ESOPs: A Winning Foundation for Construction Companies

With proactive planning, ESOPs can help contractors build on past success to ensure company legacy.
By Franco Silva
August 3, 2022

Although there are a number of ways employees can gain ownership in a company, one of the most well-known methods is the employee stock ownership plan (ESOP). At a basic level, an ESOP is a retirement plan that, like a profit-sharing plan, allows employee participants to share in the company’s success. More specifically, an ESOP is a trust set up by a corporation. The company contributes its stock—or, alternatively, cash to buy its stock—to an ESOP trust. Shares of stock are then allocated to the company’s employees over time based on their compensation levels as well as how long they have worked for the company; as employees accumulate seniority, they become increasingly vested in the account. (For further information about ESOPs, click here.)

The National Center for Employee Ownership (NCEO), a nonprofit organization that supports the employee ownership community, indicates that there are currently about 6,500 ESOPs in the U.S. The NCEO also reports that an average of 254 new ESOPs are created each year, with the construction industry serving as one of the leaders in employee ownership; indeed, privately-owned construction companies are one of the top three industries with ESOPs. Meanwhile, according to statistics provided by Certified EO, an organization that seeks to increase the visibility of employee ownership through the use of a marketing and certification program for employee-owned companies, as of July 1, 2022, there were 867 employee-owned construction companies in the United States

A Concrete Choice

There are a number of reasons ESOPs are an attractive option for construction company owners. For instance, for owners considering available exit strategies, selling the business to a third party may not be the best choice. In many cases, the sale of a construction company will not allow the owner(s) to ensure the company’s legacy, continue the company’s culture, protect the welfare of company employees and maintain the organization’s ties to the local community. However, an ESOP enables construction business owners to address all of these concerns.

At the same time, an ESOP allows construction company owners to convert shares of their closely-held business—whether they wish to sell the entire company or just a fraction of the company to the ESOP—into cash and other liquid investments.

There are also a number of attractive tax benefits associated with ESOPs. For instance, if a loan is used to finance an ESOP transaction, the contributions that are used to repay the loan are tax-deductible; in other words, the loan can be repaid by the company with pre-tax dollars. For companies that elect S corporation status, the ESOP’s share of recognized earnings is not subject to income tax at the federal level—and oftentimes the state level. Meanwhile, under certain circumstances, C-corporation owners who sell their stock to an ESOP can defer capital gains on the sale under IRC §1042. Employees also receive a tax benefit in light of the fact that an ESOP retirement account is non-contributory and tax deferred.

ESOPs can also help construction companies recruit and retain top talent. Prairie’s 2nd Annual Construction Survey, “ESOPs: Insights into 2021 and Beyond,” published Jan. 11, 2022, found that, overall, employee-owned construction companies anticipate that having an ESOP will not only continue to drive the company’s growth during 2022 but also increase employee retention, even in a difficult labor market.

During economic downturns, ESOP-owned companies also tend to respond better than non-ESOP-owned firms. According to an October 2020 study conducted by Rutgers University’s Institute for the Study of Employee Ownership and Profit Sharing along with survey firm SSRS, ESOP-owned companies outperformed non-ESOP-owned companies during the COVID-19 pandemic in the areas of job retention, pay, benefits and workplace health safety. The study also found that, during the economic downturn, companies with ESOPs were nearly six times more likely to anticipate that their business would return to its pre-pandemic level of performance than did non-ESOP companies.

While ESOPs offer numerous benefits, a few challenges may exist. For instance, if the construction business’ owners are selling 100% of the company to the ESOP, outside lenders may be unwilling to finance the full purchase price of the company stock; seller financing may be required to cover the balance. In addition, ESOPs come with several administrative costs, including the fee for an annual valuation of the ESOP stock, plan administration costs, occasional legal fees and—in some cases—fees for ESOP trustees.

Under Construction

Hundreds of construction business owners have concluded that the benefits of an ESOP outweigh any potential challenges. In order to ensure the success of an ESOP—and create value for the employees, the company and the seller—it is important that the ESOP transaction is structured to satisfy the needs of the selling shareholder and stakeholders.

Laying a good foundation for the ESOP begins during the planning stages of the transaction and should include the following:

  • Conduct a Feasibility Study: During the ESOP exploration process, a feasibility analysis should be performed in order to test various assumptions regarding the value of the company, the size of the transaction, financing options, impacts on the company’s surety and the benefits expected to be delivered to employees over time. Conducting a feasibility study helps the owners of a construction company confirm that an ESOP is the right choice for the organization.
  • Select a Strong Advisory Team: Choosing a team of advisors that include fiduciary, financial, legal and administrative professionals is key to ensuring a successful ESOP transaction. A strong advisory team will help create an ESOP structure that is sustainable over time and is beneficial to both the seller and shareholders.
  • Educate the Surety Company About the ESOP Transaction: Construction companies should understand the impact an ESOP transaction may have not only on their financial statements but also on their surety provider. Sureties may express concern over debt added to a construction company’s balance sheet in the case that an ESOP transaction requires a loan. Therefore, educating the surety about the ESOP transaction is paramount to ensuring that appropriate bonding levels are maintained post-transaction. With proper planning and education, an ESOP can actually benefit both the construction company and the surety.
  • Prepare for Management Transition: Developing the next generation of management is necessary in order to maximize value and ensure the longevity of a business. Identifying, mentoring and transitioning a company’s senior management team generally takes many years to accomplish. As such, it is important to continually search for and identify future company leaders.
  • Communicate With Employees: Once an ESOP is implemented, it is important to educate employees regarding the ESOP and the impact they can have on the value of the ESOP stock. Engaged ESOP participants are vital to the success of the company.

Engineered for Success

ESOPs—which are a unique combination of a tax-efficient leveraged buyout and an employee benefit plan—can be a highly effective tool for ownership transition as they offer a host of advantages for construction business owners. With proactive planning, an owner who implements an ESOP can build on the success the company has had in the past and ensure the company’s legacy.

by Franco Silva

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