An Employee Ownership Trust (EOT) is an ownership structure that enables employees to indirectly take on a ‘significant and meaningful’ stake in their employing company. Doing so provides the outgoing majority shareholder(s) with an effective and efficient means to dispose of their shares, as well as a substantial tax advantage compared with other methods of disposal.
Producing a robust valuation is critical in ensuring the transaction is fair for both parties, to adhere to any compliance or governance requirements, and to manage risk.
WHAT IS AN EOT AND WHAT ARE THE BENEFITS?
It is now widely considered that employee ownership has the potential to bring about many unique benefits to a company, as well as to the wider economy. To incentivise owners to sell a controlling stake in their business to the employees, specific tax reliefs were introduced in 2014 to encourage a specific form of employee ownership.
This involves shares in the company being acquired by an EOT – a specific type of trust which holds those shares for the benefit of employees.
Provided certain conditions are met, there should be no capital gains tax exposure for outgoing shareholders when selling shares to an EOT. In broad terms, the four main conditions that must be met are that:
- The transferring company must be a trading entity or the parent company of a trading group.
- The EOT must hold a controlling interest in the shares in the company at the end of the tax year in which the transfer takes place.
- Any benefits that are provided by the trust to individual employees must be provided on the same terms in favour of all eligible employees (although this does not prevent those employees from being fairly remunerated as normal). Certain individuals must be excluded from the trust, which includes anyone who holds (or has held) more than 5% of the shares in the company.
- The number of employees or directors who hold 5% or more of the shares in the company must not exceed two fifths of the total number of employees.
Selling shares to an EOT can be an attractive option if a trade buyer cannot be identified, or if there are no other options for internal succession. As well as providing potential tax benefits, selling to an EOT may also be preferable to avoid becoming embroiled in complex and time-consuming negotiations with trade buyers. This will free-up time to enable management to focus their energy on running the business, and to ensure a smooth transition of ownership. Time can then be dedicated to engaging and motivating the workforce. Additionally, the fees associated with a transfer of shares into an EOT are typically lower than for trade sales.
WHY IS A VALUATION REQUIRED?
The interests of the outgoing seller and the EOT must both be considered, and there is a risk of challenge from HMRC should the consideration be deemed to be greater than market value.
Vendor shareholders should expect to receive a commercial price for their shares. Therefore, ensuring a fair and robust valuation is a critical part of the process of implementing an EOT.
The trustees of the EOT have a legal duty to act in the interests of the employees, which includes a responsibility not to pay more for an asset than its market value. Doing so could breach the requirements of the EOT legislation and fundamentally invalidate the tax advantaged status of the trust and the availability of any relevant reliefs and exemptions. This could result in unexpected income tax charges for the vendors.
Where the transaction is to be funded out of future profits, an inflated value could also place undue financial strain on the business, protract the process of paying for the acquisition and detract from the longer-term benefits of employee ownership. If the EOT or the company borrow or enter a financing arrangement (such as sale and leaseback with a third party) to expedite payments to the outgoing shareholder, an inappropriate valuation may result in the company becoming leveraged with excessive levels of debt that are unsustainable and hamper its future success.
HOW IS A COMPANY VALUED?
An independent valuations expert should be instructed to produce a report opining on the value of the shareholding being acquired. This report must arrive at the ‘market value’ of the shareholding, which is defined in UK tax legislation as ‘the price which those assets might reasonably be expected to fetch on a sale in the open market.’
For most trading entities, a multiple of earnings will be used as an appropriate means of determining the market value. The valuer will first consider the future maintainable earnings (“FME”) of the company following a quantitative and qualitative assessment of the business. In determining a suitable FME, consideration must be given to historical performance and estimated financial forecasts; and, in so doing, gaining an understanding of any anomalies that may impact the estimate of earnings and the overall risk profile of the subject company.
The multiple applied to FME is usually derived through a review of comparable public companies, transactions involving comparable private companies within an appropriate timeframe, and market indices based on the sector, size and jurisdiction. Earnings multiples can vary significantly and require a degree of subjectivity when comparing the subject company with the information being used as a benchmark.
Alternative methods of valuation may include a discounted cash flow. This requires robust forecast cash flows to be considered and discounted to their present value using an appropriate rate. The feasibility of this approach is however dependent on the availability of reliable forecasts, which are underpinned by realistic and justifiable assumptions.
A further point that must be considered, once a whole company valuation has been established, is whether or not 100% is being transferred to the EOT. Current rules allow for up to 49% to be retained by the exiting shareholders. If less than 75% of the shares are being transferred, consideration would be given as to whether a discount is applicable to reflect a lack of control. There are a number of factors that influence the applicable discount, such as the valuation method adopted, the size of the shareholding being disposed of, and any specific circumstances. This can be material, particularly to the exiting shareholders, and so it is important to ensure that the implications are considered early in the planning process in case this influences the overall structure of the deal.
SUMMARY
Valuing a company in anticipation of selling shares to an EOT is particularly important, including ensuring that the transaction takes place on a commercial and equitable basis for all parties, and to manage the tax and legal requirements. A robust valuation that is fair, commercially acceptable, and can satisfy HMRC is an essential part of the process.
CONTACT OUR VALUATION EXPERTS
Our team of valuation specialists have extensive experience advising on company valuations in anticipation of a sale to an EOT, including a number of high-profile companies.
For further information on our valuation services, or to discuss your specific circumstances, please contact one of our specialists via the contact form below.
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