TO EOT or NOT TO EOT?  That is the question.  

These days, when business owners consider their options for exit, selling to an EOT (Employee Owned Trust), is frequently on the list.  

There are excellent reasons for this. The headline reason is that that on sale to an EOT, no Capital Gains Tax (CGT) is due. This is a hugely valuable incentive for exiting shareholders, and one which looks to become more valuable as the rate of CGT on sale of business assets increases.  

According to the consultation on EOTs which the Government launched in 2023 and which has yet to be concluded upon, the objectives of the incentive are “rewarding employees and encouraging employee engagement”. Surely then, the sale of a business to an EOT is a win: win with the vendor benefiting from reduced taxation and the employees gaining the benefits and mindset of business ownership. Presumably the expectation is that with skin in the game employees will be more driven, productive and entrepreneurial.  

The potential upsides are clear. But what do employees actually get if the business they work in is sold to an EOT ? The principle benefit is that the EOT is allowed to pay employees a tax free bonus of £3,600 a year. The value of this bonus has been fixed since 2014 and the amount has to be applied consistently across the whole cohort of employees regardless of seniority. It is possible to vary bonuses by reference to relative hours worked, salary and length of service but it is not possible to use them to mark contribution or achievement.  

The EOT will be governed by a board of trustees. At the moment, the vendor of the shares can be a trustee but under the current consultation it is proposed that this should no longer be the case. The key criteria for trusteeship is independence and the EOT has to lead the business in the interest of all the employees.  

The terms of a sale to an EOT are usually that an initial up front payment will be made for the shares, funded frequently by cash or assets on the balance sheet. The balance of consideration is usually deferred, made up of a loan due from the EOT to the vendor(s). This loan has to be paid down before the EOT members (employees) benefit from the value of the business the trust now owns. Depending on the valuation at which the initial sale to the EOT has been transacted, the period over which debt needs to be paid can be a number of years.  

The benefits of share ownership in an EOT other than the annual tax free bonus, are negligible unless there is some expectation that the business will ultimately be sold such that the employees benefit from a capital gain/lump sum. The tax rules associated with EOTs are designed to disincentivise this however.  It is clearly HMRCs intent that EOTS should retain the shares in perpetuity and run the business for the benefit of the employees. 

If the shares in the business are sold by the EOT to a third party within two years of the initial deal then the original vendor has to pay the Capital Gains Tax which would have been paid had their sale been to the same third party (ie the tax benefit is lost). If the sale of the business by the EOT is after two years then the EOT itself has to make good to HMRC the “lost” tax. Once any debt due to the original vendor is paid, and the legal and other costs of the deal are covered, and the tax accounted for to HMRC then any excess consideration can be distributed to the employees. The sting in the tail is that the distribution has to go through the payroll and is subject to normal payroll deductions (income tax and NI).  Even for a sale at a valuation well in excess of the original deal, the benefit to an individual employee is unlikely to be life-changing.  

As EOTs have matured over the last 10 years, more of them have looked to sell their shares and more of them have found just how the rules disincentivise this.  

Essentially, when you sell your business to an EOT you are removing the entrepreneurial incentive which is typically the driving force that has led to business success in the first place. Once a business is in an EOT it is almost impossible for even the most effective business leader to be fully incentivised.  

If the motivation for selling to an EOT is to realise, at zero tax, cash or assets locked in a business balance sheet then it makes sense. If the business can be confident of perpetual leadership that isn’t motivated by the opportunity for significant capital gain in the future, then that is probably ok. If it doesn’t matter hugely whether the business survives in the long term once its debt is paid down, then go for it.  

But for previously owner managed businesses, used to the driving force of an individual or individuals, the shift into communal ownership, the loss of any meaningful prospect of a capital gain and modest annual tax incentives delinked from individual performance seems highly likely to tend towards moribundity and statis.  

In a nutshell EOTs can be a brilliant outcome for vendors. But as time goes on it will be interesting to track the performance of mid market businesses under EOT ownership. The constantly cited example of John Lewis Partnership, with its £12.5bn revenues and 74000 employees, is able to invest fully in making the employee voice heard and paying an executive board healthy salaries and performance bonuses. Not so much a 100 employee business, paying down vendor loans, funding the costs of an independent trustee, funding the promised tax free bonuses for all employees regardless of their performance and without any meaningful equity stake to lure a top quality management team.  

Accepting that the tax treatment is less favourable, the would-be vendors of entrepreneurial owner-managed businesses would do well to consider other options if they want their enterprises to thrive beyond their ownership.  

Apart from finding a third party acquirer to buy the shares it is worth considering a sale to a motivated management team who will be able to benefit from the growth in value they deliver once any vendor loans have been paid off. There are a number of ways of funding the MBO of a mid market business, including private equity and third party debt (sourced either from a bank or a debt fund). A classic route for vendors who want to keep their business independent, are happy to receive their cash in tranches over time and trust their management team to deliver, is to fund the buy out themselves by means of vendor loan notes. Not as tax efficient as an MBO but with more control, more incentive for key management and with a greater ability to step back in if needed.  

In short, business owners considering EOT as an exit route should ensure that they fully understand not only the initial implications but also those in the longer term. For some businesses an EOT can become a prison that ultimately limits their progress. There are other options for vendors and it is worth exploring them side by side with an EOT before making a decision.  

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