In this guide, we’ll go through the importance of accurate valuations in Employee Ownership Trusts (EOTs) and some of the methodologies entrepreneurs may turn to.
Employee Ownership Trusts (EOTs) are popular succession plans for business owners who wish to leave their businesses in the capable hands of their employees after their departures.
According to the European Federation of Employed Shareholders, this form of direct ownership has enjoyed increased popularity, with figures at the time of writing showing that 1,756 UK companies transferred into EOTs. Of course, like any business transaction, accurate valuations are crucial.
In this guide, we’ll go through the importance of accurate valuations and some of the methodologies entrepreneurs may turn to.
Why valuation is important in Employee Ownership Trusts
Valuations are a critical part of any business transaction. You want to gain fair compensation for transferring your share of the business to your employees. Likewise, accurate valuations protect employees, ensuring they gain fair value going forward.
Achieving an accurate valuation enables both sides to profit from the arrangement. It’s also becoming an increasingly common issue as the model grows in popularity, with 6% of all business transfers in the UK in 2024 being EOTs.
How does an EOT work?
Before proceeding with an EOT, knowing how they work is vital. Unlike ordinary business sales, where you just sell the business, EOTs have specific rules in place.
In three simple steps:
1. An EOT is established.
2. The existing business owner sells more than 50% of their existing share capital to the EOT. The market value must be considered fair and backed by an independent valuation. In some cases, part of the purchase price can be left as an outstanding debt, which the EOT will pay back over a defined period.
3. Any future profits will be contributed to the EOT. The EOT utilises these payments to repay any outstanding amounts owed to the initial sellers. Specific tax relief comes into play, which can be used to reduce and eliminate any tax liabilities that would ordinarily be true.
The key to EOTs is establishing a fair market value. If the business’s shares are believed to have been undervalued or overvalued, this could impact matters like tax relief, which can be extremely costly for all parties involved.
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What to consider in an EOT valuation
EOT valuations begin by asking the right questions. Many company directors don’t know where to start, resulting in them missing key points critical to determining a fair value for their shares when they sell up.
So, what questions should you ask?
How much of a surplus does the business have?
All EOT sales are subject to capital gains tax. Since you are selling to an EOT, which is a government-backed initiative aiming to empower workers, you will receive 100% relief on capital gains.
The determined value of the business considers all surplus cash and assets within the firm. What this means is that you have an advantage because if you were selling to a third party, you’d be forced to take the surplus as a taxable dividend.
Remember, though, that you must consider the implications of extracting that surplus. After all, you want the business to continue surviving and thriving after you’ve gone.
How profitable is the business?
EOT transactions typically involve making an initial cash payment to the seller, with any remaining consideration deferred for a few years. These additional payments typically come out of the firm’s post-tax profits. With this in mind, any valuation must factor in future profitability.
How long will it take for me to get paid?
How quickly you get paid in full will depend on the business’s future prospects. Most sellers can expect to wait for five to seven years before they’re paid in full. The longer it takes, the likelier it is that you are overvaluing the company. And the trustees in charge of the EOT may well query your valuation.
Do I need a formal valuation?
Commissioning a formal valuation from an independent agent is always in the interests of both parties. With an EOT, trust law states that the trustees of an EOT cannot pay more than the fair market value for the shares they’re buying. Likewise, sellers may find that HMRC reviews the situation in the future if they overvalue the company regarding tax relief.
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Ways of valuing an Employee Ownership Trust
Valuing an EOT has many similarities with valuing any other type of business. The model chosen will depend on the industry and market in which you operate. Typically, it’s wise to use multiple models and then settle on the most appropriate valuation to settle on a valuation that satisfies both your EOT’s trustees and you.
So, what could the process look like?
Different models will also be deployed during your valuation. For example, a valuation agent may estimate the business's value using an appropriate earnings multiple. They may also examine comparable sales, focusing on similar businesses that recently sold.
Another model that comes into play is Discounted Cash Flow (DCF). The DCF model provides a current value for a business based on the value of its future cash flows.
Several issues must be factored in, and whatever method best suits your industry must be chosen. One issue is the tax implications of valuing an EOT transaction. The transaction should be as tax-efficient as possible for both sides. Moreover, legal and regulatory requirements will come into play.
EOTs work slightly differently from ordinary business sales, meaning retaining a broker and a solicitor with specific experience in these types of transactions is paramount for avoiding any problems later.
If you’re taking your first steps toward an EOT transaction, enlisting professional help is crucial for arriving at a fair valuation. At Hilton Smythe, our business experts can point you in the right direction, so speak to the team now to learn more.