“How would you like to sell your business for market value and pay ZERO tax?” It is a question that would always have ignited the interest of a business owner. Despite this, the 10% tax rate available to most SME owners on a traditional exit was usually enough to shy away from the relatively unknown Employee Ownership Trust (EOT).
The budget on 9 March 2020 seems a world away now but it did include an important change to Entrepreneurs Relief. The potential 10% tax rate available on business sales survived but the lifetime limit was scythed from £10m to £1m. In simple terms, a capital gain of £10m would now yield a tax charge of £1.9m compared to a possible £1m under the old rules.
This sizeable shock to the legislation in conjunction with the extremely uncertain business environment will change the outlook of business owners. It is likely that analysing the feasibility of an EOT will be more widely used as the first port of call when assessing exit options.
It is clear that the current situation will cause a shift in risk appetites. More owners will seek to ‘cash out’ as they have experienced first-hand how quickly the landscape can change. Once the ship is steadied post-pandemic, it is conceivable that they will no longer want to continue delaying retirement just to achieve a slightly higher price.
One of the most difficult pieces to the EOT puzzle is to ensure that the current, non-equity holding, management are appropriately incentivised. This is a particular conundrum in smaller companies where 2 or 3 individuals could be the driving force behind the business. From the perspective of personal wealth creation, these individuals may have previously been better served by completing an MBO. However in this new world, the risk appetite of some management will also have changed, meaning that an attractive employment package could be enough to convince them that control is not essential. Current management holding equity does not automatically rule out an EOT, as long as the rules regarding excluded participators are adhered to.
The current climate is tough for a lot of businesses. To necessitate their survival, drastic measures have been required which may have involved employees having their remuneration package altered in some shape or form. Although these changes are necessary, it is possible that staff members will harbour grudges even once normality is restored. An EOT could be seen as a way to heal a rift and usher in a new era, with the added bonus of increasing staff productivity. An added incentive comes in the form of a tax free bonus of up to £3,600 per year for each employee.
The overall method of enacting an EOT is not dissimilar to a regular MBO structure. Whereas a Newco would be used in an MBO, the EOT is set up as a Trustee Company. The Trust vehicle then purchases the shares in the target company through a Share Purchase Agreement. Any consideration which cannot be paid to shareholders at completion, through either existing resources or new borrowing, would be repaid over a defined period. This deferred consideration is serviced by a percentage of profits flowing from the company to the EOT and then out to the sellers. Although it should be remembered that there are additional qualifying criteria which must be achieved to protect the tax free status for the seller.
If you would like further details about Employee Ownership Trusts or would like to speak to the team about the feasibility of establishing an EOT, please contact Simon Martin.