale of shares (i.e. equity or securities)).
As a direct to head-to-head run-off, the tax treatment of a sale to an EOT is more favourable than a trade sale under current leglislation.
Ongoing business sustainability under new ownership
This is an interesting topic.
The argument for an EOT is that employees are (or will be) more engaged as a result of the company being owned by an EOT, such as:
- Improved business performance
- Reduced absenteeism
- Greater employee engagement & commitment
The one UK model that is most cited in favour of EOT’s is John Lewis. But this has been under fire in recent years as profits have tumbled together with the decline of the department store and the shifting patterns of consumers.
It seems self-evident that EOT’s will provide greater sustainability overall versus a trade sale – but is there real evidence to support that view?
Capitalism – and the reality faced daily by companies in the market, contains numerous forces that act on a business. Pressure from buyers, pressure from suppliers, innovation in the market, economic pressures, fiduciary pressures, and indeed internal people pressures from the very cogs in the machine – us “workers”. It is not clear whether a top-down hierarchy (think Steve Jobs and Apple) versus a consensus-driven employee-centric model provides for a better outcome – better in terms of financial performance, better for employee satisfaction and better for society?
In order to understand which model is more effective, perhaps we need more time. It seems common sense that an EOT will be more effective in the long-run, but is there really sufficient real evidence to suggest one way or another?
Selling a company to a larger trade buyer hints at increased risk to the company being sold – but for the most part, a trade buyer will want to maintain (and build) his / her latest acquisition – usually with the participation of the team that run the business.
So as a direct to head-to-head run-off, the EOT is anecdotally better than a trade sale when it comes to ongoing sustainability – but perhaps we need more evidence to truly judge.
In conclusion, there are significant differences between a trade sale and an Employee Ownership Trust. The EOT route offers tax advantages and probably costs less in overall professional fees; but it may not be the ideal solution if a business owner wishes to maximise the sale price and receive the monies sooner rather than later.Employee Ownership Trust, EOT, succession plan, tax advantages, Trade Sale