Originally published in Modern Contractor Solutions
By Shane Brown
As the Baby Boomer owners of construction companies consider selling their businesses to retire, many are finding that getting an attractive price for their firm is easier said than done. However, setting up an Employee Stock Ownership Plan (ESOP) can fund a good retirement and preserve the owner’s legacy.
ESOP deals are becoming more commonplace because the alternatives are often less attractive: Even general contractors or subcontractors with more than $100 million in annual revenues can find it hard to find a buyer that will even pay book value for the firm.
What are the alternatives to an ESOP? Private equity investors typically only pay top dollar for specialized firms, such as those that have added highly predictable and/or services divisions that have diversified the company to counteract economic cyclicality, thereby yielding highly predictable cash flow streams. Selling to competitors is challenging, even for a price of close to book value—ongoing work, talent needs, and capacity to manage always seem to get in the way of closing a deal.
Other options are tough, too. A sale to management is often hard to finance, while transferring to family only works if that person has interest, passion, and capability. The surety bonding requirements can also significantly hinder transition to an internal or external buyer other than another construction firm that already has a bond program. Liquidation—selling assets and winding down operations—can realize book value, but owners are left with no legacy and employees lose their jobs. So, for owners who want to maintain a legacy, protect employee jobs, and are willing to cash out gradually, an ESOP can be a viable solution.
A CLOSER LOOK
Before looking at the benefits of an ESOP, it’s worth noting that there are some drawbacks owners should consider—an ESOP is not a cure all for every situation. Setting up an ESOP must be done the right way and aggressive valuations can result in costly legal problems with the U.S. Department of Labor and Internal Revenue Service. In addition, ESOP plans can cost between $150,000 to $300,000 to set up and another $50,000-$70,000 annually for ongoing compliance. Finally, an owner may still have to sign surety for the company’s bid bonds and construction completion bonds, assuming risk for the company for years following the transaction. Additionally, the owner may need to stay involved in the business to continue ensuring the company’s successful transition as if the company cannot afford to pay for the stock, then the selling owner risks ending up owning the company again.
Still, ESOPs may be attractive to owners who desire to transition all or some of their company to their employees, have the financial wherewithal, and time to allow the company to pay for the transition. One great feature of an ESOP is that owners can sell a portion of their company or all of it to an ESOP. It is common for 100-percent ESOP-owned companies to have arrived at 100 percent in several purchase tranches over a number of years. Firstly, the deal gives selling shareholders liquidity since firms can finance ESOPs by adding debt to finance the purchase with a bank loan typically up to 7 years, servicing that debt from cash flow. Every situation is unique, but it is not uncommon for companies to take out a loan to finance an upfront payment of between 25 and 50 percent of the deal amount for the outgoing owner, with the owner carrying a subordinated note for the remainder, which is paid after the bank loan. The owner is achieving liquidity and also preserves a legacy by selling to employees who have an incentive to grow the firm. That’s important since 82 percent of contractors would prefer to transfer ownership to employees or family upon exiting their businesses, according to consulting firm FMI. Since an ESOP transfers ownership gradually, a founder that wants to ensure success of day-to-day operations can do so by staying involved while transitioning to new leadership. Finally, there are significant tax benefits: The portion of an S-Corp owned by an ESOP is not subject to current taxation and therefore a 100-percent S-Corp ESOP pays no federal income tax and very limited state taxes, thereby allowing a significant increase in cash flow that will be used to make payments to the owner. There can significant tax advantages for C-corporations, too. The proper structure should be developed with the help of experience ESOP advisors, CPA’s, and attorneys.
SETTING UP THE ESOP
The payoff can be substantial for the selling owner. Well-run construction firms can attain reasonable market-based valuations. It is very important to use quality advisors to ensure all requirements of setting up an ESOP. Since an ESOP is a qualified employee benefit plan, it is governed by the Employee Retirement Income Security Act (ERISA)—making it essential that the trust and the plan are set up in accordance with the law, starting with a fair valuation. A case in point is the recent settlement of a suit brought by the DOL against Maran Inc., a company that had financial difficulties after setting up its ESOP. In that case, the fiduciary First Bankers Trust Services Inc. was judged to have shown a lack of good faith by not negotiating for the best price. First Bankers was fined $1.3 million and the majority owner was fined $6.6 million for failing to adequately monitor First Bankers.
Getting a plan set up correctly starts with an ESOP establishing an ESOP Trust with trustee(s) that will negotiate the transaction with the selling shareholder(s), hiring an independent firm to undertake a valuation that will form the basis for negotiations, as well as annual ESOP valuations, and retaining an administrator to oversee ongoing accounting and requirements. It is highly advisable again to have quality ESOP consultants early in the process to assist with preparing feasibility studies, attorneys to help draw up proper sale and plan documents, and CPA’s who can advise sellers as to tax and accounting matters.
Plans typically give stock to all employees (union staff can be excluded, as can part-time workers and contractors) based on such factors as salary, length of service, and position. Shares vest over time, as with a 401(k), and employees can cash out when they retire or leave the firm. Such plans are popular—there are more than 9,600 ESOPs or similar plans in the United States, making about 15.1 million Americans owners of companies valued at more than $1.4 trillion. As well as helping owners sell for retirement, they can be used to facilitate management succession or to give employees a share of profits.
ESOPs work best in companies with strong cultures, where profits are growing and there is a strong second-line of managers in place to take up the leadership mantle. Once a plan is set up correctly, it can allow an outgoing owner to figuratively have his cake and eat it, too. In exchange for continuing to assume risk (by signing risk and completion bonds), an owner can negotiate warrants to share in the upside growth of the firm until the company assumes those bonds. That empowers the outgoing owner and the new owners to work together to grow the company and its legacy—a win-win for everyone. ν
Shane Brown is audit partner at EKS&H (www.eksh.com). With more than 19 years of public accounting experience, he led the firm’s construction industry practice for a decade, and now leads overall industry niche development, working with businesses on financial audits, surety/bonding requirements, construction accounting, performance benchmarking, and internal controls.