Navigate a Successful ESOP Transition

Most contractors struggle with three problems:

1. They're not sure how to get to retirement;
2. Their tax bills are high; and
3. They keep losing good people.

What if contractors could address all three problems with a good concrete aggregate mix? In the course of building a successful enterprise, contractors have needed people to trust them with work—and contractors have needed people they trust to do the work. People are the aggregate.

Exiting a contracting/construction business is notoriously difficult (if the owner wants someone to pay for it). Private equity almost never buys (they aren’t fans of bonding requirements and the cyclical nature of the business). Finding a third-party buyer is harder than finding a city inspector that listens. Regardless of the situation, we all accept that an exit isn’t as simple as nailing together top plates. An exit requires thought and a management team. Who knows the clients better? Who is in a better position to benefit from the relationships and trust the business has built over the years? No one. Employees are a great option. Clients and the management team are a form of aggregate. People (clients and employees) are, at the core, the strength of the business.

However, aggregate, in and of itself, isn’t useful as a foundation. Aggregate’s strength is magnified when bound together with cement.

In looking at BLS data, construction has one of the highest turnover rates of most industries. How do contractors stem that tide? Give employees some time and something to cement themselves into the business. If an owner is considering an exit in the next five to 10 years, reward/attract loyal employees now.

An exit should be planned. Just as a business owner would never take on a job and bid without a set of plans (or defined specs), he or she shouldn’t take on a buyer and their bid without a set of plans. The IRS frowns on people avoiding taxes. However, the IRS does not frown on people structuring the manner in which they pay taxes. Equally as important, the government seeks to encourage responsible corporate governance and, as such, provides tools that honor certain choices made by business owners.

Just as a contractor would put down forms for concrete, form intentions ahead of time for an exit. To do this, it’s important for business owners to answer a number of questions.

• To whom do I sell the company?
• When do I exit?
• How much do I want?
• Where do I go from there?

However, there is one question that often gets missed. Business owners miss it. Attorneys miss it. Brokers miss it. Investment advisors miss it. However, it's likely the most important question to the business owner: How much do I get to keep?

The best concrete binds together aggregate. The best exit planning tools do the same. An example of that tool is an Employee Stock Ownership Plan (ESOP). A tool is only as useful as the job for which it is built.

Before jumping into the parameters of responsible ESOP use, let’s note the existence of some other tools. There are installment sale trusts, phantom stock, stock appreciation rights, stock options and more. All these tools have different applications based on the benefits the person is trying to obtain.

Therein lies the first recommendation. The business owner should take some time to determine what he or she wants from the exit. A good advisor shouldn’t walk in with the solution. A good advisor walks in ready to draft plans according to what he or she wants. A good advisor wants to get to know the business owner, his or her goals and what the company looks like. From there, a good craftsman should ply different tools based on the job at hand.

Ideally, ESOPs are a tool worth investigating if the company has been operating for over three years, has more than 15 employees, is profitable, has an EBITDA of $1,500,000 and has a capable management team that can succeed the owner. The business owner typically is looking to maximize the value he or she keeps, is okay with a gradual sale and transference of the business, is looking for liquidity (or the ability to take some chips off the table), wants to transition the business over a five year (or so) period and has the desire to reward key people.

This tool is not a good fit if employees don’t have an interest in the company’s success, the company lacks a strong management team, owners are not open to lifting up their key people to an ownership position or if the company is struggling financially.

The downside is that these structures are complex, requiring expertise, compliance and management. The upside is that the structure offers flexibility. Maybe the company has multiple owners and only a couple want to be bought out. No problem. Often, after tax, a business owner keeps more money from this transaction than they would from selling the company to a traditional, third-party buyer. In some cases, this structure can make a company exempt from state and federal income taxes and, thereby, increase cash flow. The National Center for Employee Ownership has also found that ESOP companies often see an uptick in production.

As noted above, contractors struggle to sell their businesses in a traditional manner. When they do find buyers, they are often competitors interested in purchasing assets from the company. In this sense, a traditional buyer wants to negotiate price based on book value, whereas sellers want to negotiate price based on cash flow multiples. The ESOP provides flexibility. A business owner can sell a portion to an outside buyer and transfer a portion to loyal employees.

Selling a construction business is no small feat. Finding a buyer can be hard, but the solution may be sitting just across the hall. Before business owners jump in, take some time to chat with a good advisor. They need to understand the end goals before making recommendations. It may take a little time, but it will likely result in better long-term value for business owners and their estates.