Meeting the EOT's financial commitments

In the third article in our series, Employee Ownership Trusts: Looking to the Future, the TLT Employee Ownership team discusses the EOT’s financial commitments and how they are funded, both on and after transition.

What are the EOT’s financial commitments during the transition stage?

An EOT structure involves the trustee(s) of the EOT acquiring, as a minimum, a controlling interest in the trading company (or the parent company of a trading group). The selling shareholders will generally expect to receive a market value (or close to market value) consideration for the shares they sell to the EOT. The market value of the shares will be established by the EOT obtaining a valuation of the trading company.

In addition to the purchase price of the shares, the trustees may also incur professional fees for legal and valuation advice and stamp duty payable on the transfer of the shares.

Is it important for the EOT trustees to obtain an independent valuation?

Yes. At the Autumn Budget 2024, the government announced a package of reforms to the taxation of EOTs including the introduction, with effect from 30 October 2024, of a requirement that the trustees of an EOT must take all reasonable steps to ensure that consideration paid to acquire the shares does not exceed market value at the time of the disposal.

In the light of the new market value requirement (which will come into force on enactment of the Finance Bill 2025), we would expect both the selling shareholders and the EOT trustees to want the comfort of obtaining an independent third-party valuation.

How do the EOT trustees typically fund the initial financial commitments?

Since, prior to completion, the EOT trust fund is likely to consist only of a nominal amount of cash, funding the purchase consideration and acquisition costs upfront can be difficult for the EOT trustees and takes careful planning.

The financing challenge is commonly addressed in one of two ways, by using a vendor-finance structure or debt-financing. Sometimes a combination of vendor finance and debt finance may be adopted. These funding methods are explored further below.

What is a vendor finance structure?

Vendor finance means that the selling shareholders agree to receive:

• a payment from the EOT on completion of the sale; and
• the balance of the consideration as deferred consideration paid by the EOT in instalments over a number of years following completion, typically 4 to 7 years.

It is important that the EOT trustees consider the affordability of any deferred consideration payments – if the payment schedule is too onerous and doesn’t appropriately consider historic and projected profitability of the business, this could cause financial difficulties post-transition.

Also, when negotiating the terms of any deferred consideration, the EOT trustees should be mindful of another of the EOT changes announced in the Autumn Budget 2024 which requires that any interest payable in relation to deferred consideration does not exceed a reasonable commercial rate.

Under a vendor-finance structure, the consideration payable on completion and the associated sale costs are often funded by a contribution/gift of cash to the EOT by the trading company. Legislation to be introduced when the Finance Bill 2025 is enacted later this year confirms that such contributions to the EOT, which will benefit from a specific relief from income tax distribution treatment, will be tax-free receipts for the EOT.

What does debt-financing involve?

Debt financing is a more traditional method of financing and involves the EOT borrowing money from a bank, or another third-party lender, to pay the full consideration to the selling shareholders on completion.

The EOT is liable to repay the money borrowed, plus interest, over a set period.

In some cases the target group will borrow the funds, which are then paid to the EOT to allow it to pay the consideration to the selling shareholders.

It is possible for the lender to ask for, and be given, a charge over the shares in the trading company held by the EOT as security for any loan funding to the EOT.

Alternatively, a lender may request security over the assets of the trading company, but where the security relates to lending provided to the EOT, not the trading company, careful consideration would need to be given to whether such a request could be granted to ensure the trading company’s continued compliance with UK company law.

What are the EOT’s financial commitments after the transition stage?

After transition, the EOT’s primary financial commitment will be:

• paying any outstanding consideration to the selling shareholders; and/or
• repaying any lending as a result of the transition.

However, post-transition, the EOT’s only asset is likely to be the shares in the target company (which may be used as security for debt financing as mentioned above).

This means that the EOT is reliant on the company making contributions to the trustees to enable the trustees to meet the EOT’s financial commitments. The EOT’s ability to make payments (whether to the selling shareholders or a lender) is therefore dependent on the profitability of the employee-owned company since the company will be able (under UK company law) to make contributions to the EOT only when it has sufficient distributable reserves (sometimes referred to in a company’s accounts as “retained profits”).

In addition to the primary financial commitments, the trustees will expect to incur expenses in connection with the ongoing ownership of the shares in the trading company following the acquisition. These expenses could include the fees of appointing an independent or professional trustee to the board of the EOT trustee company, the cost of arranging external finance and ongoing legal fees for advice. Unfortunately, the legislation (which will come into force on enactment of the Finance Bill 2025) which provides income tax relief for contributions made to an EOT by an employee-owned company, does not, currently, extend to contributions relating to these types of post-acquisition expenses.

What happens if an EOT-owned company fails?

If an EOT-owned company faces insolvency, the same procedure will apply as with a company under conventional ownership. This means that an administrator or liquidator may be appointed and the conduct of the directors of the trading company in the period leading up to insolvency may come under review.

Generally, the directors are obliged to act in the best interests of the shareholders, therefore, if the company is wholly owned by the EOT for the benefit of the employees, the directors should be considering the employees’ best interests. However, the directors should also be aware that their duties will change in the face of insolvency meaning that they must consider the interests of the company’s creditors.

The employees (in their capacity as beneficiaries of the EOT) will have no liability for the debts of the trading company (except in the case of misconduct by directors). However, it may be the case that jobs are at risk unless an alternative solution to liquidation can be found.

If the company ceases to be employee-owned within the clawback period (being the period of four years following the tax year of transition for disposals to an EOT on or after 30 October 2024), then the capital gains tax relief claimed by the selling shareholders is likely to be withdrawn giving rise to a tax charge for the selling shareholders. If liquidation occurs after the clawback period, there is likely to be a capital gains tax charge for the EOT.

TLT comment

Employee ownership can lead to better employee engagement and increased profitability. There is also the potential added benefit to the brand as a whole which will likely boost both customer and supplier support.

However, employee-owned businesses are subject to the same challenges as any other business, including, rising operational costs, pressure from competitors and greater industry regulation. It is therefore crucial post-transition to ensure the proper management of the employee-owned company and that the trustees of the EOT engage with the directors of the trading company to ensure management has a clear understanding of the EOT’s financial commitments and obligations.

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 March 2025. Specific advice should be sought for specific cases. For more information see our terms & conditions.