Like any successful business transaction, accurate valuations are crucial. In this guide, we discuss the importance of accurate valuations in Employee Ownership Trusts and how to arrive at one.
Deciding on an Employee Ownership Trust (EOT) as your succession plan is one of the best options for transitioning the business to those who helped build it. Managing directors increasingly rely on this model to preserve their legacy and culture and to leave a sustainable business behind when they move on.
According to the Employee Ownership Association, it’s why the EOT model has reported 90% growth since its introduction in 2014. Moreover, it’s no longer just big businesses but firms of all sizes taking advantage of this model.
But like any successful business transaction, accurate valuations are crucial. In this guide, we discuss the importance of accurate valuations and how to arrive at one.
Understanding Employee Ownership Trusts (EOTs)
Employee ownership brings unique benefits to companies and the broader economy. Recently, the sector has seen renewed interest, with the number of employee-owned businesses growing by 37% in the UK in the last few years.
EOTs are a specific type of trust that holds the shares of these companies on behalf of their employees, with tax relief and other advantages in place. As long as certain conditions are met, company directors selling up pay no capital gains tax on selling their shares.
Here are the four main conditions:
1. The company making the transfer must be a parent company of a trading group or a trading entity.
2. The EOT must acquire a controlling stake in the company.
3. All benefits provided by the trust must be provided to all eligible employees on the same terms.
4. The number of company directors/employees holding 5% or more shares in the company can’t be more than 2/5 of the total number of employees.
As long as you’ve complied with these conditions, your EOT will qualify for capital gains tax relief, allowing you to leave your company in the hands of its employees.
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Why valuation is important in Employee Ownership Trusts
Accurate valuation is always pivotal in any business transaction so both parties are satisfied with the deal. Buyers want to avoid overpaying so that they can build a sustainable business, whereas sellers want fair compensation for the company they built.
Ordinarily, buyers and sellers may decide on whatever price they want, but EOTs differ slightly. Since there’s specific tax relief involved, HMRC may challenge the final transaction if they believe fair market value wasn’t used.
That’s why an independent valuation is more vital than ever when an EOT is involved in a business transaction. In particular, the trustees of an EOT are bound by law not to pay more than fair market value. Doing so will invalidate the tax-advantaged status of this model.
Legal issues aside, these transactions may be partially funded by future profits. Arriving at an inflated value only adds more strain to the business, which may compromise the firm’s long-term viability.
What to consider in an EOT valuation
EOT valuations rely on examining not only the financial health and future potential of your company, but also how it fits into your overall market. Anyone who’s been through a business sale before will see that the valuation process doesn’t differ when dealing with an EOT.
So, what are the key considerations in valuing an EOT?
A fair valuation benefits both sides, and taking an honest look at your organisation will ensure you arrive at a deal that satisfies everybody. That’s why you should never self-value your company.
Ways of valuing an Employee Ownership Trust
Call an independent valuations expert to produce an objective report of your company. Doing so ensures you comply with current UK rules on tax liabilities and EOT-based transactions. In short, fair market value is defined as the price of your assets that may be reasonably expected if sold on the open market.
Several methodologies exist for valuing an EOT:
Multiple of Earnings:
Typically, a multiple of earnings will be used, varying based on the industry. With an appropriate multiplier in place, it will be used to multiply a company’s earnings to arrive at a valuation.
For example, if a company’s earnings were £1 million last year and a multiplier of four is used, the value of the entity would be £4 million. Of course, any multiplier used must be justified and backed up by appropriate evidence.
Valuing an entity could also take the form of comparable sales. It’s the most straightforward option and examines similar transactions. If sufficient transactions are available, a basic analysis of these transactions could help you arrive at a rough fair market value figure.
Discounted Cash Flow:
You can also use the Discounted Cash Flow (DCF) model. Essentially, this is where a valuation agent examines a company’s projected future cash flows to arrive at a valuation by discounting them to their present value using a realistic rate.
Comprehensive valuation reports will likely use several methods to provide a robust range of figures and offer solid evidence of why the valuation is legitimate and realistic. Since HMRC pays so much attention to EOTs and the concept of “fair market value”, leaving no stone unturned is vital for protecting your interests.
Your first step in any transaction is connecting with a reliable business valuation agent. Every transaction is different, meaning you require bespoke support. At Hilton Smythe, our consultants bring decades of collective experience to the table, so if you’re dealing with an EOT transaction, contact us today to obtain the support you need.