Preparing for transition
Transferring a Construction or Real Estate Business to Owners or External Parties
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Business succession planning for construction and real estate companies is multi-faceted, and an owner’s considerations and preparations depend on who will take over the ownership of the company.
We previously discussed the unique challenges and advantages to passing a business on to family members. This article outlines the steps you must take if you plan to pass on the business to existing owners or an outside party.
Transfers to existing owners and management
Ownership transfers to existing management or employees may take place either through a private sale of the company, mechanisms such as Employee Stock Ownership Plans (ESOPs), or a combination of these methods. A good buy/sell agreement is crucial for planned transitions to existing shareholders/partners. While buy/sell agreements are arguably one of the most important documents a construction or real estate company may have, it is also often one of the least understood.
Buy/sell agreements establish a mechanism for the transition of an owner’s interest in a business at the time of a triggering event, i.e., quitting, firing, retiring, and disability/death (QFRDD). These agreements among owners have the benefits of providing a guaranteed buyer, providing liquidity for exiting owners, establishing a selling price, maintaining peace amidst stressful transition periods, and restricting ownership transfers outside of a select group of existing owners.
They may take the form of redemption agreements where the company buys back and retires the ownership interest, cross-purchase agreements where other owners buy the ownership interest, or hybrid arrangements that combine these approaches (e.g., partial redemption or partial sale).
Funding the purchase is crucial, as the best agreements can go to waste due to a lack of funding. Insurance products such as life and disability insurance can be used to fund some arrangements. Other agreements will utilize cash-flow from the business from either built-up reserves set up to fund future buyouts, or post-transition cash flow. Some agreements may require outside investments by existing owners.
It is best to establish the rights and responsibilities of the company and its owners prior to the QFRDD event, so the buy/sell agreement terms can be efficiently implemented at the time of the event. The structure chosen can dramatically impact both the business and its owners, and there are benefits and consequences of each type of structure:
- A redemption agreement paid over time may put a large liability on the company’s balance sheet, which might violate loan covenants or impact bonding capacity. This may be avoided by using a holding-company redemption agreement.
- A cross-purchase agreement creates personal (rather than corporate) liability on each of the other owners.
- An all-cash transaction guarantees payment to the departing owner, but may take too much cash out of the business and/or reduce its equity to an unacceptably low level.
- A deferred-payment option provides flexibility for the business but creates payment and liquidity risks to the departing owner. However, it may allow the owner to defer taxation on the payments.
Transfer to outside investors
Outside investors might be brought in to provide additional investment into the company’s growth or offer a secure exit strategy for the existing owners.
Growth-strategy investors may include friends and family, venture capital, and angel investors (i.e., an affluent individual who provides capital for a business in exchange for ownership equity). Exit-strategy investors might include private investors, funds, private equity groups, other businesses or consolidators (whether or not they currently operate in the construction or real estate industry), and public markets.
A variety of funding mechanisms may be used for this type of transition. In addition to the buy/sell structures mentioned above, a sale to outsiders may involve a continuing ownership interest, in which the seller keeps some rights to the company, and can possibly defer taxes on the transaction. Transitions of ownership to outside owners are often structured as either sales of company stock or assets, or mergers.
Don’t wait for a triggering event
Prepare a buy/sell agreement as soon as possible. Having a succession plan in place that clarifies the financial terms of the transfer will help with the ownership transition when a QFRDD event occurs or when the company’s owners are ready to sell to outside investors.