Succession Planning and Ownership Transfer: Do It Right the First Time

Transitioning a construction firm is perhaps the most difficult process a privately held company will face in its business life cycle. Family, key employees, competitors and financial investors all play a role in the process.

Many U.S. construction industry leaders are approaching the age of 60 and above, with a recent study conducted by PricewaterhouseCoopers concluding that 33 percent of all construction firms will be transitioned during the next five years.

With privately held family-owned construction firms, transition planning generally occurs only once in a company’s lifetime. As such, transition planning must be done correctly the first time.

While construction firm owners have vast knowledge in their trade niche, most have limited experience in the sale and divestiture of their own business interests. Not only must the owner decide what the proper course of action is, but he or she also must be able to resolve any issues that arise during the process. Additionally, the owner must acknowledge the possibility that the transition plan may not work.

Mistakes, Challenges and Opportunities

Four common mistakes are made during the transition process:
  1. failure to identify and prepare the next generation of company leaders;
  2. failure to implement the proper executive leadership team, operating systems and advisors;
  3. failure to properly communicate and negotiate the long-term vision of the company with key family members and executives; and    
  4. failure of the business owner to truly understand the transition process from a realistic financial and emotional perspective.
Even if the transition is properly contemplated, planned and executed, companies will face a great number of challenges. There are many important questions to consider during the transition process:
  • Are there internal personnel or family members capable of being part of the transition process?
  • Is the company better off being sold to a competitor, a strategic buyer or a financial buyer?
  • What options will most likely bring success for the future owners?
  • How can the company be sold efficiently while maintaining its culture, philosophy, reputation, revenue-generating ability and financial health—while at the same time maximizing the financial return to the owner?
  • Are there financial incentives to retain and reward key transition employees?
Key factors that impact the value of the construction company can generally be categorized into the following four main areas:
  1. ability to bid work successfully and identify high-risk cost areas upfront in the bid process;
  2. ability to complete projects on time and in line with profit expectations;
  3. ability to identify, negotiate, resolve, and collect change orders and resolve field issues; and
  4. ability to manage the unique factors of the construction market, including effectively negotiating materials prices, controlling labor costs, addressing construction delays and contract modifications, managing construction claims and litigation, managing subcontractor performance issues and dealing with poor working site conditions.
Maximizing Value
The value of a construction company can be maximized if the company has four fundamental strengths.

The first is a strong financial condition. This includes a healthy balance sheet, strong working capital, minimal line of credit borrowings, positive bank and bonding company relationships, and minimal historical and prospective exposure to sever job losses and contract litigation.

The second fundamental strength is a strong backlog. Look at the quality of backlog projects. Does the construction company have the right experience to tackle those projects? Are they within favorable geographical performance zones? It’s also important that the projects in the backlog will yield quality gross profit margins with minimal “booking risk” and “profit erosion risk.”

The third fundamental strength is having strong executive and field personnel. It’s critical to invest in seasoned leadership and strong talent.

And finally, strong financial systems. Construction companies with proven fiscal controls, established reporting and budgeting systems, and credible and timely financial reporting are seen as more valuable than companies without those systems in place.

Business Transition Methods
While there are many business transition methods, following are the most popular methods used in the construction industry.
  • Internal sale. The company, under the new ownership structure and management team, secures funding from a bank in order to buy out the current owners, or the existing owners provide self-financing of the transaction.
  • External sale. An external (third-party) sale is typically the best opportunity for the company’s shareholders to maximize value and liquidity while minimizing deal risk. However, the external sale creates the most exposure to future change.
  • Recapitalization. The current owners identify a financial partner who is willing to acquire a majority of the stake in the company. The financial partner typically invests heavily in the company and ultimately seeks a premium with a three- to five-year exit window.
  • Employee stock ownership plan (ESOP). An ESOP trust is formed in order to acquire stock from the selling owners in exchange for liquidity. Shares are then allocated over time to the accounts of eligible employees based on various factors. The ESOP offers the opportunity to create significant tax savings to the selling shareholders as well as to the company, if the company makes an S corporation election.
  • Old company and new company plan. The old company ceases to build up value and essentially ceases its operations while the new company finishes out the work of the old company under a project completion agreement. The old company guarantees the bank debt and bonding line of the new company for a period of time for the new company to establish its financial strength. After a period of time, the old company is liquidated.
Proper Reporting
It is imperative that a transitioning construction company properly reports its earnings. It is just as imperative that the company report any unusual transactions or financial terms of operations that may impact the intrinsic value of the business. Examples of unusual financial transactions include, but are not limited to:
  • one-time construction project gains, losses or other unusual items;
  • excess or insufficient salaries or benefits that are paid to owners, family members or executives;
  • excess family or executive perks;
  • non-market rental or lease arrangements with related parties;
  • non-recurring professional fees; and
  • non-recorded financial transactions, including contingent gains and losses from construction litigation.
Overall, it is very important to decide what the best course of action is in order to ensure the goals and objections of the selling shareholders are met. If there is one industry that understands the need for planning, it is construction. Timelines, deadlines and changing conditions are factors that construction leaders deal with on a daily basis. The companies that are strategic, methodical, realistic and committed to a successful transition will be the ones positioned for positive results.

 
Todd A. Feuerman is a director in the Baltimore-based audit, accounting and consulting department of Ellin & Tucker, as well as chair of the firm’s construction services group. For more information, email tfeuerman@ellinandtucker.com.