Preparing for transition
Construction Company Owners: An ESOP Could Resolve Succession Planning Woes
Of the many challenges facing closely held business owners, finding ways to turn the equity in their business into cash for retirement or other purposes can be especially difficult. For many construction company owners, selling their business to outsiders or passing it down to family seem to be the easiest way out. Yet, an often-overlooked option is selling the business to employees by means of an employee stock ownership plan (ESOP). ESOPs are not appropriate for every construction company, but for those that are a good fit, they can be very advantageous.
What is an ESOP?
Similar to a profit sharing or 401(k) plan, an ESOP is a tax-qualified retirement plan that must invest in the company’s stock. To set up an ESOP, a company establishes a trust fund and contributes new shares of its own stock, or provides money so that employees can buy existing shares. The shares in the trust are then allocated to individual employee accounts, based on compensation, and the employees become vested in the accounts over a specified period of service years.
An ESOP allows for either a gradual or immediate change of ownership. It also allows the owners to retain a portion of the company, including a majority share. According to the National Center for Employee Ownership (NCEO), 92 percent of ESOP companies are happy with their ESOP transactions. Since 2010, an average of 230 new ESOPs are created each year. Only about 11 percent of construction companies had ESOPs in 2016, and they have historically used ESOPs less than other industries, but there is evidence that this is beginning to change.
Benefits of choosing an ESOP
ESOPs create a productive ownership culture for employees and are an effective tool for business ownership transitions. Employees-as-owners have a different set of priorities than employees-as-workers. With an ownership mindset, employees are generally more motivated, involved, loyal, and invested in the company. All of these factors combine to help the bottom line of the construction company. Do bear in mind, however, that if the value of the company does not increase over time, employees may feel that the ESOP is less attractive than a profit sharing plan.
Effective succession planning
For many family-owned or closely held businesses, there isn’t a family member or employee who’s capable of or even interested in taking over when the owner is ready to retire. With the implementation of an ESOP, the company can make tax-deductible contributions to the ESOP to buy the owner’s share, or have the ESOP borrow money to buy shares. In these cases, the company reaps the tax advantages while also helping to resolve the succession dilemma.
Special tax incentives are available to ESOPs, as contributions made by the business are generally tax-deductible. In many cases, the owner can also defer the taxes on the transaction. For C corporation shareholders, the gain from the sale to the ESOP can be tax-deferred by re-investing the proceeds in the securities of other domestic corporations. An S corporation or partnership can also be converted to a C corporation before the sale and receive the same tax deferral. The tax benefit that comes from a business maintaining its S corporation status is that there isn’t any federal tax at the corporate level. In addition, ESOPs are allowed to borrow. When the plan borrows to buy new or existing shares, the company can then make tax-deductible contributions to the ESOP in repayment. In these cases, both the principal and interest are deductible.
Attractive to surety brokers
Contractors, particularly those that bid on public projects, rely on their ability to secure surety bonds, which guarantee a project owner that the company will perform its work in compliance with the contract terms. Surety brokers evaluate the company carefully before issuing bonds to ensure it is well managed, generally able to meet its obligations, and preferably, profitable. For surety agents, ESOPs are appealing since they provide an ownership-transfer vehicle that ensures continuity. They also provide an incentive plan to retain key employees and have the potential to enhance the contractor’s financial situation. Research by NCEO shows that companies that set up an ESOP tend to increase annual sales, employment, and productivity at an average of 2.5 percent.
Things to consider before implementation
Contractors interested in pursuing an ESOP should meet with various advisors, including their certified public accountant, lenders, attorneys, sureties, fiduciaries, and administrative professionals. Implementation of an ESOP requires significant management time and resources and can complicate financial accounting. The ESOP also follows complicated Department of Labor rules, which make it critical for the company and the ESOP to employ professionals with significant ESOP experience. The exploration process should include a feasibility analysis to test various assumptions regarding the value of the company, size of the transaction, financing options, and the expected ESOP benefits delivered to employees.
The construction industry is very cyclical, and it is important for construction firms and their business partners to recognize some of the challenges that a contractor may face with its surety company when considering an ESOP structure. Several factors must, at a minimum, be present when considering an ESOP implementation.
- The company needs to be profitable enough to buy out an owner.
- Payroll must be adequate to cover the purchase.
- If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan.
- If the seller wants to take the tax-deferred rollover, the company must be a regular C corporation or convert from S to C status. S corporations can establish ESOPs, but their owners cannot take advantage of the tax-deferred rollover described above.
- The seller must be willing to sell its shares at fair market value, even if the ESOP pays less than an outside buyer would.
- Management continuity must be provided.
Is an ESOP the right fit?
ESOPS provide a way for business owners to preserve their legacy with employees and the community, retain a role in the company if they so desire, and receive tax benefits. While an ESOP is an ideal solution for many owners of closely held companies, they simply won’t work for others. For one thing, ESOPs are expensive to set up and maintain. They require a formal annual valuation and other recurring annual costs. Contractors need to consider the company’s debt, revenues and net profits, cash reserves, company benefits, total assets, and potential for future growth. The following instances are examples of when an ESOP will not be a good fit:
- The company is too small — ESOPs incur considerable startup and maintenance costs. Even small businesses may have to spend tens of thousands of dollars to get an ESOP up and running.
- There is no successor management — Retention of key management is critical to demonstrate that those responsible for past performance of the entity will continue with the company and ensure future success.
- The payroll is not large enough — The business is subject to limitations on how much it can contribute into its ESOP every year, and payroll must be adequate enough to cover the purchase. If the appraised value of the business is high in comparison to its payroll, an ESOP may not be a good option.
- The company is not profitable enough to afford the contributions — The business must generate enough cash to buy out the owner while maintaining its operations. Contractors commonly face cash flow dilemmas associated with the unpredictable nature of construction projects and backlog, and an ESOP may add unwanted financial strain.
- Management is not comfortable with the idea of employees as owners — Management must feel confident that employees are capable and interested in keeping the company going.
Consider that, while sureties may appreciate the potential benefits of an ESOP in facilitating the transition of ownership and management of a construction company, they may view the implied cash flow commitments negatively. Financing arrangements arising from an ESOP’s purchase of company stock typically involve either direct borrowing by the company (which then lends this amount to the ESOP) or an indirect credit relationship (the ESOP borrows from a third party and the company guarantees the loan). The related commitments can have a negative effect on a surety analysis. The age and turnover rate of the company’s workforce and the requirement to buy back the vested stock benefit of departing employees can lead to further concerns for the surety.
Establishing an ESOP is a major undertaking for any construction company. But for those that are good candidates, an ESOP offers an alternative for owners to transition out of the company on their own terms, while also providing valued employees a stake in the company. When structured properly, ESOPs can help facilitate the continuity of a successful construction company.
How we can help
Making big decisions related to the succession of your business can be both stressful and emotional. CLA’s construction team has a deep understanding of what it takes to develop a thorough succession plan. Our professionals are here to provide you with valuable resources and to help you determine the best direction for your construction company as you prepare for retirement.