People get confused where money for an EOT comes from:
- staff don’t pay anything for shares
- no external investor puts money in
- yet somehow the founder gets paid
How?
What are the options for funding an EOT?
In the long run, payment for the founder’s shares must come from trading company profits.
In some situations if the founder needs paying quickly, external borrowing could be sought.
Hence payments can come from:
- historic profits
- future profits
- an external loan (to be repaid from future profits)
- combination of the above
Long term
Long term, it will be the efforts of staff that clear that debt.
Their work will hopefully(!) generate profits.
Some will be used to pay off the founder for the purchase of the company’s shares.
Short term
Short term, the founder normally funds it.
Whilst you’re selling shares, it’s normally for an I.O.U.
The Employee Ownership Trust is a newly set up entity. It has no money on day one.
The EOT will own shares in the trading company, so be entitled to its profits.
But it also has a large debt. Money it owes to the founder.
There are some ways a founder may be able to get some/all the money they’re owed more quickly.
Historic profits to fund an EOT
Often companies will carry some cash. A war chest/rainy day fund.
Sometimes excess profits are stockpiled for tax reasons. E.g. the company makes profits of £100k post corporation tax each year, but the owner is happy living off £50k. They restrict dividends to keep their personal tax bill modest. Hence sometimes the war chest is way beyond working capital needs.
This can be used to make an upfront payment to the founder immediately following sale to the EOT.
Tax planning
Remember the amount the EOT pays to the founder for the shares is typically tax free for the founder.
Dividends on the other hand can suffer 39% or higher personal tax.
Hence if you’re planning on selling to an EOT in the next few years, and can afford to do so, it can be tax efficient to deliberately restrict your dividends to a modest level in the run up to EOT transfer. This will lead to a larger pot of cash building up in the company, that can then come out to you tax free immediately following transfer.
Future profits to fund an EOT
Normally the source of most payments to the founder.
Businesses are typically valued based on profitability, not cash in the bank.
Your company is normally worth more than balance sheet net asset value
This is a good thing for you, as typically this value is often much higher than the net asset value. It reflects the loyal customer base, brand recognition, internally generated goodwill.
The downside is it means you normally won’t be paid in full immediately following the EOT transfer.
Deferred consideration
Amount the EOT will owe you upon transfer, and pay gradually from future profits.
“But I thought the staff get the benefit of future profits?”
Yes, but only after any required payments to the founder are made.
This can mean in the short-term profit share payments available to staff may be modest. Often a large chunk of profits will go towards paying you for the business.
Payment plan
How much you get paid and on what dates is flexible. Typically a payment plan will be agreed as part of the sale process. Key thing is that the business does well enough to make these.
Many companies which have recently transitioned to Employee Ownership will know their date of transfer, but be more excited about “Financial Freedom Day”.
It’s important you keep the employees enthused at least for some time post transfer. If they give up immediately following transfer, the business may die, profits with it, meaning you won’t get paid!
External loan to fund an EOT
Potentially you may be in a situation where:
- you as exiting founder need the money ASAP
- company doesn’t have cash in the bank to pay it
In that situation, it may be worth approaching specialist lenders. It’s a new area, but there are some lenders prepared to make loans to companies in this situation.
Doing so is great for you as founder, it means you get paid much earlier.
It’s less good news for the company. The business has converted an unsecured loan to you, into a secured loan to a lender. Almost certainly the interest rate will be much higher too!
We therefore would recommend against this option, unless it’s vital to your plans.
Financial Freedom Day
The payment plan will set out how much of future profits will go to the founder, £X/year for Y years.
The date when the founder is fully paid off is often termed “Financial Freedom Day”.
Some people view an EOT buying a business as akin to buying a house with a mortgage. You get the benefits of ownership straight away. But there’s a big debt that comes with it.
The feeling when that debt is cleared is great!
Critically this also means there’s more profit to play with.
- staff can enjoy much larger profit share payments
- they might increase charitable donations/community support
- maybe the business can consider big investment opportunities
When financial freedom day occurs, and its significance, depends on the deal initially agreed with the founder.
If the founder agreed to a modest valuation, paid over a long time, financial freedom day may be irrelevant.
In this situation profits paid to the founder each month/year would also be modest.
If the founder went for max valuation, paid over a short timeframe, financial freedom day could be massive!
Suddenly the business would go from busting a gut to pay most rewards to the founder, to having all those rewards available for staff to enjoy.
The trading company has a different owner. But the transfer doesn’t cause the trading company to have any new assets/liabilities.
A key thing to remember is legally it’s the EOT itself, the trust, that owes the money to the founder. NOT the trading company.
As the EOT now owns most of the shares in the trading company, it’s entitled to most of the profits.
However, the trust itself won’t be doing much. It’s essentially a pass-through vehicle. It has no need to hold any money. It has no need for a bank account.
The trading company will therefore make EOT related payments directly to the founder and/or staff.
Most payments to the founder will be from future company profits.
Those profits must suffer corporation tax, then are available for distribution to the owner. Like dividends you’ll have taken before.
The owner now is the EOT. But the EOT owes a big debt to the founder.
For ease, cash transfers bypass the EOT
Legally the money goes via the trust. From a practical perspective there’s no benefit in cash actually going into then out of the trust.
I.E. if Alex owes Bob £100, and Bob owes Chris £100. Alex can pay £100 to Chris and clear all debts.
That’s what happens with deferred consideration payments. The trading company pays the founder on the EOT’s behalf.
In practice, the EOT is a “middleman”. The trading company makes payments direct to the founder.
How does this show on balance sheet/in statutory accounts?
Again, legally the debt to the founder is NOT a debt of the trading company. It shouldn’t appear anywhere on its formal balance sheet for small companies.
The closest depiction of the payments to the founder to clear off the EOT’s debt would be dividends.
Remember though these are NOT dividends to the founder, and certainly won’t be taxed as such. They’re effectively dividends to the EOT.
Some businesses may choose to show the EOT debt on the balance sheet of the trading company in informal management accounts.
Whilst it may look scary (i.e. company has a huge liability, often dwarfing assets), some staff like seeing things this way. They can then see that balance reducing gradually. Much like seeing a mortage balance drop with each monthly payment.
This isn’t technically correct, but some find it useful in informal accounts.
These are very different to the payments to the founder. One similarity is that the EOT won’t make physical payments.
The trading company will make extra profit share payments to staff.
These payments go via payroll. Unlike payments to the founder, these are from pre corporation tax profits.
It’s a reason EOT companies often have modest corporation tax liabilities. Where they do make profits, they pay the staff more, minimal profits left to suffer corporation tax.
Up to £3,600 of that profit share per tax year per employee is income tax free. It does suffer NICs though. Other than the income tax free status, it’s treated no differently to salary.
The trading company processes it, assesses tax/NIC/student loan etc status. The employees just receive the net salary amount, with the company doing all the calculations.
More info re tax impact of EOTs
Is it difficult to fund an EOT?
This is an odd question, but one that gets asked.
As above, generally funding comes from within the business itself (internal funding).
However short term it can come from a lender (external funding).
Internal funding (i.e. profits)
It’s only difficult to the extent that making profits can be difficult.
Remember the business will have been running for a while pre EOT transfer. It should already be stable and profitable.
Whilst the EOT transfer may shake things up, making profit shouldn’t be as hard as it is for brand-new start ups.
Having the founder paid out via short term future profits is also a great way to align motivations:
– founder wants business to remain profitable to get paid
– employees want business to remain profitable long term, to get big rewards
The founder’s role will often gradually decrease over this time. So by the time they’re paid off, the senior employees have been properly running the company for a while anyway.
External funding (i.e. loan)
This can be tricky. The market for it is currently small. Most high street banks wouldn’t consider it.
Small market means high interest rates.
It also transfers the risk of business failure imminently post transfer away from the founder.
Whilst founders do (and we believe should) expect to be paid for their companies, we feel they should remain responsible for the company’s short-term future.
If founders manage to get paid 100% on day 1, by lumbering the trading company with a huge external debt, then they have no financial incentive to help the business succeed.
Aligned motivations
No more us vs them
One key principle of EOTs is aligning motivations.
In normal businesses you can have a mercenary situation:
- employers want as much work as possible from staff, for the lowest salary they can get away with
- employees want to be paid as much as they can for as little effort possible.
Sure, many privately owned firms/their staff don’t operate this way. There often is some mutual loyalty. But financial motivations are not aligned.
With EOTs, employees directly benefit from their efforts.
If the business does well, it’s those same employees who reap the rewards of increased profits.
Applying that to EOT funding
Where founder payoffs are funded from profits, there is no opposing motivations in terms of business success.
Obviously the founder wanted the business to do well pre sale. It was their business, they got all the profits, and associated business value.
Post sale the founder still needs the business to succeed for a while, to ensure the deferred consideration gets paid.
This is one reason we have mixed views on seeking external funding to pay off the founder early.
It reduces incentive for the founder to ensure a smooth transition. They’d have no financial motivation in the business succeeding as an EOT company.
Where the EOT owes money to the founder, both staff and founder need the business to succeed!
Terms of the deal is different
There can be opposing motivations here.
E.g. staff would be better off if the founder gave their shares away for nothing.
We understand this can be a tricky ethical conundrum for founders. They’re largely in charge of the deal.
Anything making the deal better for the founder, normally makes it worse for the staff.
There is no right/wrong answer to this.
But at least once the deal is signed off, you’re all on the same page again.
How Go EO can help
Go EO will discuss your situation with you.
- Does the company have excess cash?
- Size and reliability of profits?
- Feasible time frame for founder payments.
Considering this for your business? Get in touch!
Summary
EOTs are generally internally funded:
- historic profits can create an up front payment
- future profits will pay the rest
- short term, founder and staff will share profits
- this helps ensure amicable sale, founder & staff co-operating
- longer term (post financial freedom day) staff enjoy all profits
- external borrowing may be an option, but has issues
The payment plan should set out how the founder gets paid.