What is an employee ownership trust (EOT)
and how are UK businesses benefitting from them?
In this guide, we give you the lowdown on all things EOT – including the advantages and disadvantages as well as an example of a business that has transformed into an employee ownership trust, and how the funding process works.
The Financial Times recently reported that a record number of UK companies have set up employee ownership trusts, known more commonly as EOTs, in 2022. But what exactly is an employee ownership trust? And why have they become popularised this year?
As its name suggests, an employee ownership trust is a trust created by a company’s owners to enable its employees to become beneficiaries of it, and indirectly hold a stake in it.
You may have also seen the initialism ETO used – EOT simply means employee ownership trust. EOT and employee ownership trust are often used interchangeably within the industry. The main goal of an employee ownership trust is to give all employees ‘a significant and meaningful’ stake in the business they work for.
In general, employee ownership can be either direct or indirect. For example, employees may own shares directly in the business through a share plan. Alternatively, shares can be held on behalf of employees by a share trust – this is known as an indirect ownership model and this is what an employee ownership trust is.
Sometimes, indirect and direct models are combined to create a hybrid model – this means the trust can buy back shares from those who leave the business or wish to sell, and the trust can make shares available to employees via gifts or sale.
In 2012, under the coalition government of the Liberal Democrats and The Conservative Party, economic advisors reviewed the findings of an important independent paper by Graeme Nuttall which explained the obstacles and opportunities of employee-owned companies. Known as the ‘Nuttall Review’ the 83-page document gave the government recommendations on how to promote and improve the employee ownership process, so it was less complicated and more appealing to business owners and entrepreneurs.
Following the Global Financial Crash in 2008, countries across the world were trying to recover from the recession – this meant focusing on economic growth and new ways to stimulate business growth and employment in a responsible way. Diversity in business ownership and the way businesses are run and owned was identified as a focal point, with research providing evidence that aligning employers’ and employees’ needs and goals leads to higher success levels.
The Minister for Employment in 2012, Norman Lamb, declared ‘I want this to be the decade of wider employee ownership’ – while he may have missed it by a year, now in 2022, as the government once again turns to economic growth plans to help pull the UK out of a deep set recession and high rates of inflation, Lamb has definitely achieved his goal of ushering in a new business model that helps productivity and bolster growth. By the end of September last year, almost 500 ETOs were established, a sharp increase from the previous two years of 235 and 56 respectively.
Business owners and entrepreneurs will often have shifting priorities and goals. At times, their future plans will involve exiting the business to focus on new challenges. If a business wants to sell it can look at a few options: the most common exits come in management buyouts, acquisitions or initial public offerings (IPOs). You can find more about this topic and more in our complete guide to corporate acquisitions.
Acquisitions and takeovers often mean selling to a third party, which although works for some business owners, isn’t always the best option for others. This is because:
So, rather than sell their company privately, more and more founders are considering employee ownership trusts, simply because they can often provide solutions to some of the above problems.
As mentioned above, founders have a few different options when it comes to selling their stake in the business. Employee ownership trusts are just one of these succession options, but why are they so attractive, especially now in 2023? Here are some of the benefits of EOTs:
When a founder or founders exit the business and it becomes either publicly owned or comes under new majority private ownership, there is no certainty that the business will continue to operate as it previously did. Change is usually inevitable and employees can sometimes feel worried about the long-term stability of the business, especially as mergers and acquisitions can be quite disruptive. Employees of the business being acquired can often face doubt as to what will happen to their role, or the future of the company. This can lead to low morale and negative sentiment, and ultimately more resignations.
Businesses don’t want to lose their workforce as that will hamper productivity and impact their objectives. Luckily, this doesn’t have to be the case, especially if you give employees a proactive voice and say on how the future looks, using the trust.
Not only does this safeguard the business’ future by improving employee retention, but it also boosts morale and productivity too – in fact, research into the UK’s fifty largest employee-owned companies shows that average productivity increase for EOPs is double that of the UK average.
When you start a business, it’s important that the small team around you shares the same values and vision for growth that you do. These values soon become the foundations for you to scale, but also your USPs – the things that set you apart from competitors and make your brand memorable.
The quicker you scale, the easier it is to lose what made you different, this is equally if not more resonant when the founder leaves. If the third party buying the business brings in a different set of values and a culture of its own, at times incompatible, then values become dissolved and employees become disillusioned with their own goals and motivations. If employees get to retain the culture they helped shape, they’ll not only feel happier but be able to drive better outcomes for the business, customers, and wider society.
Research from the Employee Ownership Association shows that over 70% of employee-owned businesses have a statement of purpose which includes a commitment to make a positive impact on society and the preservation of the environment.
Rather than a traditional hierarchical approach where management dictates the business strategy and sends orders down the ranks, all employees drive forward the strategy and help make informed decisions as a collective, as they all have skin in the game and want the business to succeed. Because employees are invested in the future success of the company they’re more likely to bring new ideas to the table and be proactive in innovating to improve growth. They’re also more likely to make decisions for the long term rather than operating with a short-term mentality, which can often be detrimental to the overall strategic direction of the business.
A healthy economy is one made up of diversity and inclusivity. The financial crash of 2008 revealed that the UK economy was too narrowly focused on one type of business model and a few specific sectors. This meant there was a real push to stimulate new growth and help long-term job creation with a more evenly balanced and nuanced approach to business management. Employee ownership trusts were already tried and tested in some of the UK’s most well-loved businesses, like John Lewis which employs over 80,000 people.
Founders or owners that make a profit when selling their business are obligated to pay Capital Gains Tax. Depending on the nature of the business, the profit it makes and other factors such as personal tax bands, Capital Gains Tax is typically between 18-20%. But, if you’re eligible for Business Asset Disposal Relief, you may only pay 10% Capital Gains Tax.
Shareholders that choose to exit a business by selling to an employee ownership trust are exempt from Capital Tax Gains so long as the trust acquires at least 51% of the business which is a controlling interest. Additionally, when the business becomes employee-owned, it can pay its employees annual bonuses exempt from income tax.
Employee ownership trusts are an attractive model for some businesses, but they won’t be the right approach for others. While progress has been made to streamline the setup process and make it more cost-effective and efficient, there’s no denying that the process can still be very complex to complete, so requires expert guidance, consultancy and time investment. Here are some of the disadvantages of EOTs to consider:
Unlike a normal acquisition, the employee trust purchasing shares don’t typically have the financing upfront to buy the business and therefore pay the founders for their shares. Employees are not expected to pay for any shares in the business directly so unless the company itself has the liquidity to pay out shareholders, then they would have to wait for the business to pay out instalments from future profits – or take on debt for the takeover which can make the sale riskier.
Employee ownership trusts are different to employees owning direct shares in the business through a shared ownership plan (ESOP). Because employees do not buy shares directly, they are beneficiaries of the trust, which pays out tax-exempt bonuses to them based on the company’s success.
The trust does not dictate how the business is run, but acts as an advisory board to make sure the business is set up for success and acting responsibly to deliver its goals. Trusts need to work closely with an employee council for them to effectively represent the voice of staff.
Because selling to an EOT is different to selling to a third party, there are a few differences when it comes to the valuation process. Before a sale goes through, there will need to be a robust tax valuation of the holding, in addition to a commercial valuation.
The tax valuation is used to determine the market value of the business if it were being listed for sale on an open market. The commercial business valuation will be calculated using a multiple of its profits, but given the sale of the business to an EOT requires paying for the sale with business profits, a high profit multiple may mean the EOT will be paying out for the sale longer than expected – which can have a negative impact on employees.
An EOT is set up by acquiring a controlling interest in the company by purchasing the shares from the current majority shareholders. There are a few conditions that need to be met to become an EOT:
A lot of people rightly ask the question, how is a sale to an EOT funded? There are two ways that shareholders can get paid depending on whether the business is in the position to take out debt finance or not.
If a business doesn’t take out a business loan, shareholders will have to wait for their sale payment in instalments taken from the business’ future profits. This can take a while and isn’t always the best option for the company, or those exiting that may need their money sooner.
Often, a business will take out a business loan to buy out former owners either in full or partially on the sale date. The business then pays the lender back over an agreed term with added interest.
As the economic and geopolitical challenges of 2022 continue to impact the way businesses operate in 2023, many entrepreneurs will look towards EOTs to provide stability and security for their employees and wider growth. Staff shortages and inflation are creating difficult hiring periods, so employee retention is more critical than ever. What better way to reward employees’ hard work and dedication than by giving them direct involvement in the business’ future and financial rewards for when the business thrives?
If you’re a founder or entrepreneur that wants to safeguard the future and legacy of your business with an employee ownership trust, OakNorth can help you with fast flexible debt financing that helps you focus on the outcomes. Get in touch with our experts today to find out more.