In today's dynamic business landscape, Employee Ownership Trusts (EOTs) have become an increasingly popular mechanism for succession planning, enabling companies to stimulate employee engagement, ensure business continuity during a change of ownership, and catalyse growth.

At the heart of this transformative model lies the essential component of valuation, which has significant implications for both the selling shareholders and the inheriting employees. For the selling shareholders, it ensures they receive fair compensation for their hard-earned stake, while for employees, it provides a clear understanding of the value they are inheriting.

An accurate and transparent valuation provides a solid foundation for these EOT structures. It provides added assurance to ancillary stakeholders like financial institutions who may be extending debt financing to facilitate share purchases. Additionally, EOT transactions may come under scrutiny by the tax authorities, given the generous tax reliefs available to the selling shareholders. A fair and well-substantiated valuation is imperative to ensure compliance with relevant tax legislation and prevent potential inquiries from the tax authorities.

In particular, the complex employment-related securities (ERS) legislation can give rise to unexpected and potentially significant tax liabilities for the shareholders and/or the company where shares are not transacted at a supportable tax market valuation.

The Valuation Process

Obtaining a robust valuation requires engaging professionals to analyse both quantitative and qualitative information objectively.

• Quantitative analysis: This involves reviewing historical and forecast financial information, including audited financial statements, management accounts, and forecasts. As the value of a business should be based on its future earnings potential, the valuer will rigorously evaluate next year's budget and long-term financial projections. Projected figures need to be considered in the context of what the business has achieved historically.
• Qualitative analysis: This assesses factors such as customer base, competitive positioning, market share, management expertise, and other intangible value drivers. While qualitative strengths can enhance value, weaknesses in these areas may conversely detract from valuation.

Valuers often use a range of approaches to derive a value for a business:

• Income approach: Discounted cash flow (DCF) analysis – This methodology can serve a dual purpose in EOT valuations and planning. On the one hand, DCF analysis is used to estimate the enterprise value of a business based on expected future free cash flows, discounted to their present value at a rate reflecting the time value of money and ownership risk. At the same time, the DCF model provides the foundation for prudent cash flow planning to fund the EOT transaction. By forecasting future cash flows, the company can assess whether the purchase price and proposed payment schedule to the selling shareholders are sustainable without straining distributable reserves.
• Market approach: Multiple of earnings or revenue – This methodology estimates the value of a business based on either publicly traded peers or recent M&A transactions of comparable entities. The benchmark multiple often requires adjustments for differences in growth, profitability, and risk profiles between the subject company and selected benchmarks.
• Cost approach: Net asset value – This valuation methodology involves deriving the value of a business by reference to the fair value of its net assets. This approach is likely appropriate for a business whose value derives mainly from the underlying fair value of its assets rather than its earnings, such as asset-intensive companies and investment businesses.

For most trading companies, valuers will utilise a combination of income and market-based methodologies to determine a value range. Since EOT acquisitions are often funded using debt, to be repaid out of future profits, an excessively high multiple risks the EOT paying for the buyout over many years - potentially undesirable for both employees and sellers. Therefore, prudent EOT valuation requires balancing profit multiples and future cash flows.

Summary

The journey to employee ownership is not just a financial transition but an emotional one. Business owners have a strong attachment to their company, often having built the enterprise from scratch, and this may at times cloud objective judgment on valuations. Obtaining an independent valuation ahead of an EOT deal can provide owners with realistic expectations of a fair sale price in the absence of a third-party negotiation. Many EOTs involve independent valuation experts to ensure an impartial and accurate valuation. These experts bring objectivity to the process, helping to establish a fair market value that benefits all stakeholders, and reduces the risk of unexpected tax consequences arising in connection with the transaction.

Are you embarking on an EOT journey? Ensure you're on the right path with an independent business valuation. Please contact Krekar Kawani for further details.

Touchstone Advisory is an independent valuations advisory firm comprising a diverse team of skilled professionals with extensive experience across the leading ‘Big 4’ valuations teams. When you work with us, you benefit from the expertise and technical capabilities of the largest professional services firms, but with the dedication and agility of an independent practice.