Employee owned trusts: an alternative route to succession

In this penultimate episode, Natalie is joined by Paul Joyce, a partner in Mazars’ Mergers and Acquisitions team. They discuss employee-owned trusts as an alternative route to succession. Trusts come in many different structures that can be incredibly flexible and tax-efficient, but ultimately whether they are appropriate or not often depends on specific business objectives. An Employee Owned Trust provides a structure to purchase a controlling interest in a company at market value without any capital gains tax. As well as the obvious tax advantages, it provides a framework resulting in less disruption, greater confidentiality, and more opportunities for the existing employees and family members to acquire ownership and control.

Show Notes

In the penultimate episode, Natalie is joined by Paul Joyce, a partner in Mazars’ Mergers and Acquisitions team. They discuss employee-owned trusts as an alternative route to succession. Trusts come in many different structures that can be incredibly flexible and tax-efficient, but ultimately whether they are appropriate or not often depends on specific business objectives. An Employee Owned Trust provides a structure to purchase a controlling interest in a company at market value without any capital gains tax. As well as the obvious tax advantages, it provides a framework resulting in less disruption, greater confidentiality, and more opportunities for the existing employees and family members to acquire ownership and control.

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If you would like to find out more about how we can help you as a family business, please do not hesitate to get in touch by clicking the button below and Natalie or a member of the team will contact you. 

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Natalie Wright: You are listening to the Exploring Family Business Podcast, brought to you by Mazars. I'm your host Natalie Wright, Head of Family Business at Mazars UK. And having worked extensively with family businesses for a number of years, I'm keen to support this valuable sector of our society. At Mazars, we believe there is nothing more personal than a family business. Every family and every business are unique, that we look forward to sharing knowledge, insights, and practical tips for those navigating the unique issues that arise from being in business with family. Now on with this week's show.

Hello and welcome to episode five, of season two's, Exploring Family Business Podcast. Today's episode is a little bit different, as we're going to be exploring two specific funding opportunities that can lend themselves well to a family business, as part of long-term succession planning. We'll be covering Employee Owned Trust, commonly referred to as EOTs, and Employee Benefit Trust, commonly referred to as EBTs. Now, over recent years, these types of arrangements have become more well-known after adoption by the likes of John Lewis and Richer Sounds, so you may have heard of them. But I do think it's important to explain that these are not exclusively available to family businesses, and in fact, we've seen many non-family, privately owned businesses that we work with across the UK using both EOTs and EBTs successfully.

However, over the last year, we've seen a significant rise in inquiries for these type of arrangements from family businesses, largely because they're well-suited for managing that transition of ownership, and also ensuring there's a suitable custodian for the business, and potentially the family name, as well as providing some very generous tax benefit. Now, this isn't going to be a tax analysis, so we will cover some very, very high level points on the tax side of things. But this session is really designed to explain to potentially different routes for succession, which you may not have considered, or in fact may never have come across. To discuss this further, I'm joined today by Paul Joyce, a partner in our Mergers & Acquisitions team based in London. Paul advises businesses on exit strategies and supports them through transition of ownership, whether that's to the next generation of the family, the existing employees,or to external third-parties. Thanks for joining us today, Paul. Could you explain more about your role, and more specifically how you work with family businesses, who are transitioning through succession, specifically from an ownership perspective.

Paul Joyce: Of course. And Natalie, really nice to be on here. Thanks for having me. A little bit of background first. I spent the last probably 15 years advising owner managed businesses and family owned businesses on how they transition their ownership. That can be, whether it's through a trade sale, through an MBO, and actually quite a lot more recently, to trust structures like EOTs EBTs. We've got some very recent experience of doing that. My background is Deloitte for 12 years and I've been at Mazars for 4, and it has been a fantastic period. We've worked with a lot of family owned businesses.

I think the key for me is that every owner managed, and founding a business is different. What's important when you start to consider something like this is, what's important to you as a shareholder base, what's important to you as a business, and to really think through that process. Once you've done that you can work out whether any EOT or an EBT is the right structure for you to achieve those goals. I don't think you should go in thinking, "I want to put an EBT in place, or an EOT in place." I think we start with what you're trying to achieve in the business, and then we work out whether this is the right structure for you. We adopt very much the opposite of a one size fits all approach. We know that every business is different. It's about understanding that those businesses really carefully and really clearly before you even start trying to put any structures in place.

Natalie Wright: Thanks, Paul. I think that's echoed through actually in each conversation we've had this season, that the objectives need to lead the planning and not the other way around. And more important than ever for family businesses, and thinking about all the different complexities that come with it. If we can just talk about the M&A market generally a bit before we move on to EOTs and EBTs, it probably surprises a lot of people to see how busy it's been in the M&A market, how much is going on, particularly with the events of the last year. Do you want to just give us a rundown as to why there is so much activity in the market at the moment, and any impact that you've seen on the family business sector?

Paul Joyce: 100%. There are a number of elements really at play. The first one is that there's an abundance of capital in the market at the moment. Interest rates are incredibly low and continue to be incredibly low, and that makes borrowing more affordable than ever. We've also seen the establishment of a number of product debt funds, who are competing very aggressively with the traditional high street banks, plus product you'll raise a record amount of capital, which they need to put to work. So the amount of funding is as high as it's ever been. One of the things we're seeing is the last two, three year have had a number of bumps in the road, whether it be Brexit, whether it be COVID. And now that we're starting to come out of that period, people are starting to want to put money to work, where perhaps it's been a bit of a backlog in terms of investment over that period of time.

I think another factor is the risk of tax rises. More than ever, government spending over the last 12 months has to be funded somewhere. There's a general consensus, and you'll know better than I do, that tax rates are likely to rise over a period of time, where we saw obviously corporation tax rates go up at the last budget. And given the chancellor has been pretty clear about the triple lock on income tax VAT and national insurance, there's quite a lot of concern about capital gains tax and where the rates are going to go in the future. And that risk is getting people to think, "Well, is now a good time to realize some or all of my capital gain before those tax rates go up?"

And lastly, I think that the last 12 months have prompted people to just reassess what their priorities are in life. Whether that's their view on future economic growth may have come down, whether it's this concern there'll be another pandemic or another economic shock, similar to what we've seen over the last 12 months, or whether it's just a reflection on the fact that life is pretty short, and that people want to spend more time with their family and their loved ones. All of those have brought forward some of those succession conversations, and all of those in combination, have driven a lot of the M&A activity over the last 12 months.

Natalie Wright: It's interesting. I can see all those aspects as well from the side of the work that I do, looking at the financial planning and planning for the future. Certainly the change of perspectives and objectives for people has been significant over the last year. And something that you mentioned there about funding, that is an important aspect related to what we're talking about. So we'll pick up on that shortly. But if we come on to today's subject of EOTs and EBTs, and I just want to give a disclaimer at this point that they can be complex structures, and as Zoe and I discussed last week, it's important to take advice before you take action.

But if I just summarize what they are at a basic level for anyone who's new to either term, EBTs, Employee Benefit Trust, they're often used by private companies in order to create an internal market for the shares, without that need for the company to sell. An EBT can be used with other employee share schemes, to purchase shares from leavers, and in turn they can be recycled and used for future employees. EBTs can also be used to facilitate to full or partial exit from existing minority shareholders. Lots of different options, very flexible.

Now an EOT, an Employee Owned Trust, is a special form of Employee Benefit Trust, which buys a controlling interest in a company. And it holds that interest on behalf and for the benefit of their employees. They are also extremely attractive because it's possible to sell at market value without any capital gains tax, but they also carry other benefits. There's less disruption, greater confidentiality, as well as providing opportunities for the existing employees, all of the family members. Fundamentally they are both trust arrangements, but we don't want to let the word trust put you off. Trusts come in many different structures that can be incredibly flexible and tax efficient, but ultimately whether they are appropriate or not often depends on your specific objectives. Now, Paul, can you explain why and in what circumstances that you've been seeing EOTs as a suitable option for succession?

Paul Joyce: Yeah, of course. Probably you mentioned it earlier, the most obvious and high example of an EOT is John Lewis, who not only uses the structure to incentivize their employees and to encourage their retention, but he also uses it as part of their external marketing. They describe themselves as a genuine partnership, and this helps them attract and retain their employees. It also creates that real bond between the employees and the business, and it sends a message to their customers that they can be trusted. It goes even beyond just the ownership structure of the business. This is something that really is fundamental to the way the business is going to be run and operated going forward, and that runs through the entire business.

For me, there are a number of positives about that type of structure. Firstly, obviously, it's very tax efficient for the selling shareholder. There's no capital gains tax at all payable on the disposal, if it's done correctly. And it enables people to pass their business on to their employees, family members, without the need for some sort of external equity ownership. We know with a lot of family businesses that legacy can be really important, and they don't want to have some external ownership. Maintaining the ownership within the business, within the employees, is a really attractive option. As you say, shareholders can sell some or all of their shares. It needs to be a controlling stake, but there's flexibility in that deal structure. And that means that the shareholders are able to determine the manner of their exit and their transition. It's not being dictated by a third party who is going to describe how they want to buy the business. The shareholders themselves are able to drive that conversation and do that planning themselves.

It also involves probably the least disruption to the business. There's typically no change in branding. There's no moving of premises. There are no external stakeholders who need to be managed. If done correctly, it can be an absolutely seamless transaction, and a transition from one ownership structure to the next. But it's also worth flagging. There are a number of factors which anyone considering this type of structure needs to be aware of. One of the ways to help ensure we maximize value on it, on a typical external set of companies, is to run a competitive process, and have a number of competing trade buyers typically, even at the sale of an EOT is not an external transaction. We aren't testing that value in the market. And again, HMRC will want to be sure that what you're selling at a fair price, and that typically requires an independent valuation. If your objective is to get the highest possible price when you're selling your shares, this might not be the structure for you.

It also should be viewed very much as a long-term or a permanent transition. The situations where we've seen this type of structuring work poorly is where some people see it as an intermediate step towards the sales with third parties. Not only is this a very complicated process, but it also begins to negate the beneficial tax arrangements. If you're thinking about an EOT, that should really be considered as a permanent or long-term forever transition to employee ownership, not as a stepping stone towards something else.

Natalie Wright: Thanks, Paul. I think you've highlighted some really valuable points that are specifically in relation to family businesses, because we talk about the owners of a family business being custodians of the legacy of the family name, under the business. That often extends to their employees, that creating that partnership and having a bond between all the stakeholders is certainly an important aspect, which kind of feeds in nicely to what you've said there. If we come on to EBTs, because I suspect this is something that people may have heard of, but perhaps in a different context. I know EBTs have been around since the late 1980s, believe were used extensively by quite high earning employees, historically, with the main aim of minimizing tax. It possibly carried some negative press with them. My understanding is there was an attack on these types of schemes in 2011. But are we talking about the same thing here, or is this a different type of arrangement?

Paul Joyce: I think it is fair to say that EBTs have had a bad name over a period of time because there was some poor tax advice, they were using the wrong circumstances. Also, people were overly aggressive in their planning, and they were using it very much to avoid tax. And this led to a lot of anti-avoidance legislation and a reduction in their use, or a nervousness around their use. Now they're better understood. The structure from an accounting and a legal perspective is still the same, but it's the circumstances now which they're used in that's making them much more widely used and much more accepted by HMRC. If this is a process that's being used to enable the genuine transition of a business from one ownership to another, then that's clearly well understood.That's something that HMRC and the government is keen to encourage and make sure it's done properly. It's not looking to restrict people who have a genuine commercial purpose for the transaction they're putting in place. Because it's now better understood and people are getting proper tax planning, this is something that's becoming much more mainstream.

Just in terms of some of the differences between EBTs and EOTs, I find that EBTs can be a lot more flexible than EOTs. They provide a number of the same benefits, and they can be used as part of that transition process. I said a few moments ago that an EOT should be seen as very much a permanent transition, as a forever solution. An EBT is much more flexible and it'd be able to be used as part of a stepping stone towards perhaps a full sale over a period of time. They aren't quite as permanent as an EOT structure. But again, that has to be done with the right planning and the right forethought, because again, if you get things wrong, that's when HMRC tends to come and knock on the door and ask you some difficult questions.

For me, the key to sort of working out whether an EOT or an EBT is the right approach, is to come and have a conversation and discuss really what the objectives are. And then for me, the structuring follows on from that. We're getting a good understanding. If you're clear in what you're trying to achieve, again, whether that be value, whether that be long-term ownership of the business, whether that be transitioning to the next generation of the family, then we can work out which of those structures is the right structure. And then we can make sure that the structuring in terms of the tax planning and the capital structure is put in place, that it's absolutely HMRC compliant, and we can get clearance. In fact, during that process, you've got comfort that what we're doing is approved by HMRC.

Natalie Wright: Thanks Paul. Again, you've highlighted that you need to take advice before implementing any action and, don't let the tax lead the planning, it needs to facilitate it. If we move on to something you mentioned earlier about funding, how do you find the options for funding when it comes to these types of transactions? I suspect most people thinking, a trade sale transaction is pretty standard. It's easy to fund provided you figure stack up for the bank, or you've got the cash available. Then probably goes for an MBO where the forecast and influence of the senior management team are likely to be more important. But how did those types of structures diff from this when it comes to London?

Paul Joyce: There's a couple of things to observe here. The first one, and it ties really nicely into an observation I made right at the beginning, the capital markets today are a wash with funding at the moment. There's clearly an appetite from banks and debt funds to put money to work, but they are commercial enterprises and they want to make sure that they're putting money into the right businesses and the right opportunities. Whilst there is a lot more funding available, it still has to be for the right opportunity. What I am seeing is that lenders are becoming much more familiar with these types of structures. They're much better understood. They're much more compliant now with HMRC requirements. They're put together in a well thought through way by professional advisors. And that is giving lenders a lot more comfort than perhaps you would have seen 5, 6, 7, 8 years ago, where they were much less understood and they were perceived to be trying to do something untoward. Now, banks and debt funds are seeing these and are getting much more comfortable with them. 

What I would say is that these still need to be really well thought through and really well-prepared. The business that you're lending into to support the acquisition of the shares into the trust, needs to be robust. The financials need to be well-prepared. The management accounts need to be well-prepared. The banks or lenders are going to want to do their due diligence to make sure that their lending and their investment into the business is going to be safe. That's a really important part. 

I also think what's really important is that particularly in family businesses, if the owners who are looking to sell a proportion of their shares, if they're looking to hand the business over to the next generation, are the next generation ready to do that? Obviously it sends a signal to anyone putting money into the business that there is going to be a transition, and the banks and the lenders want to see that that transition has been really well thought through. Because whenever somebody who's important to the business divests in a stake and becomes less involved, there's always a risk that business doesn't perform as well going forward. For me, this has to be a really well thought through process, and that has to be articulated clearly to the lenders to get them comfortable. If they're going to put some money into a business, that money is in safe hands. And that, as we say, is either under the ownership of the employees or as part of the transition to the next generation. That's a really important element. 

What we're also seeing is that it's important to have a few conversations with different lenders. It's obviously very normal and very natural to go and speak to your existing bank. You've probably known them for a long time. You're probably very familiar with them and they've done everything that you've needed up to that point, but they might not be the right partner for you going forward with this type of structure.

One of the things we will typically do is speak to a number of lenders during that process. You'd be amazed at the difference in terms you get for something that's fundamentally the same requirement. That could be that some banks will lend more or less than others. Some will offer better interest rates. Some will have different capital repayment profiles, different covenants. And finding which of those structures is most appropriate for you and your business is really important, because every business again is different, and some are really keen to get the highest number they can in terms of lending. And some are really keen to make sure they have the flexibility to continue to make the investments they want. So maybe there's a capital repayment holiday in the short term. All of these things are really important. I think any of us when we're making a big decision like this, would shop around a bit. That's a really important part of the process to make sure you're getting the best possible structure in place.

Natalie Wright: Absolutely. And I like what you picked up on there about, it's not just about the financials. Actually, there is that personal element of understanding who'll be leading the business, who's going to be making the decisions going forward, and what kind of risk could that carry so that you can prepare yourself when you are collecting all this information and presenting it to a lender. So we've talked to lots about the opportunities that EOTs and EBTs bring, which is all fantastic, but let's look at what can potentially go wrong. Are there any pitfalls that you've seen when it comes to structuring, or the actual implementation and management of either of these structures which, if you point it out now, could save a lot of time and potentially costs at a later point?

Paul Joyce: That's a really good observation, Natalie. There's a couple of comments I would make on that front. Firstly, and it ties back to this idea that, making sure you properly plan through for these processes, and know what the restrictions are once you put a structure like this in place. For me, the situations I've seen that have worked worse, the ones where people have put in place, for example, an EOT and thought that this could be something that can be used as a stepping stone to then sell the business to a third party in due course. And what that does is that negates all the tax benefits that you've put in and becomes a very costly and time consuming process to unravel and unwind that structure.

Get that advice, really think through what it is you want to do with the business going forward and understand what the pitfalls might be if you change your mind in the future. EOTs can sound very attractive with a no percent tax rate attached. But I think that if it's not the right structure for you, because it's part of a broader process that you want to go through, then those are the situations I've seen where that's worked most poorly.

The other piece I've seen where things have gone bad is when you don't have the records and financial information in place going into the process. Preparation is really important. Act in haste and repent at leisure, is a very apt description of this situation. The number of people who think they can chain all the businesses and think they can save time by doing things more quickly, will end up spending more money, longer time process. Trying to unravel something that is put in place in haste is a real reminder that preparation in these situations is absolutely key. And having a good conversation, understanding with your advisor, what the art of the possible is, what you're trying to achieve. And then putting that structure in place will inevitably, over a long period of time, get you to a better outcome. It'll save you money and it will be quicker and easier and better for the business in the long term.

Natalie Wright: Thanks, Paul. You shed loads of really valuable information. Then, for me, this has been a really incredibly valuable session. I'm sure it will have prompted some questions. For anyone listening, I'll leave your contact details in the show notes, in the event anyone wants to reach out. Fortunately, we didn't cover taxing in too much detail. What I will do is leave in the show notes a link to a recent webinar that our tax team hosted where they've specifically explored the tax planning points for EOTs in more detail.

That brings the fifth episode of the Exploring Family Business Podcast, season two, to a close. If you enjoyed today's show, please subscribe to the series and leave a review on iTunes. It will help us to extend our reach to the family business community. Join me next week when I'll be speaking with George Lagarias, our Chief Economist. George will be discussing how the events of the last year have impacted specific sectors, as well as sharing his insights on what lies ahead and how family businesses can prepare themselves for the new economic landscape. I look forward to sharing more with you then, but for now, thank you for listening.

Get in touch

If you would like to find out more about how we can help you as a family business, please do not hesitate to get in touch by clicking the button below and Natalie or a member of the team will contact you. 

Get in touch

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