EOT share valuation – looking for the PAYE risk

In this guest article, Ritchie Tout from Azets looks at some of the risks involved in valuing companies for employee ownership trust (“EOT”) transactions and the possible challenge from HMRC for over-valuations. Share valuations are one of the areas that can cause EOTs to go wrong.

The problem with valuations

A common phrase you hear from EOT advisers is that the tax rules do not mean you have to sell shares at a discount on sale to an EOT.

Although this is true in terms of the EOT tax legislation, it has led valuers down the rabbit hole of producing hypothetical valuations and overlooking the fact that they are valuing shares for a real transaction.

The problem, common to many tax-focused valuations, is that in producing the hypothetical valuation the valuer only considers one party to the transaction; the sellers. The EOT trustee is treated as a passive spectator.

This issue is important as EOTs are too often marketed as a “tax product” so the share valuation ends up as an adjunct to the tax planning and ignores the fact that there is a real transaction in shares. The EOT is taking on a liability to pay an amount of consideration and its only source of funding is the net cash profit generated by the company it is buying. For the EOT trustee, things like EBITDA, the historical earnings profile or market multiples are irrelevant.

The only thing which matters to the trustee is what cash profit it can access to pay the deferred consideration. In turn, this is a function of the length of the period the trustee thinks is acceptable to pay off the deferred consideration.

The trustee’s situation is no different to an external investor who is borrowing to fund an acquisition. They will assess the price they are able and willing to pay according to what cashflows they can generate to service and repay the debt.

Potential HMRC challenge

A hypothetical tax valuation is still relevant but only in terms of the Transactions in Securities and Employment-related Securities (“ERS”) rules. At the 3 May 2024 Fiscal Valuation Forum, HMRC advised that their review of EOTs is looking at the ERS sale at overvalue rules. This anti-avoidance rule results in the overvalue element being treated as liable to income tax for the sellers. We can assume this review has been prompted by a significant number of EOT transactions which have been renegotiated because the original acquisition price proved to be unaffordable as well as a handful of companies that have become insolvent after having paid out significant cash sums to the former owners.

Common Valuer’s error

In this context, an issue that valuers routinely overlook is that the way in which the purchase price will be paid is also a function of the price. The nature of the trade, contract length and concentration of customers might mean that a substantial proportion of the headline price might be paid as contingent consideration or as an earn-out. It is not that the valuation is wrong, but a buyer will manage their risk by not committing to pay a fixed price regardless of future trading. If a seller is demanding a fixed cash amount, they will inevitably have to accept a lower price.

Leaving aside the commercial risk of putting a business under unsustainable financial pressure, if an adviser is structuring an EOT transaction on the basis of a high EBITDA based valuation payable wholly in cash, it is critically important to sense check the valuation against affordability. We have seen examples where the mismatch between EBITDA and actual net cash profit means that it is impossible to repay the deferred consideration within the period set out in the SPA. If HMRC are looking at a sale at overvalue under the ERS rules, the PAYE liability is calculated according to the open market value of the shares at the date of the transaction. It is not clear that there are any provisions that reduce the tax charge where the sale proceeds are not ultimately paid.

What should trustees do?

Trustees should not rely on the valuation produced on behalf of the sellers. It is advisable for the trustees to obtain an independent valuation, preferably from a valuer with experience of EOT transactions, and also consider the cash flow and affordability of the deferred consideration. There is nothing worse than finding out within a year of the transaction that the deferred consideration is unaffordable and the purchase price needs to be renegotiated. No one will be happy – the sellers will have to accept a price reduction or an extension of the payment term, the management team will be under additional pressure to perform, and the employees will question the benefit of being employee-owned if there is no prospect of receiving an EOT bonus.

If you would like to get in touch with Ritchie Tout regarding anything in this article please contact Andrew Evans