Employee-ownership trusts: issues with lending to employee-owned companies

Employee-ownership trusts (EOTs) are becoming increasingly common in the UK, with approximately 576 businesses owned or partially-owned by EOTs as of June 2021 and an estimated 40,000 jobs sustained or created by EOT businesses.

High-profile examples of successful employee-owned businesses such as Richer Sounds and Aardman Animations have paved the way for an increase in the number of EOTs being established across the UK. The COVID-19 pandemic has also led to many business owners considering their succession plans and manoeuvring towards EOTs as a way of securing the future of their businesses. However, whilst EOTs are a positive step for both workers and the UK economy, there are some potential issues to overcome for lenders.

What are EOTs and why are they increasingly common?

Employee-ownership trusts are a specific form of employee benefit trust (discretionary trusts set up for the benefit of a company’s employees). They came about as a result of the Government’s 2012 Nuttall Review of employee ownership, following a political desire to introduce more diversity in the UK economy. There was a widely-held belief that the introduction of EOTs into the economy would:

• lead to increased productivity and inclusivity
• enhance performance
• lead to the development of independent and resilient regional economies
• increase employee engagement; and
• allow employees to participate in a more transparent business model.

As a result of this, the Finance Act 2014 introduced tax reliefs to companies owned by EOTs in an effort to encourage an uptake in the establishment of these business entities. These are more generous than previous EBT reliefs, but the associated conditions are more onerous.

There are a number of common reasons for setting up an EOT, including:

• social good and philanthropic reasons;
• an ability to award income-tax free bonuses (of up to £3600 per tax year per employee); and
• to take advantage of tax reliefs (as shareholders disposing of their shares to an EOT may qualify for CGT relief if certain conditions are met).

The most common structure for an EOT is to have a UK-based corporate trustee, usually a company limited by guarantee. The board of the trustee is then commonly populated with a mix of employees, directors nominated by the company, and independent trustees. This allows for a good balance of employee representation whilst ensuring that all parties have their voices heard in respect of the running of the EOT.

Funding an EOT

As with any company, an EOT-owned entity will often need capital for operating purposes. Further to this, the trustee of the EOT will usually need to raise funds to acquire the shares in the company.

There are a number of ways in which an EOT can raise funds, with the most common being vendor finance. EOTs typically find it difficult to raise finance via other means (and it is highly unlikely that an EOT will borrow the funds itself), and as such loans or contributions from the company itself are also very common. In any case, it is highly likely that some form of borrowing will be required. There are some specific issues for lenders to bear in mind when lending to fund a company owned by an EOT.

Firstly, under the rules governing EOTs, an EOT cannot grant security or guarantees in relation to money it is not borrowing. Where the employee-owned company itself is the borrower, this means the EOT cannot grant security in support of this borrowing. Therefore, security over the shares in the company held by the EOT cannot be granted.

A second issue in respect of lending directly to the EOT is the fact that the EOT finds itself in a position whereby it owes money to the lender, but does not make any money or hold any assets (other than the shares in the company). Therefore the EOT finds itself entirely reliant on the company to put it in funds to repay the debt in circumstances where it is not in a position to require the company to pay it. However, carefully drafted guarantee and security provisions can mean that any adverse impact of this is reduced. It should also be noted that where the company is a PLC there may be additional complications due to increased compliance requirements.

A further possibility is that the employee-owned company could borrow the money itself and then either lend, or contribute, funds to the EOT. Again, a lender will require security over the company’s assets in order to facilitate any kind of funding and this comes with a range of issues for the company and its directors, including but not limited to:

• firstly, it may not be possible for a company to enter into any further funding if its current level of borrowing is too high or if any existing lending and any related security prohibits further borrowing
• secondly, if a company makes a contribution to the EOT then this will be classed as a distribution, and as such the company will need distributable reserves to allow this to occur
• further to this, issues arise with the concept of directors’ duties found in the Companies Act 2006, such as determining the corporate benefit and addressing potential conflicts of interests.

As with lending to the EOT itself, a lender may have questions over the security packages and structure of a deal to lend to the company. Provisions should also be included in the facility agreement which grant the company the ability to fund the EOT with the monies received.

Conclusion

It is clear that the employee owned sector is one which will continue to grow in the future, and as such the demand for funding will increase exponentially. Whilst the above has shown that there are some areas of note in which lenders should be cautious, as long as there is a clear understanding of the EOT legislation and the abilities of the parties to grant security then satisfactory deals can be reached.

To the extent that you would like to discuss EOTs and their funding, please contact Lisa Hayward, Alex Nelson, Alex Schaafsma or Devreaux Gravell.