The pros and cons of selling your business to an EOT
Selling your business to an Employee Ownership Trust
Hi, my name is Garry Karch and I'm the Head of the EOT practice at Doyle Clayton. We are a law firm based in London and Reading and we have a very strong EOT advisory practice, probably one of the more experienced in the UK. I am here with my colleague Robin Hartley, who will introduce himself.
Hello, I am Robin Hartley and I am a Legal Director in Doyle Clayton’s EOT practice. I've been working with Garry since 2016. Today we're going to be discussing the pros and cons of selling your business to an employee ownership trust or EOT.
Pros of selling your business to an EOT
Robin: I think to my mind there are around 5 main pros to selling your business to an EOT. What do you think, Garry?
Garry: I think that's right. We'll dive into these in a little bit more detail during the podcast. But I think the real key to take away overall, is that an EOT transaction is a commercial transaction. A lot of people think of selling to employees as selling on favourable terms, taking a discount, you know, getting paid when you're able. We take a different approach. I think as we walk through the five points, you'll get a good sense of how we like to approach these and why we think the EOT is a really attractive option for business owners.
Robin: So I think the five on my list as follows:
• Receive a fair value for your business. I think that's one of the most important
• And the second is receiving the payment for your business, tax-free
• Three, it's a low stress transaction
• Four, I think there's something about a positive legacy for your employees. I don't know if you agree with that one or not.
Garry: Yeah, I do. And I think what's probably as important as the legacy is the fact that employee-owned businesses tend to perform better over time. They tend to be more resilient in downturns, which leads to greater job preservation and creation, which is key in these times.
• And then the fifth one was about day-to-day control of the business, and the vendors can either retain that day-to-day control or at the very least they can carefully plan the transition to a new management team over whatever period they think makes sense for the business.
Garry: That's an important point, because what we've seen with a lot of our clients is that they aren't 65 or 70 looking to walk away tomorrow from the company. A lot of our clients are in their 40s to mid-50s and they aren’t ready to go do something else at this point, but they want to de-risk, they want to potentially crystallise value and certainly the capital gains tax relief is very attractive to them. The question we get asked a lot is, can I stay involved? Can I remain as MD or CEO of the company? And the answer is absolutely you can. And in fact, we actually encourage that, for clients that are going to be paid out over time. You want to be in a position where you have oversight and a modicum of control over how the business operates so you can get paid out.
1. Fair value for your business
Robin: Regarding the EOT deals we worked on, we use principles to value the business that are identical to those on a third-party transaction and to my mind that means a value based on a multiple of earnings...typically, in a four to six times range. But that range depends on the sector in which your business operates and growth prospects.
Garry: I think that's right. And I think one thing that's important to take away from a valuation perspective is that again this goes back to our commercial approach. We will do an initial feasibility analysis for clients, and we actually will value the company as part of that feasibility analysis. But for all our transactions, we actually have clients get an independent third-party valuation. So, it's not just ‘I think my company is worth ….’ that valuation provides comfort to the trustees who are making the decision to buy the shares. They can rely on something that says ‘the company is worth X’ something which is done by an independent third party who has no skin in the game. They're going to be looking at that and saying, yeah, at this price, you're not paying more than fair market value. We never want them to come back and say that you're paying significantly less than fair market value because you know that's not in the interest of our client. But that's a real key and not a lot of advisors will actually do that, but to us that's actually a requirement, even though it's not under the law a requirement.
Robin: Yeah, it just anchors the whole transaction, doesn't it?
Garry: It does. And I think people have a lot more comfort, when they're asked to serve as a trustee director, that they have a basis for their decision rather than just, taking a vendor's word for it, that my company is worth X because it's basically a part of life that all vendors think their companies for the most part are worth more than an independent party might think they are. So, this builds protections in for everybody in the transaction.
2. Receiving payment for your business, tax free
Robin: Second on our list was receiving the payment for your business tax free and in some ways, this is a dead simple one. If you're selling your business for ten million and with normal CGT rules, you would pay somewhere around the two million mark. Equally, if you were just going to sit on the company and have that amount paid out in dividends over six or seven years, you'd be paying just under four million. Therefore, in effect, your tax saving is somewhere between two and four million.
Garry: And that's a real key factor. And I think particularly looking forward, I don't know anyone who thinks the tax rates are going to go down, if anything there are some moves afoot to potentially raise CGT more in line with income tax. Who knows what's going to happen with dividend tax rates? But I think when you look at this, it's only going to get worse for a third-party sale transaction, whether it's trade sale or private equity.
And that sort of ties in a little bit; Everybody talks about the synergies that come with a trade sale, well, that is true in many cases, but you also have to consider you're going to pay significantly more in taxes. So, when you look at the net proceeds to you, those net proceeds in a lot of cases, are going to be greater with an EOT transaction than they would be with a third-party sale. Roll into that the fact that you look at a commercially structured deal, which means your vendor loans are going to carry market interest rates, and the overall proceeds to you selling to an EOT can be significantly more than you might receive in a third-party sale transaction. So, it's going to vary based upon circumstances and who your buyer is, but it's certainly something that everybody should at least take a look at and see what the numbers actually look like.
Robin: - Yeah, I think that's one of the nice things about delivering our feasibility studies… is the expression on the client's face when they see just how much value there is for them.
Garry: That's absolutely right. You know, they fixate, I think, a lot on just the purchase price. But when you roll the overall structure in, when you roll the tax savings in, all of a sudden, you know, it's a different comparison than they might have thought they were making before the feasibility study.
3. Selling your business to an EOT is a stress-free transaction
Robin: The third pro was it's a low stress transaction, maybe more than that, it's an enjoyable transaction, I think, for a lot of our clients.
Garry: It is. The big problem with the trade sale, or private equity which is probably just as bad, if not even worse, since they're looking at purely returns, is really the confrontational nature of the transaction. In those types of deals there's a winner and there's a loser. And what's very common in those types of transactions is someone will make an offer for the business to try to get the opportunity locked up, and they'll do that typically at a higher price, with more favourable terms.
And then once you've signed up for an exclusivity period, then they tend to start trying to re-trade the transaction and that's never to increase the purchase price. It's always… we found these issues during our due diligence process. Therefore, we need to reduce the purchase price to take that into account. And that doesn't happen with an EOT transaction. Everybody goes into it knowing what the objective is, knowing that there's going to be a valuation, which is really in most cases the key issue when you have a third-party transaction, it's the battle over how much the business is really worth, and then if its synergies, who gets what percentage of those synergies in terms of purchase price versus discount; that's never going to happen with an EOT transaction. You've got the parameters laid out. Everybody has agreed with them.
The only even small friction point that I could see with an EOT transaction really just relates to those with companies that are large enough to access third party financing. In those cases, the issue isn't really negotiating the general terms of the transaction with the lender, but it's the documentation; it's the representations and warranties that you might have to make to the lender to entice them to go through the transaction. And that usually comes from their law firm, the banker just wants to get the transaction done; They liked it, they run it through their credit approval, it's been approved, and then once they turn it over to their lawyers, all of a sudden, you've got people who are trying to negotiate almost every point in the transaction as it affects the financing so, that's really the only point. We've never had an issue with that ever being a problem that kept a deal from getting done. But there will be more discussion around those issues than there ever would be in a vendor financed transaction.
Robin: Yeah, and I think it's got a lot easier over the past couple of years as we've sort of built up relationships with quite a few lenders and they've now got quite a lot of transactions under their belt... everyone really knows what they're doing now. Whereas maybe a few years ago it was still new to everyone.
Garry: I think you're right. And you know we've been through some painful processes with people educating lenders on how these work and on how they need to approach these. But they get there, and we've got a good group of lenders we work with for businesses that are looking to finance with a third-party debt component.
4. Positive legacy and am I giving up control of my company by selling it to an EOT?
Robin: Is there a bit more to say on the day-to-day control and the transition to a new management team?
Garry: Yeah, there really is. This is a real key to successful entrepreneurs, I think, because most of them have built their business by being laser focused on what the company is doing and how it's doing it. And, all of a sudden, they're looking at this sale transaction, and it is a sale transaction, you're selling to a trust, a trust overseen by trustee directors, and when they look at that, the real question is, am I giving up control of my company?
You know, so the answer is technically from an ownership perspective, yes. From an operational perspective, which is really the key, the answer is absolutely not. We have had clients where, prior to the transaction, they were the sole member of the trading company board. So, at the end of the day, everything stopped with them and post completion they have remained as the sole director of the trading company.
With multiple vendors, same thing. You've had two people that may have been the directors prior to the transactions; They remain in place. And the reason for that is the trust and the trustees aren't going to substitute their judgment, from a greater distance away from the day-to-day operations, for the judgment of the businesses managers. That remains vested in the executive team, it remains vested in the trading company board, because the assumption that trustees have to make even going into the transaction is, we're doing this and we are going to work with a team that knows what they're doing. Otherwise, if they had concerns, they shouldn't do the deal. Therefore, I think from that perspective, you look at it and say, ‘can I still operate the company as I have seen fit in the past?, the answer is ‘yes’. The trust is really there, and the trustee directors are really there, to make sure that there's nothing untoward that happens with the business. And given the fact that the company has traded successfully, prior to the transaction, the chances of that happening are slim to none. These are successful companies, they've operated successfully, they've done well, they've grown, and that will continue and that's all the trustee directors are looking for, just to make sure the business continues to operate as it has successfully been doing and in doing so, they're making sure they’ve operated in the best interest of the beneficiaries, which is really what their overall charge is.
Cons of selling your business to an EOT
Robin: So those are all the pros. Are there any cons?
Garry: Yeah, I think there are potentially always disadvantages or cons to any kind of a transaction. It is harder to find them with an EOT, I think. The biggest drawback to the EOT structure, and this is for vendor finance transactions, is that you are going to get paid out over time compared to a lumpier payment that you would get with third party debt. So, if you're a large enough company and you can raise debt, and for most SMEs you can generally look at raising two times your operating profit or EBITDA as part of a senior debt structure, but the key there is your size. So, for businesses with less than a million to a million and a half pounds of EBITDA, it's really difficult to access the third-party debt market. You know just a cash flow loan to an SME is tough enough to begin with. But when you have a change of control transaction, you know that's something that's a little frightening to some lenders. They want to make sure that there's enough resiliency, the companies could withstand the loss of a client, or several clients, and not affect their ability to repay the debt. So that, I think, is the first drawback, that you're going to get paid over time compared to a much more accelerated payment for your sale with a bank finance transaction, or a trade sale or private equity transaction. With a trade sale or private equity, you might get paid 100% up front, although what we have seen is more and more buyers are looking to defer a portion of the considerations and pay that out over two or three years post completion. So, they’re hedging their bets a little bit and in a lot of cases, they’ll tie that into performance.; We call that an earn out. You do see some of that in those transactions.
One of the things that always comes up when you're talking about a third-party trade sale is the idea of synergies, and I touched on these earlier. In synergies, what a buyer might look at is the ability to eliminate duplicate functions within the acquired company, and in doing so, they're able to increase cash flow and profitability. So, you will lose those entering an EOT transaction, that just won't exist, just because there is no true third-party trade buyer in a transaction like this; it's a financial transaction.
In most cases, the seller is - going to be the beneficiary of the majority of those synergistic benefits. The buyer is looking at this and saying I can increase profitability by 10% post completion, by eliminating the duplicate functions, whether it's related to accounting, whether it's other parts of the finance structure, whether it's different parts of sales management, where you've got a strong sales organisation in the buyer,. so, the question is always who gets the benefit of those cost reductions and the increased profitability? The buyer is going to always say we do, the seller is going to say, well, let's negotiate this. So, there is definitely the potential for a higher purchase price with a trade buyer, but again you've got to sort of go through this and say, ‘OK on a net basis, it's not what I get, it's what I keep, on a net basis., are those synergies going to be great enough to offset the significant increase in taxes that you’ll pay as part of the transaction. In some cases, the answer will be ‘yes’, but in a lot of cases the answer will be ‘no,’ when you factor in the overall transaction, which is the interest on the vendor loans, which may be what we call an equity kicker or a further payment down the road as part of the financing structure to make sure the return is appropriate for the vendor financing source, So it’s a consideration, something to be discussed, But, I think, at the end of the day, the numbers are going to show what makes the most sense, and I think that's why that feasibility analysis we discussed earlier is just so important.
Robin: Yeah, because, I guess, around 50% of our clients when they come to us, they've already been out to market with their business and have got a feel for what the market is offering and they may have a couple of offers in the bag. So, we know that and people are able to make that ‘like with like’ comparison and see just what the financing structure and the tax relief offers them and my feeling is about 90% of clients with that ‘like for like’ comparison end up favouring the EOT.
Garry: I think that's right. I mean, you look at sort of what we'll call the ‘conversion rate’. Once we've gone through a feasibility analysis with someone, and they look at the results of that and they compare that, and that's probably the best test of the EOT case, is if someone has gone to market, they have a real basis for comparing the two alternatives. I can think in the last six years that we've been doing this together, I can think of maybe one case where somebody pursued the trade sale after we had done the feasibility and they had been considering both. So, the case is strong. I think the other point for smaller businesses, is that it's really difficult to get a trade buyer to pay a significant premium for those companies.
Because for smaller SMEs the alternative for a lot of the trade buyers is to just create that function, or expand their business to cover what the potential acquisition target does. They have a point at which they say, it's cheaper for us to build rather than to buy. And I think that's what you're up against with smaller SMEs, you are in a position where you're almost at the mercy of the trade buyer when it comes to trying to build synergies, that they'll say, ‘take it or leave it’ in a lot of cases, ‘this is our offer because we do have options’.
The pros and cons of selling your business to an EOT- summary
Robin: I think we've reached the end. So just to sum up.
The advantages or pros of selling your business to an EOT
1. Getting fair value for your business.
2. You receive the payment tax free.
3. It's a low stress transaction.
4. There's a positive legacy for your employees and strong job retention in any EOT business.
5. And you can retain day-to-day control of the business or carefully plan the transition to a new management team.
The disadvantages or cons of selling your business to an EOT
1. You're going to get paid over time compared to a much more accelerated payment for your sale with a bank finance transaction, or a trade sale or private equity transaction.
2. In most cases, the seller is - going to be the beneficiary of the majority of synergistic benefits rather than the buyer (but there is the opportunity to negotiate synergies as we have explained).
3. There is the potential for a higher purchase price with a trade buyer (but not always as we have explained)
And anything to add, any final words of wisdom?
Garry: I think that pretty much covers it and I would just encourage anybody who is listening to this podcast to feel free to reach out to us if they would like to discuss the EOT or if they'd be interested in having us do a feasibility analysis for them. We don't charge for that and it really, in our view, is the only way to make an informed decision as to what the right option for you is.
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