The National Center for Employee Ownership (NCEO) publishes an annual list of the nation’s 100 largest employee-owned companies. Construction and contractors accounted for 13 of the firms on the 2020 list, with over 85% of those firms using an employee stock ownership plan (ESOP) rather than other employee ownership options, such as profit sharing, to achieve broad employee ownership.
The construction industry not only survived during the pandemic, many companies outperformed expectations. While many firms were hit with project delays due to health protocols and/or government funding delays, the industry was deemed an essential business and stayed the course. This type of resilience is a natural fit for the ESOP construct given the cyclical nature of the construction industry. According to the NCEO, a study tracking the entire population of ESOP companies over 10 years found that privately held ESOP companies were only half as likely as non-ESOP firms to go bankrupt or close, and only three-fifths as likely to disappear for any reason.
Using an ESOP as a succession planning strategy can help clearly define a firm’s ethos, especially for construction firms that thrive on reputation, legacy and employee morale.
ESOP Benefits for Construction Companies
Maintaining Founder Legacy
Founders of construction companies are often motivated to use an ESOP as a way to preserve the legacy of the business, which may be at greater risk with a third-party sale. A financial buyer will be driven to achieve a certain return and, therefore, may look to reduce overhead and other fringe benefits. A strategic buyer may have an entirely different culture, to the detriment of current employees. An ESOP, on the other hand, can create a flexible path for shareholders to transition ownership at fair market value (FMV) while preserving the legacy and culture of the business.
Boosting Employee Retention and Recruiting
The construction industry faces several employment challenges, including turnover and talent shortages, which can make it difficult to achieve business growth objectives. An ESOP provides an added retirement benefit that can be an effective tool to both attract and retain talent. The value of the stock should increase year-over-year, provided the company achieves projections, and will especially impact those with the longest tenure, creating a golden handcuff to improve employee retention and provide a key recruiting advantage. An employee in an ESOP would need to consider switching costs before moving to another firm, as the vesting schedule and share accumulation in an ESOP can lead to a significant long-term retirement benefit. If an employee leaves the company before his or her ESOP shares vest, he or she would forfeit those shares, which typically would then be recycled back into the plan and made available to new or active participants.
To incentivize and retain key employees, a management incentive plan can be used to reward certain individuals above and beyond any ESOP share allocations. A management incentive plan is a non-qualified plan that, unlike an ESOP, can be concentrated among the company’s higher-paid employees.
A BDO client identified competing for a limited pool of talent in their market area as a major obstacle that was limiting their growth potential. The company decided to use an ESOP as a way to be more competitive in the hiring process and more reasonably achieve their future growth objectives.
Overcoming a Short List of Buyers
Unlike industries experiencing consolidation through M&A activity, such as the technology, healthcare, and life sciences sectors, the construction space historically has had a limited pool of buyers because of several factors:
- There are low barriers to entry in the construction industry due to its focus on labor and process rather than on technology or intellectual property.
- There is little industry concentration, with the five largest companies in the industry controlling less than 5% of total revenue. A third-party buyer may be interested in an acquisition because of the target company’s geographic market share or particular clients, but those opportunities are infrequent.
- The construction industry can be highly cyclical and tied to the economy’s overall performance, and a financial buyer is unlikely to be interested because the potential return may not match investment objectives. An ESOP, on the other hand, has no specific investment objectives, which allows the interests of the company, management and ESOP participants to be aligned. Each party has the long-term health of the company in mind.
Receiving Fair Market Value (FMV)
The most commonly used method for valuing a business for an ESOP transaction is the discounted cash flow method. This method discounts future free cash flows of the business to determine the present value. Many construction companies are able to confidently forecast their revenue multiple years into the future based on the backlog of jobs under contract. Many may keep a bid backlog that weights opportunities based on the likelihood of winning that work. These factors may support a lower discount rate and thus a higher FMV because there is greater confidence in achieving a forecast supported by multiyear projects under contract. Keeping a detailed report of work in progress and open bids is critical for a construction company considering a liquidity event.
Realizing Tax Benefits
ESOPs can provide a range of tax benefits to the sellers and the firm, including potential deferral of capital gains for the seller on the sale of a construction business operating as a C corporation, reduction or elimination of the income tax burden to the firm, deductibility of ESOP contributions, and an opportunity for tax-deferred growth on the retirement benefit to employees.
Construction companies regularly find themselves in competitive bid situations where they must weigh the impact of competing for and winning bids that ultimately may not be profitable to the company due to low margins. While ESOP sale transactions involving S corporations do not currently provide the capital gain deferral afforded to sellers of C corporation stock to an ESOP, there is a valuable forward-looking tax benefit that can be a favorable tradeoff. The tax benefit applies to ESOP-owned S corporations, because those entities will not face the cash flow impact of corporate taxes or significant shareholder tax distributions since the pass-through income allocable to the ESOP is not subject to income tax. This gives ESOP-owned construction companies a significant competitive advantage in the bidding process because they typically have larger potential net income margins to work with and can submit competitive bids that are still profitable for the company.
ESOP Requirements Unique to Construction Firms
Participants in the construction industry often must adhere to significant bonding requirements in order to operate. These requirements are meant to protect consumers from poor business practices and can include tangible measures such as minimum net worth, net working capital and minimum cash requirements of the business. Since ESOP transactions are often leveraged up to 100% of the FMV of the business, the transaction can have a substantial impact on the company balance sheet. If the proper structure is not used, the transaction could put the company out of compliance with bonding/surety requirements. The bonding company will want to understand how a transaction would affect the net worth of the business, among other items. If the relationship with the bonding company is jeopardized and it is unwilling or unable to provide sufficient bonding capacity for the company to bid on large jobs, it could severely impact the business’s day-to-day operations. There are bonding companies that understand the ESOP structure and that debt is repaid quickly, thus rightsizing the balance sheet in a short period of time.
Licensing requirements often differ by state and require proper experience to navigate. For example, the state of Georgia requires that a general contractor must demonstrate financial responsibility to the general contracting division by providing financial statements showing a minimum net worth of $150,000. The requirement is reduced to $25,000 for limited-tier contractors (GA Rule 553-4-.02). Given the ESOP structure, specifically the financing of a leveraged ESOP transaction, a reduction in net worth occurs in almost all cases. For example, a $20 million purchase of stock by the ESOP would typically be financed by a combination of outside financing and seller debt, creating a $20 million liability with a corresponding $20 million decrease in net worth.
Close attention should be paid to licensing requirements in each state in which the firm does business or plans to conduct business. Advance planning will reduce delays and allow the company to remain competitive in the bidding process when they enter new markets. In any transaction, extensive state-by-state due diligence should be performed.
Is an ESOP right for your construction company? We’re happy to offer a free consultation – feel free to reach out to us with questions.
Written by Blake Head and Scott Leach. Copyright © 2021 BDO USA, LLP. All rights reserved. www.bdo.com.