How using external debt can help turn an EOT wish into reality

Chris Budd is one of the UK’s leading authorities on Employee Ownership Trusts (EOTs), having transitioned his financial advice business to an EOT structure in 2018. He now runs the Eternal Business Consultancy advising businesses on all aspects of succession planning including EOTs.

In this article he addresses the conundrum faced by many business owners who may be attracted by the idea of transitioning to an EOT but also require the certainty of an initial payment.

Recent figures from the Employee Ownership Association (EOA) show that increasing numbers of business owners are choosing to sell their businesses to Employee Ownership Trusts (EOTs). In the first quarter of 2021, a record 71 businesses transitioned to an EOT structure, taking the overall number to almost 600 since EOTs were first established in 2014.

There are many attractions to selling to an EOT for owners and employees alike. These can include:

•    ensuring the business continues the owner’s legacy

•    encouraging deeper engagement by employees in the ongoing success of the business 

•    lower execution risk due to the familiarity between buyer and vendor

•    retention of commercially sensitive information within the business

•    owners receive a fair market value for their business

In addition, there are tax incentives, including a capital gains tax exemption for owners and income tax exemption on profit share of up to £3,600 p.a. per employee.

It is key to note, however, than an EOT owned business does not operate like a typical founder-owned business. It is crucial, therefore, that owners take time to transition the business into one that is ready for employee ownership.

The initial payment conundrum

Remember – with an EOT, owners get paid from future profits of the business, or profits previously accumulated. This is known as the deferred consideration.

One potential downside of going the EOT route is that business owners may be looking for larger initial repayments than the business has available from its own resources. Some owners may decide against selling to an EOT in order to receive an initial payment from a trade sale.

However, there is a solution to this conundrum. A loan to the business can be helpful for owners that are attracted by the advantages of the EOT, but also require a certain level of initial payment

The deferred consideration and debt from the third-party lender are then repaid out of the future profits generated by the business. 

Lenders will, however, want assurances that the EOT has been structured to sustain the business’s profitability, as more responsibilities for running the business pass from the owner to the employees.   

This is the main reason why it is so important for owners to prepare their business for life in employee ownership.

Sources of external debt

The perceived complexity of EOT transactions, potential unequal sharing of risks between lender and the EOT as well as reliance on future cashflows are some of the reasons why traditional lenders such as banks are lukewarm about funding EOTs. As a result, a number of alternative lenders, including ThinCats, have moved in to fill this gap in the market.

The amount that can be funded by cashflow loans is typically up to 3x sustainable EBITDA depending on the strength of the underlying business. The lender will be keen to understand potential risks that could impact the EOT’s ability to service its debt. Factors could include general economic growth prospects through to sector and company specific considerations. 

Unlike asset backed lenders who can assess risk against the value of specific assets as security, cashflow lenders need to take a more holistic view to analyse a wide range of risks that could limit the borrower’s capacity to repay its debt. In this respect, cashflow lenders need to adopt a long-term perspective to properly understand the risks and opportunities faced by prospective borrowers.

Creating an Eternal Business

The EOT is an ideal structure for creating long term, sustainable businesses. So it is great news that there are lenders who are also willing to take a long term outlook, and in particular to look favourably on businesses who have prepared for life as employee ownership. These are areas that are covered by the Eternal Business Programme, and include, among other things:

•    Engendering employee engagement

•    Establishing new governance structures

•    Preparing leadership teams for a new style of leadership

•    Information flow

•    Trustee training

By preparing the business for sale to the EOT – a process that, to be done properly, can take a year or two – an owner can manage the risks associated with the sale. And, in doing so, the business will become more attractive to a lender.

This can mean that the owner can create a business which will last, if not for eternity, then at least long enough for them (and the lender!) to be paid.