Employee Ownership Trusts: What are the alternatives?

Employee Ownership Trusts: Alternatives

Formulating any exit strategy requires proper, calibrated assessment of, and impartial advice on, the viable transaction alternatives in the specific context of a business and its owners. Tax is a factor too, but tax avoidance is never a reason to do the wrong transaction.

For business owners, the need to pay CGT on the proceeds of an MBO can be offset by the potential for significantly higher upfront cash, whether from private equity investment or greater lender appetite. Banks and investors often view EOT structures as commercially opaque and technically complex, preferring instead to support motivated management teams with real “skin in the game”. Key employees can also be rewarded and incentivised through tailored option schemes.

Further, there is no minimum time restriction on selling (four years for an EOT), should that become merited post the MBO. In contrast to EOTs, MBOs, and other forms of equity release can very much be structured as interim transactions.

If there is no evident leadership succession, a trade sale to a strategic corporate buyer can maximise value, deliver the most cash consideration up front and achieve a much shorter timeframe to full exit.

Structural Considerations in EOTs

Of course a sale to an EOT can prove to be the optimal route for a particular business, but as a long term, complex structure it must be tailored correctly to best meet the owners’ objectives and mitigate the risks.

Some employee-owned businesses will stay employee owned forever and thrive as autonomous entities. John Lewis, for example. However, it is inevitable that some businesses will underperform or suffer a reduction in valuation, such that there is little or no implicit value for the employees.

Deferred consideration could take longer to pay or even be at risk. Raising finance, particularly equity finance, to strengthen the balance sheet, pay out the former owners, invest for growth, or make acquisitions can be problematic.

There is a risk that the company becomes a zombie business or even insolvent.

Getting an EOT Structure Right

If the conclusion of an exit strategy review is that a business has the commercial and financial strengths for long-term autonomy, the owners’ succession plans and timeframes can be met and that management and employees will both understand and be motivated by an EOT, then the deal structure and process need to be optimised.

It is important to note that management and employee behaviour will not change just because the share ownership structure has. Succession needs planned and will not happen by itself.

The planning and preparation phase includes agreeing on the board structure, selecting appropriate trustees, empowering leaders, and developing a communication strategy that will ensure employees appreciate the potential rewards and understand how they can contribute to the new culture.

Business valuation must be fair. The HMRC requirement of “market value” not being exceeded requires detailed, documented professional opinions, often sought independently by both trustees and the owners. HMRC is likely to challenge valuations ever more forcibly, not least because of the historical practices of some shady advisers.

Retention of a minority interest by owners might be merited where future growth is expected to be significant, and/or if they expect to continue working in the business for some time. Deployment of a share option scheme alongside the EOT can skew more value to incentivise a senior leadership team.

Deal structures favour cash-rich businesses, and new lending should be conservative to avoid undue financial pressure. As lending appetite into EOTs is cautious, free cash on the balance sheet to fund initial consideration is an important aspect of the structure, as are the requisite working capital and capex facilities when it is gone.

The profile, duration and refinanceability of deferred consideration necessitates forecasting, alongside the appropriateness of paying or accruing interest. Sensitivity analysis is an important reality check for owners on how long it will take to pay this off.

In the next article, Roger concludes his EOT deep dive with a look at the future outlook for businesses owned by EOTs and whether an EOT is right for you.