How shareholders get paid on sale to an EOT
Employee Share Ownership Trusts (“EOTs”) are being increasingly used by the owners of a business to sell out and take out cash from the business 100% tax free. And, there is a HMRC clearance procedure to avoid the risk of claims from HMRC of tax avoidance. We explore how EOTs work in terms of paying out consideration for the shareholders.
We look at:
- Brief recap on how an EOT creates a sale of the business
- How will the sale to the EOT be funded
- Illustration of financing choices
How a sale to an EOT works
Before EOTs came along in 2014 historically when shareholders faced the issue of what happens to the trade when they are no longer involved there was the choice of:
- pass the business to the next generation if they have an interest;
- Sell the business to a trade buyer
- Sell the business to private equity investors; or
- Sell to management under an MBO
There is now a 5th choice which is a sale to an employee benefit trust.
In summary an EOT creates a sale of the business under which shareholders receive consideration as they would in any other sale context.
The EOT Company
A new company is created which will act as the employee share ownership trust – the “EOT company”.
The Sale to the EOT company
The shareholders sell their shares in the trading company to the EOT company. The sale is agreed via a share purchase agreement in much the same way as a sale to a third party would be agreed. Upon completion the trading company becomes a wholly owned subsidiary of the EOT company. The trading company continues trading.
The Consideration due to selling shareholders
EOT has to pay the selling shareholders for their shares in the form of cash and or loan notes. Cash is taken from the cash in the trading company sold to the EOT company. The seller’s loan notes are satisfied by future trading profits arising from the trading company. In many cases the consideration payable to the shareholders is more than the trading company’s cash reserves as bank loans are used to fund the consideration. We examine funding in more detail below.
How will the sale be funded?
As a basic structure a sale to an EOT can be funded in the following way:
- The trading company contributes cash to the EOT company. Once the sale of the trading company to the EOT company is complete cash can be transferred without incurring tax charges as the trading company and the EOT company forms a group for tax purposes.
- The EOT company can use the cash transferred to pay the sellers. Working capital needs to be reserved so the business can keep trading.
- To the extent the sellers have not been paid in full, the EOT company issues a loan note to the sellers. The loan note represents the sellers’ deferred income or consideration which can be drawn down over a given period decided upon by the sellers and the EOT and set out in the loan note. The loan note is security which can be secured against the business to give the sellers some protection. Loan notes are often described as vendor loans.
- Going forward the trading company will make payments out of post tax profits to the EOT company. The EOT will re-cycle this cash to redeem the loan notes from the sellers.
Approaches to EOT financing
The choice on how to fund is down to the sellers and the EOT company. There is very little prohibitive legislation relating to funding to negotiate around in order to preserve the tax free sale. Some sellers set up the EOT to extract cash reserves they have accumulated over years of trading. In these cases they do not seek a multiple on EBITDA. In other cases, the sellers seek multiples of EBITDA to increase the total consideration received. The only restraint is that the EOT is a trust and has to act in the best interests of the beneficiaries the employees. One of the duties of the EOT trustees would be to agree reasonable repayment terms it is likely that the trading company can support.
Assume that the trading company has EBITDA of £1,000,000.
Assume the business is valued at a multiple of 4 x EBITDA
Excess cash – £1,500,000
Distributable reserves – £1,000,000
Valuation – 4 x 1,000,000 plus £1,500,000 = £5,500,000
Fees and expenses – £50,000.
Ideas to consider
Shareholders sell to the EOT for £5,500,000
Excess cash is more than is needed to fund working capital. It serves as a potential source of funds to finance the transaction.
In this case the sellers could receive on the sale to the EOT £5,500,000 (ignoring fees and expenses) if the structured as follows:
Bank loan 2.5 x EBITDA 2,500,000
Seller loan notes 1,500,050
Uses of funds:
Purchase of shares 5,500,000
Fees and expenses 50,000
In this example the sellers leave sufficient cash in the business to finance working capital by way of loan notes. The loan notes can be redeemed as and when the business has sufficient funds. The sellers can remain involved in the business albeit not as trustees. The loan notes can be drafted to include repayment terms mutually agreed between the EOT and the sellers. For example, if the sellers consent, the loan notes could expire after a fixed period of time to the extent not fully repaid.
In some cases there is no set repayment schedule for the seller loans. The trading company makes contributions to the EOT when cash flow is available. Loans may or may not be interest bearing. Increasingly transactions with an EOT are commercially structured and the seller loans are structured in the same way as a third party would structure its debt facilities.
Fixing the multiple used to value the trading company is a commercial discussion. There is no golden rule. Typical multiples for private companies can range from 3 to 6 x EBITDA. If the EOT trustees feel justified in paying higher multiples by for example relying on rainy day clauses there is nothing to stop a transaction completing a higher multiples.
Shareholders sell to the EOT for the level of distributable reserves £1,000,000
The shareholders in a cash rich business can use the EOT to extract the cash leaving enough working capital. Alternatively, the shareholders could sell the business to the EOT at a favourably price if they wanted a share of goodwill as well as cash. There is no legislation restricting what can be done.
Shareholders gift the business to the EOT
The sellers can transfer shares at completion or over time to the EOT for no monetary payment if they intend to gift the business. Ownership of the business is moved from the sellers to the employees via the EOT trustees.
Helping hand for employees
Each year, employees can receive annual tax free bonuses of up to £3,600 each. How good is that? Dividends are rarely paid as the shareholders of the EOT as the trustees and that would defeat the objective.