We are seeing increasing numbers of law firms converting to the Employee Ownership Trust (EOT) structure. In this article, we explore the magic of EOTs for founders, employees and law firms as a whole.
Technical insight kindly provided by RVE Corporate Finance, experts in EOTs.
Law firm Employee Ownership Trusts are becoming more popular – Why?
In short, EOTs are an attractive alternative to the traditional law firm founder exit.
Instead of merging, selling to a third party or closing down, founders have the option of converting their law firm to an employee-owned business. Think John Lewis on a smaller scale.
For law firm founders this presents a tax-efficient way to exit the business.
For employees, an EOT is a golden opportunity to take a beneficial stake in their employer without having to buy in.
For the law firm itself, the structure bakes employee retention and performance incentives into its DNA. A law firm is only as valuable as its people. In which case, an EOT provides a route to increased valuation.
What exactly is an Employee Ownership Trust?
An EOT is a trust formed to acquire a controlling interest in a business being sold by its owners.
The trust acquires the shares for the benefit of all the firm’s employees, giving the employees indirect ownership of the company.
An EOT is run by trustees, a majority of which must be independent of the former owners of the business. Trustees typically include the company’s directors, employee representatives and external professionals.
Can any law firm become an Employee Ownership Trust?
A law firm must first become an Alternative Business Structure (ABS) before the EOT transaction can complete. This is simply because the ownership will move to ‘non lawyer’ ownership i.e. the trust and its trustees, for the benefit of the employees.
To convert to ABS from a traditional law firm, the Solicitors Regulation Authority requires an ABS Application.
As an ABS, the law firm will have the additional flexibility of adding non-lawyer Directors to the Board (e.g. Finance, Business Development or HR professionals) and raising external capital for growth.
What businesses are suitable for an Employee Ownership Trust structure?
To qualify for the generous tax treatment the business being sold by the owners needs to be a trading company (as opposed to an investment company) and to have a minimum level of employees who are not the owners or connected persons (e.g. spouses).
The owners must also be able to sell a controlling stake (more than 50% of the company’s shares) to the EOT.
Because the EOT model is self-financing (no external finance is required) the business needs to have a certain level of financial resilience to make it suitable for an EOT transaction. The business should not have significant borrowings and its trading outlook should be profitable and cash generative.
Having surplus cash in the business is a positive benefit as it can be used to part fund the purchase consideration.
Law firms and other professional service businesses find selling to an EOT particularly attractive.
What price does the trust pay for the law firm and how does it finance the acquisition?
The EOT pays a fair market price for the shares it acquires from the owners based on an independent valuation. This is a full price reflecting the sale of a controlling interest rather than a minority stake.
The purchase consideration typically comprises a cash payment at completion (paid out of surplus cash in the business) together with deferred consideration which the EOT repays over an earnout period (typically 5 years in length) using cash generated by the business.
How does a sale to an Employee Ownership Trust work?
Selling to an EOT is effectively an “in-house” transaction controlled by the owners and negotiated with the company and the EOT, which the law firm establishes.
The business is independently valued to ensure the trustees of the EOT can be satisfied they are paying a fair market value. This valuation sets the sale price to be paid to the owners which the EOT settles in cash (using any surplus cash in the business) and through deferred consideration.
The deferred consideration is paid by the EOT over the earnout period, subject to the EOT receiving funding from the company. During the earnout period or until the deferred consideration is fully repaid the rights of the EOT are restricted and the owners will continue to retain an element of control of the business.
What are the tax benefits of selling my law firm to an Employee Ownership Trust?
Owners who sell a controlling interest in a business to an EOT benefit from very generous tax breaks paying 0% capital gains tax on all sale proceeds (for qualifying transactions).
In addition, a company controlled by an EOT can pay its employees tax-free cash bonuses of up to £3600 per annum.
Who runs the law firm after it is sold to the Employee Ownership Trust?
The company’s directors continue to run the business following a sale to the EOT.
The trustees of the EOT have a supervisory role with the right to remove company directors acting counter to the EOT’s interests. In principle the trustees can also sell the business.
During the earnout period, or until the loan notes are fully repaid, the rights of the trustees are restricted and the owners will continue to retain an element of control of the business.
Can the law firm founders continue to work in the business?
Yes, the founders can continue to work in the business, and typically do. This does not affect them being able to sell their shares free of capital gains tax.
How long does it take to do a law firm EOT transaction?
Selling to an EOT can be a relatively quick process once the law firm founders have made the decision to sell. This is because the key steps in an EOT transaction are relatively straightforward and the negotiations are “in-house” involving the owners, the company and the EOT.
With an EOT transaction there are no long delays in identifying buyers, preparing information memoranda, waiting for debt and equity finance to be arranged and negotiating with potential buyers over price, disclosures and onerous warranties.
How do law firm EOT deal costs compare with other exits?
Deal costs for an EOT transaction are typically much lower than with a traditional trade sale or management buyout.
As with all share sales, stamp duty is paid at 0.5% of the sales price and is borne by the buyer (the Employee Ownership Trust in an EOT transaction).
What are the deal risks with an EOT transaction?
Deal risks on an EOT transaction are much lower than on other exit routes because:
- There is a clear buyer (the EOT)
- The price is set by an independent valuation
- There is no requirement for external financing
- Negotiations are “in-house”, involving just the owners, the company and the EOT
The key deal risks for an EOT transaction are
- the owners changing their mind, and
- unforeseen changes in the trading outlook for the business.