Of course, we think EOTs are great. But they can have issues.

We recently spoke to the senior team of an EOT controlled company that’s had a very rough ride! For reasons that may become clear, they didn’t want to be named.

In the below we discuss the various safeguards to help ensure an EOT transfer goes well…and how these can fall apart!

Background

The company was a typical small business:

~3 years ago, the founder decided an EOT could be a good route forward for everyone.

All good so far…but this is where things started to go wrong.

Run up to EOT sale day

The senior team were aware of the decision to sell to an EOT several months before sale day, but given no details. No valuation/sale price, nor proposed repayment schedule. These crucial elements were only shared the day prior to sale.

Management had no input in the decision or set up in the lead up to sale day, when they were suddenly presented with sale documents and asked to sign without time to read/understand them, or seek advice. They were only informed of their new roles and responsibilities a week before sale.

Whilst employees will generally have no control over the terms of the deal, it’s normal to discuss with senior team some time before sign off. It’s important they understand and are happy with the plan. If they’re not, and they leave, the business can quickly die, meaning payments to founder stop too!

This is particularly true if the founder moves on very soon after sale, as happened here.

The gradual transfer of power/knowledge should start at least a few months before sale date. Ideally it would’ve been drip fed over several years pre-sale.

Potentially it can be done after sale date, with the founder staying for a while to try to ensure a smooth transition. However this gives no scope to backtrack if significant problems arise. Hence why it’s strongly advised to consider and discuss things beforehand.

Professional advisers

Normally with significant transactions the seller would have their adviser, and the buyer would have a separate adviser. Each party has an expert “on their side” in the negotiation.

Conflict/who is the client

An EOT sale is one of the few situations where you can potentially just have one adviser acting for the whole transaction.

The logic is with EOT sales is the adviser is working for the company itself. The sale should be “amicable”, focussing on a “win-win” outcome. If the deal doesn’t work for staff, there’s a real risk it doesn’t work for the founder either. As typically the founder is reliant on the team making sufficient profits for multiple years post sale to pay the founder off.

So…whilst multiple advisers may be involved, it’s not rare in EOT sales for there just to be one adviser, chosen and appointed by the founder. But this adviser should be working for the company itself (i.e. not for the founder).

The adviser should be neutral, creating a fair deal that works for all parties.

Valuation/payment plan

As part of the adviser role, they’ll independently value the business. In practice for EOT sales the valuation should be based on what the company can realistically afford to pay, over a reasonable timeframe.

This is one safeguard. A layer of protection to help ensure EOT sales are fair, and work for all sides. This valuation figure forms the upper limit the founder can sell for.

Valuations can be a tricky area. They are subjective. A “fair” valuation will typically be based on future profits…which of course aren’t known with confidence pre-sale. Hence you could ask 3 different advisers and get 3 different valuations. None of them would necessarily be right/wrong.

What went wrong

The founder provided the adviser with very optimistic forecasts, well above historic trends. The advisers used those, then made further arbitrary upward adjustments to predicted EBITDA to get to a valuation the founder was happy with. They also recommended more cash be leveraged from the sale via a high interest loan arrangement.

Combine these and you get a very high sales price, with pressure to pay it quickly to minimise excessive interest.

No alternative valuations were sought, nor was affordability considered based on previous growth patterns. In the senior team’s view, the advisers acted in the founder’s sole interest.

Financially the EOT deal was set up to pay top whack to the founder, as quickly as possible, with minimal thought to viability for the ongoing team.

EOT sale sign off

Another safeguard is the purchase side of the transaction needs to be signed off by the EOT trustees. Their role is to act in the best interest of staff. Whilst the founder is often one trustee, there should also be an employee trustee and independent trustee.

However, often the founder will choose these people. Plus peer pressure can work wonders!

Therefore the situation can be:

That’s what happened here.

Hence these safeguards were of no real protection either.

Post sale – options considered

The sale completed. The founder disappeared into the sunset, though did remain as a trustee.

The senior team were left to it, and felt like a rabbit in headlights. Not prepared. They were good at their jobs, but had no experience in business operations. Far from ideal!

They tried to discuss this with the founder, but were met with a harsh “come on, you don’t want to fail do you? Be more optimistic!” response.

Over the many months that followed, they considered various options.

Litigation/legal liability?

At various stages they considered taking legal action.

Possibly against:

In practice, they knew these would be an uphill battle. The safeguards had technically been followed. Litigation can get very expensive, with no guarantees of success.

Jumping ship?

This was in theory an easy option. If most staff quit soon after an EOT sale, as long as those staff are able to get similar jobs elsewhere, they don’t lose much. The founder on the other hand could lose a huge amount. Without staff the business would collapse, leaving founder to get virtually none of the sale proceeds for selling their shares.

Whilst this option was seriously considered multiple times, the senior team really wanted to make it work. They didn’t want to be seen as having failed (even if it was largely due to being given a handicap!). They also cared about the team, and didn’t want to abandon them.

Additional advisers/support

This was an area the senior team had success. In particular they’d say a big thank you to:

Sue Lawrence of Independent Directors and Trustees Ltd
Sue helped them understand how the trust works. Who has what power. How to make the best of things.

Andrew Evans of Geldards LLP
Andrew helped them understand the legals of the situation. This included correcting a few misconceptions they’d learned from the founder.

Employee Ownership Association
The business signed up as EOA members. Senior team members found the courses on how to be a good director/trustee invaluable. These are skills most founders learn gradually over many years. But the senior team had it dumped on them suddenly.

Between the above they helped ensure good governance practices were put in place. Educating both the trustees and senior team members where the lines of involvement and responsibilities are drawn and boundaries set. The company could begin to operate independently, in confidence, and thrive.

Renegotiation

With assistance from their new advisers, a few months post sale they renegotiated a more realistic payment schedule with the founder. This included lower interest rate for an initial term, after which the higher interest rates would resume.

This process was a struggle, but they convinced the founder this was the only way the company might succeed (hence his payments continue).

The end result

Through the grit and determination of the senior team, they’re now over the worst of it.

Whilst there are still payments owed to the founder, they’re no longer losing sleep over the repayment schedule.

It’s been a baptism of fire for them. Their attitude is one of “what doesn’t kill us makes us stronger”. They certainly don’t want to re-live the last few years, but are proud of what they’ve achieved, and optimistic for the future.

Financially the founder has done very well. The company has managed to pay most of the hefty price tag plus interest.

However the legacy is that his name in the company is mud. For John Lewis/Julian Richer etc, most staff think fondly of the key person who gave them the opportunity they now have. In this company, the founder is viewed as “a self-interested miser”!

It could easily have ended badly for the founder financially too. The senior team could have decided it wasn’t worth the long hours and sleepless nights, and found jobs elsewhere. This would have killed the business, hence the repayments. Fortunately for the founder, they didn’t, and found a way to make it work.

Key learning points

A few key messages come out of the above:

Founders

Professional advisers

Trustees (both independent and employee)

Leadership team