Our Employee Ownership Explained webinar series for 2023 continued with Bruce Farquhar, Chair of Anderson Strathern. In this webinar, Bruce discussed the legal requirements of the Employee Ownership Trust (EOT) legislation. You can view the recording of the webinar below.
Anderson Strathern were one of the first legal firms to gain prominence in advising on employee ownership transactions. This involvement began prior to the introduction of the EOT in 2014. At that time, employee benefit trusts (EBT) were the vehicle involved and this experience led to Anderson Strathern paying more attention to the new legislation when it came into force. This experience developed by discussing with the firm’s own client base and making companies aware of the benefits which employee ownership offers. This landed well and led to a number of business owners approaching Anderson Strathern directly to discuss exit options. These transactions transcend a wide variety of sectors including architects, software businesses, demolition companies and garden centres. The corporate team quickly built up their knowledge of the technicalities of the EOT transaction. They found the deals interesting and rewarding projects to work on.
The two key tax reliefs associated with EOTs are Capital Gains Tax exemption on the sale of a majority interest to an EOT, and the payment of bonuses to employees free of income tax up to a set amount.
There are four prime requirements that must be satisfied in order to qualify for these tax reliefs.
- The controlling interest in the company must transfer to the EOT which means that the EOT must hold more than 50% of the ordinary share capital and voting rights of the company. The EOT must be entitled to more than 50% of the profits and assets on its winding up.
- The target company must be a trading company or the holding company of a trading company.
- Any property held in the EOT must be applied for the benefit of all eligible employees (i.e. all employees, subject to a qualifying period of no more than 12 months, excluding those who hold 5% or more of the shareholding).
- Any benefits accruing to the EOT must be applied or distributed to eligible employees on the same terms. That doesn’t mean that all employees need to get equal amounts because it is possible to vary amounts based on other factors detailed in the legislation: length of service, hours worked or proportionate to salary. This is called the equality requirements.
The first consideration is whether the employee ownership route is appropriate for the particular individuals and organisation concerned. We would want to be comfortable that the prospective vendor is making an informed decision and has reviewed other options. We would also recommend they access the excellent resources made available by Co-operative Development Scotland.
The Professional Advisory Team
This is a collaborative transaction and it’s good to have all advisers working together. This won’t just be lawyers: there will be the accountants, tax advisors who will typically be involved in valuation, tax clearance structure and financial projections. Employee Ownership Specialists can play an important role and we have included such a specialist in every transaction we have worked on. These specialist advisers bridge the sellers with the employees and advisers and bring with them a wealth of experience of many transactions.
Who is the client?
Typically, the initial engagement has been with the target company and not the founder or the employees or the EOT. You do have to recognize that as the transaction develops, there may be different interests involved and other legal advisors may be necessary. You can’t advise everybody, so both the founder and trustees are recommended to take their own independent legal advice as a transaction moves ahead. Obviously, it’s up to them whether they do so, but there needs to be no doubt or lack of clarity about where the client solicitor relationship sits.
Typically, there is very little due diligence carried out in these transactions. The founders will continue to be involved in the company post transition as long as there is deferred consideration outstanding and will already be familiar with the business and issues that might impact it. There may be third party consents that have to be managed as part of the transaction, for example, change of control clauses in contracts or banking agreements, property leases etc.
Resources for advisers
These webinars are an invaluable avenue to build knowledge for advisers, and lawyers are able to access a central bank of documents for the EOT transaction. Bruce recommends Robert Postlethwaite’s book The Employee Ownership Manual as a good source of information.
Key Decisions to be made by sellers
There are four decisions that will shape the transaction:
- Share value. The sellers have to be happy with this or there is no deal
- Percentage of shareholding to be sold. As long as the controlling interest is sold to the EOT then the transaction qualifies for the tax exemption which means that it does not have to be a sale of 100% of the issued share capital
- Funding and timing of payment. It’s in no-one’s interests to stress the company by imposing a challenging repayment schedule on the business. There are a number of specialist lenders in this space who are supportive of EOT transactions. There is also specialist insurance available for deferred consideration.
- Engaging employees. There is no set timetable here. Bruce believes it’s best to engage people in the process early so they are part of the process. Some transactions don’t tell the employees until the transaction is complete and, whilst there may be good commercial reasons for this, it seems counter-intuitive to the ethos of employee ownership.
It is usual for there to be some matters reserved either for the vendor or for the trustees where approval must be sought by the company’s board. Examples might be expenditure over a certain amount or restriction on selling the company during the restricted period while consideration is outstanding. Bruce advises against the inclusion of any items that would suggest that the founder still have an active control of the company.
Structuring the Trust
Bruce stressed this is a personal view and that the circumstances of the company should be considered. His preference is to implement a Corporate Trustee for two reasons. Firstly, if there is a change in trustee, i.e. when a trustee stands down, then it’s easier to process in a Corporate Trustee. If there is no Corporate Trustee in place then a formal deed of retirement and appointment would be required. Secondly, the Corporate Trustee gives additional protection through limited liability.
Typically trustees are appointed from 4 categories:
- Employees , reflecting their role as beneficiaries of the trust
- The vendors as they still have a continuing interest while consideration is deferred
- The directors of the trading company
- Independent or Non Executive Trustees external to the company
It’s important that the Trust is structured in a way that provides the ability to hold the board to account and act as steward for the employees’ value in the business.
Leadership is a potential issue. Having a clear plan for leadership succession is critical and lack of clarity can lead to confusion and resentment. It’s worth exploring whether future leaders should be incentivised, for example with an incentive scheme.
Involving employees appropriately is important. It may be best to involve the senior managers before rolling out the plan to all employees. They will likely be the first port of call for employees and you want them to be positive and comfortable in communicating the proposition to the staff.
There is still work to be done and we as professional advisers have a role to play. We need to make sure that our clients and our colleagues are aware of employee ownership. This doesn’t mean promoting employee ownership over any other exit route, but rather making sure that it’s included as one of the options which need to be considered in the mix.
Bruce believes Co-operative Development Scotland has been a tremendous support and thinks the feasibility report is an excellent first step for any company considering a move to employee ownership.
Bruce’s advice for new advisers is that the employee ownership model needs to be on the radar so that they can fully advise their clients of the options that are available on exit succession scenarios. Getting up to speeds with the key features of the legislation would be the first step.
A useful discussion followed the presentation. See below for a note of the audience question and answers. The answers do not provide advice and professional assistance may be needed before deciding what to do in particular circumstances.
Questions and Answers
Q. What are the ball park legal costs for an SME looking to implement an EOT? And who picks up the bill?
A. Of course, it depends very much on the complexity of the transaction. I’d give a range of £15k – £25k as a very rough, ball park figure. It would be usual for the company to pay these costs.
Q. In your experience, do the owners remain in the business?
A. Yes, in most cases, the former owners will remain with the company until all consideration is repaid. They may reduce their time in the business. This is welcomed by both employees and customers as it gives continuity and allows a phased handover to the new leadership team.
Q. How do the costs of an EOT transaction compare with the normal M&A transactions that you work on.
A. Generally, costs will be significantly less than a third party sale as there will be less contentious negotiation around the documentation.
Q. What happens if there is a sale once the EOT is implemented?
A. Care has to be taken around timing of any future disposal. A sale within the first two years of the transaction would be seen as a “disqualifying event” and may result in a claw back of the tax relief.
Specialist tax advice is probably required before committing to any future sale. The proceeds would be distributed to the employees.
A sale might not fit with the long term ethos of employee ownership but there may be good reasons to consider a sale. Many companies have a clause in the articles that provides for employees to approve any sale of the business in future, usually requiring 75% of the employees to agree.
Q. What support does CDS provide for companies considering a sale to an EOT
A. Currently and we expect going forward, CDS offers three days of advisory support. This covers an ownership succession review and an employee ownership feasibility study. The output is a document which outlines how employee ownership might work for a particular client taking into account their specific circumstances. In essence, it’s a decision making tool for the owner to decide is this for them.
Q. Can we have information on the book recommended by Bruce Farquhar?
A. The Employee Ownership Manual by Robert Postlethwaite can be purchased from here.
Bruce is the Chair of Anderson Strathern. He is a partner in the corporate and commercial team and leads the energy sector group, as well as being a member of our Brexit group. He’s also a director of the Scottish Hydrogen and Fuel Cell Association and a former charity trustee of the micro-certification scheme charitable foundation.
Having worked on a number of significant employee ownership transactions, Bruce has specialist expertise and knowledge of Employee Ownership Trusts and is well placed to advise business owners considering employee ownership.