Written by Chris Budd…….
A business owner currently going through our online Eternal Business Programme recently asked a question. This answer will, I think, be of interest to every owner thinking about or actually preparing for the sale of their business to an Employee Ownership Trust (EOT).
This owner is planning on retaining some shares, and will therefore be a minority shareholder post sale. His question concerns how to protect himself from what we might call ‘malign influences’ who may seek to take over control of the company, and therefore the profit.
Our owner set up a hypothetical situation:
- The company has £3m turnover;
- Its admin costs are £1m;
- Its staff costs are £1m;
- The annual profit is £1m;
- The company is valued at £3m;
Let’s say there are 10000 shares and 5001 are sold to the EOT (so just over 50%). A repayment schedule is established to pay £250k p.a. for the deferred consideration (def con), thereby taking 6 years to pay out the owner.
If trading continues at this level, therefore, the profit is distributed as follows:
- EOT gets £500k (with rounding)
- Minority shareholders get £500k.
The EOT uses its payment to pay the def con of £250k. The additional £250k is distributed to employees.
The question is this: what is to stop the directors staff agreeing to award them and the employees huge pay rises/bonuses, thereby wiping out the profit? There would be no profit, but the staff don’t care as they’ve got the extra £1m rather than £500k of it. The main loser is the minority shareholder.
It’s important to understand the reason for such a question. It is not so much a worry about the current employees (although it may be!), but about the potential for someone in the future to see an opportunity to get involved in the business and ‘steal’ the profit from the minority shareholder.
There are two parts to the answer: during the def con period; post def con/general protection for minority employees.
Paying the Deferred Consideration
During the 6 year def con period, the EOT has an obligation from the repayment schedule to make payments of £250k. This means that at least £250k of the £1m profit must go to the EOT for payment of the def con.
Now, there is a technicality here. The EOT legislation was drafted to allow for the payment to the EOT to be a gift, not a profit share (to avoid trust taxation). This means the usual rule that all shareholders must be treated equally can be circumvented, and a gift made but no profit declared.
It is therefore essential that the articles reflect this unusual situation and ensure the minority shareholders have certain controls to protect abuse of this situation.
This is a great example why you should only use a legal firm with plenty of experience of EOTs. This is a very specific issue related to the EOT, and could easily be missed.
Part of the legal paperwork at time of sale is a sale and purchase agreement (SPA). This has lots of protection in it for owner/vendor during the payment period. This typically includes the right to be a director (or to appoint one). If def con payments aren’t made, owner/vendor may have the right to swamp the board. And so on.
The second line of defence, so to speak, is the standard company documents to protect the minority shareholder, specifically the shareholders agreement and articles of association. These will probably need to be rewritten to cover the scenario above i.e. to prevent the board from voting bonuses to themselves or other employees over and above the normal expected for their roles (the legal people have a much better wording for that!). This is specifically designed to prevent the issue raised in the original query.
And finally, there are the trustees, who exist to hold the board to account. If, as we would always recommend, you have an independent trustee, then they should be keeping an eye on the sort of situation described.
Handing over control is scary, so such concerns are entirely understandable. My sale of my financial planning firm, Ovation Finance, to an EOT required 52 documents to be prepared. This is why it is so important to use solicitors with experiences of the issues peculiar to the sale to an EOT.
The Eternal Business Programme gives you everything you will need to prepare a business for the sale to an EOT. We have recently launched a starter version of the programme for owners unsure if the EOT is right for them: https://programme.theeternalbusiness.com/bundles/programme