Planning for debt-free day

In the fifth article in our series, Employee Ownership Trusts: Looking to the Future, the TLT Employee Ownership team discusses how “debt-free day” (sometimes called “financial freedom” day) can impact on the Employee Ownership Trust (EOT) and the employee-owned company.

What is “debt-free day”?

It is common for an EOT to fund the acquisition of a controlling interest in the trading company by either:

• borrowing money from a bank, or another third party lender; or
• agreeing with the selling shareholders that it will pay some, or all, of the consideration in instalments over a number of years following completion (typically 4 to 7 years). The deferred consideration is often funded by a contribution/gift of cash to the EOT by the trading company. This structure is commonly referred to as “vendor finance”.

For further details about financing the acquisition by the EOT, see our insight here.

The point at which the EOT repays all of its borrowing and/or makes the final payment of deferred consideration to the selling shareholders is commonly known as “debt-free day”.

How will the governance of the EOT be impacted by “debt-free day”?

Where the selling shareholders have agreed to a vendor finance structure, it is common for one or more of the selling shareholders to be appointed as a director of the EOT trustee company. This is to ensure that the sellers have a role in protecting the value of the trading company so that the trading company is in a position to fund the EOT to pay the deferred consideration.

It is not uncommon for the articles of association of the EOT trustee company to provide that the selling shareholder(s) director appointment will end when the deferred consideration has been paid in full. This means that “debt-free day” may trigger the resignation of the selling shareholder(s). The EOT trustee will need to plan ahead of “debt-free day” to ensure that plans are in place for a smooth transition in these circumstances. The continuing directors of the trustee company may need to appoint additional directors to the trustee company board to comply with both the EOT’s articles of association and the EOT legislation.

Key questions for the continuing directors to consider include, how are new trustees appointed, how long will the process take and who should be involved in decision making. The EOT’s governance documents may provide for the employees to have a say in the appointment of new trustee board directors and any consultation will need to be built into the timetable for appointment of new directors.

How will the board of the trading company be affected?

It is common for a selling shareholder to remain as a director of the trading company board following the sale to the EOT. The selling shareholders may have been crucial to the success of the business for many years. By remaining on the EOT board post-transition they can provide a level of reassurance to both the EOT trustee company and to the employees, that not only will the business continue profitably but that the culture and ethos of the business will be maintained.

“Debt-free day” may be the point at which the selling shareholders wish to step back from the business and therefore they may resign as directors of the trading board. It is important that the period between transition and “debt-free day” is used to reconfigure a board adapted to the next phase of the company’s development so that employees of the business approach “debt-free day” with confidence.

Does the EOT becoming debt-free impact on existing share incentive arrangements?

It is possible that awards over shares in the trading company may have been granted to certain employees post-transition under share incentive arrangements to motivate those individuals to remain with, and contribute to the growth of, the business.

The exercise, or vesting, of those share awards may be triggered by “debt-free day” and therefore consideration needs to be given to what that means for the employees and for the EOT. For example, will employees acquiring shares be given the opportunity to sell those shares to the EOT so that they can realise value from their shares? If so, how would the purchase price of the shares be funded by the EOT?

For more details about the types of share incentive arrangements that can be established by an EOT-owned company, read our insight here.

How can the EOT engage with employees after debt-free day?

As employees are the beneficiaries of the EOT, subject to certain conditions, they are eligible to receive an annual bonus of up to £3,600 per employee which can be paid to them free of income tax (although National Insurance contributions will apply).

Since this bonus is payable by the trading company, not the EOT, whilst the trading company remains obliged to fund the repayment of debt or the payment of deferred consideration by the EOT, the trading company may not have sufficient resources to fund an annual bonus for each employee. “Debt-free day” may therefore give the trading company the financial freedom to start making annual income tax free bonus payments to its employees (or to increase the amount of the annual bonus that it pays to each employee to the maximum £3,600). In many ways, it is the first time that the employees have the potential to share in all the economic benefits of employee ownership.

To celebrate “debt-free day” the trading company may consider introducing new employee benefits and/or making a one-off bonus award to employees (in addition to the annual profit share referred to above).

It may also be a good time to introduce new longer-term incentives for employees, such as an all employee share incentive plan, to allow employees to acquire actual shares in the company.

It will be crucial to the ongoing success of the business that the EOT and the trading company communicate with employees to ensure that they feel the benefits of the EOT structure. Explaining how “debt-free day” will impact on employees and sharing the strategy for the next stage of the company’s development will be key steps.

What is the strategy for growth post “debt-free day”?

The company’s ability to grow significantly during the period between transition and “debt-free day” may have been limited as profits realised by the company are likely to have been utilised in making contributions to the EOT.

However, post “debt-free day” the company is likely to be better placed to pursue a growth strategy. Profits might be available for that purpose and with the repayment of any existing lending, the EOT or trading company will have more flexibility to secure new lending to further any growth strategy.

Like any other trading company, it can achieve growth in any of the following ways:

• by the acquisition of competitor and/or complementary businesses;
• by seeking investment from third party investors; and
• by organic growth from the company’s existing business.

However, there are some specific considerations that an employee-owned company will need to take into account when planning for growth which we explore further in our insight here.

Are there any other practical steps that the EOT will need to take as “debt-free day” approaches?

It is common for third party lenders to the EOT to take security over the EOT’s shares in the trading company or the assets of the trading company. Where vendor finance has been used, sellers sometimes hold a preferred share until “debt-free day” arrives. Steps will need to be taken once the debt is repaid to cancel any preference shares and/or release any security provided by the EOT.

If the selling shareholders hold any residual ordinary shares in the trading company post-transition, consideration will need to be given to what will happen to those shares. The EOT may be willing to acquire those shares if the trading company has sufficient profits to fund the acquisition by the EOT.

TLT comment

Reaching the “debt-free” milestone is an important stage in the development of an EOT-owned company and is often seen as the first day of full employee ownership. Whilst the financial freedom presents an exciting opportunity for the EOT to grow the business and build on its success, it may also bring to an end the relationship between the selling shareholders and the EOT or trading company which can present some challenges for the trustees and the trading company.

Planning ahead is key to addressing those challenges and successfully growing the business after “debt-free day”.

How can we help?

TLT has been a leading firm active in the employee ownership sector for a number of years. Our specialist, and experienced, employee ownership lawyers have a diverse range of clients in England, Wales, Northern Ireland and Scotland.

We provide insightful strategic direction to employee-owned businesses at every stage of their journey and have led a number of the most high-profile employee ownership transactions within the UK.

If you are interested in discussing any of the topics covered in this article, get in touch with our employee ownership specialists below.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at April 2025. Specific advice should be sought for specific cases. For more information see our terms & conditions.