How is an Employee Ownership Trust (EOT) Financed?

An Employee Ownership Trust (EOT) offers a tax-efficient way for business owners to sell their company while preserving its legacy and ensuring long-term stability. By transferring ownership to employees, sellers can receive full market value, benefit from capital gains tax exemptions, and structure repayments through loan notes. However, financing complexities must be carefully planned, including cash flow management, loan note interest taxation, and potential bank lending requirements. This guide explores how EOTs are valued and financed, highlighting opportunities and essential considerations.

How Do You Value a Company for an EOT?

Determining the company's value is a key step in transitioning to an EOT. While we will cover the valuation process in greater detail in a future article, here’s a high-level overview for context.

Valuations for EOT transactions should follow Section 272 of the Taxation of Chargeable Gains Act 1992, which defines the company’s value as “the price that would be obtained in an open market sale between a hypothetical willing seller and buyer.”

Typically, valuations are conducted by independent financial advisors and are presented on a cash and debt-free basis with a normalised level of working capital. Before the transaction is completed, adjustments are made to reflect this, often displayed through an enterprise-to-equity value bridge. If the company holds surplus cash, this amount is added to the share value and qualifies for capital gains tax exemption.

Fig.1: Example Enterprise to Equity Bridge

How is an Employee Ownership Trust (EOT) Financed?

Since the EOT rarely has enough cash reserves to fund the entire purchase upfront, financing is typically structured in stages:

Immediate Payment: When the transaction closes, the seller receives the difference between the company’s equity and its enterprise value, often referred to as surplus cash. If the full amount is not immediately available, the balance can be added to the deferred consideration or loan notes. The initial payment and the deferred consideration are exempt from capital gains tax, making it beneficial to maximise surplus cash in the year leading up to the sale.

Loan Notes: The remaining balance is issued as loan notes to the seller, which accrue interest at a market rate. These loan notes are repaid over time from the company’s post-tax profits, as outlined in the agreement between the selling shareholders and the EOT trustees. (see fig.2)

Tax Implications of EOT Financing

Loan Note Interest: Deferred consideration can pose a risk since it is linked to the future performance of the business. However, this risk is mitigated by the ability to charge interest at a competitive commercial rate, which makes the transaction resemble an investment in a well-established asset. It is important to note that interest is subject to income tax, so efficient structuring is essential.

Loan Note Principal: Exempt from both income tax and capital gains tax, creating a highly tax-efficient exit for the seller.

Financial advisors often provide repayment illustrations and cash flow projections based on various performance assumptions to help sellers understand potential repayment timelines.

Fig. 2: The left side compares proceeds from a trade sale with an EOT using senior debt versus an EOT with vendor loan only. The right side compares repayment periods for senior debt and a vendor loan only.

 Should You Consider Bank Lending in an EOT Transaction?

Sometimes, selling shareholders may choose to secure external bank lending to reduce the loan note value and increase their upfront payment (see Fig.1). While this can be beneficial, it comes with specific considerations:

Priority of Repayment: Bank loans take precedence over loan notes, delaying loan note repayments until the bank debt is cleared unless the company generates substantial cash flow during the repayment period.

Financial Covenants: The company must comply with the bank’s financial covenants and reporting requirements.

Risk Considerations: Banks usually don’t require personal guarantees from selling shareholders, but they are generally less flexible than shareholders during financial challenges.

Since introducing bank debt adds complexity, financial advisors can model different scenarios to determine whether external borrowing makes economic sense.

Key Takeaways

EOTs offer an innovative way to transition business ownership while preserving the company’s culture and long-term viability. However, successful implementation requires careful valuation, thoughtful tax planning, and a well-structured financing strategy. Working with experienced advisors ensures a smooth transition while safeguarding your financial goals and your business’s future.