By Stephen P. Katz
Changes related to the COVID-19 crisis and the construction and surety industries are still occurring; some data in this article may have changed from the time of article submission and the publication date.
When is it right to start thinking about succession planning and preparing a construction company for transition? Many would agree—in concept, at least—that serious thought regarding succession and transition planning should begin at a company’s inception and be revisited throughout its lifecycle; but as a practical matter, it is frequently not part of the owner’s mindset when growing a business. This article explores issues that construction company owners and their advisors should consider in order to achieve smooth transition of ownership and control. We will address three critical questions:
- What happens to the business when an owner retires;
- What happens to the business in the event an owner(s) become disabled; and,
- What happens to the business when an unplanned exit occurs (owner pre-deceases her/his exit from the company)
Owners who do not plan carefully for transition are often faced with the less than appealing option of liquidating their business for much less than its value or of closing the business with no return upon that event. However, those who plan carefully can realize the value of their life’s work, pass the business to the next generation, and see their legacy continue.
To ensure smooth business operations and maximize value on a transfer, a successful transition plan should address the following key components:
- Retention of key employees through economic and perhaps ownership incentives;
- Minimization of business interruption upon an owner’s exit;
- Maximization of the value of the business;
- Contingency plans for unplanned exit events (that is, the sudden and unexpected death of an owner); and
- Training of the next generation and clear identification of their ongoing roles
When preparing and implementing a transition plan, company owners need to be prepared to identify and prepare the next generation of company leaders, properly implement the plan for executive leadership, and communicate the long-term vision of the company with the next generation of leaders, whether they are family members or executives. While these challenges can be daunting and complex, there is one challenge, especially for company founders, that may be the most difficult of all—the challenge of giving up control and choosing the next generation of leaders from among family members or long-time key executives. Handled properly, these difficult waters can be navigated. When handled poorly, it can lead to conflict and uncertainty that will undo years of hard work to build a successful construction company.
To address these challenges, a good transition plan will identify the ideal successors to run the company. To identify ideal successors, owners are encouraged to assess the talent pool by exploring company needs, such as:
- Who can best lead the company and continue to develop business/procure new projects;
- Who will employees respect and be willing to follow;
- Who has the experience to identify risks and costs;
- Who has the ability to oversee the performance of projects;
- Who has demonstrated skills in resolving disputes/change orders with clients; and
- Who works best with subcontractors and vendors
In many cases, no one person will be ideally suited to address all of the needs outlined above. Therefore, it is very important for current ownership to honestly evaluate personnel to determine who is best suited for a given role and foster his/her growth.
For an example, a company was going to be transitioned from a father to two sons. The two sons could not have been more different. Son A was a born salesman and a great people-person. Son B was a skilled accountant and far more comfortable working numbers than a room full of people. Recognizing this, their father made sure to create roles for his sons that matched their personalities and skill sets. The transition plan made clear Son A would be responsible for handling business development, dispute resolution, and most other client/vendor matters, while Son B was responsible for company finance, compliance, and risk assessment. Because these roles were defined early on and made clear, it avoided conflict between the two sons as successors of the business. Conversely, when the transition from a parent to the next generation is not thought out and roles are not defined, many times conflict will arise, which can have the unfortunate consequence of litigation and potential business disruption, or, worse yet, destruction altogether.
Once the next leaders are identified and their roles defined, the plan should lay out the creation of carefully written employment agreements and bonus and equity incentive plans to ensure future leaders remain with the company through a transition.
As important as determining who the next generation of leaders and owners will be is the economic planning of a transfer of ownership that meets the objectives of the exiting company owner. A realistic transition plan balances the exiting owner’s retirement planning against unduly burdening successors or the business with a buyout plan that extracts an inordinate amount of cash. Thought must be given to the pluses and minuses of gifts of ownership to family members, lump sum buyouts, payments over time, earn outs, and so on. It is important to consider this from all perspectives and to evaluate each case in order to formulate a solution that works best from a business, economic, and tax perspective. To best accomplish this goal, owners should engage in a business valuation and have several years of well-prepared income statements, balance sheets, and cash flow statements. Once prepared, owners should consider a valuation performed by a third party. A third-party valuation is important even for an internal transfer to determine the tax effect of the transfer and whether any type of financing is involved (especially for ESOPs), as the financing source will most likely require it. Once these pieces are in place, the appropriate mechanisms and buy/sell or gift transfer legal documentation can be prepared to effectuate an orderly planned transition of ownership.
Consideration must also be given to critical business arrangements, such as bonding capacity, bank loans, office leases, and other material agreements, so that they are not adversely affected by an ownership transition.
As mentioned previously, a strong transition plan must also account for contingencies when a planned transition may not be possible. Having an appropriate buy/sell agreement as part of a transition plan can accomplish that. In addition to providing for a buyout within the planned retirement scenario, a buy/sell agreement can provide for buyouts in the event of an unplanned occurrence such as death, disability, or disputes among owners. For example, a buy/sell agreement can contain the following provisions:
- A guarantee that an owner’s interest would be repurchased under defined triggering events such as death, permanent disability, or abandonment of the business;
- A restriction mandating that the stake of a deceased or disabled owner be sold to remaining owners;
- An agreed-upon methodology for valuation and designation of a valuation expert to determine the price to be paid in a buy/sell upon the occurrence of a triggering event;
- Requirements for funding sources for a buy/sell, such as key person life insurance and disability insurance;
- A mechanism to provide for a buyout in the event of a deadlock between the owners of the business;
- Indemnities in favor of the exiting owner for personal guaranties and personal indemnities given by the exiting owner for bonding and credit line obligations; and
- Obligations of new ownership to guarantee bonding and credit line obligations to the extent required by sureties and banks
There are many facets to transition planning, and a strong transition plan requires a well-coordinated, multi-disciplinary approach. To get started and best coordinate the development of a transition plan, owners of construction companies should coordinate with trusted professionals to assemble a team of advisors consisting of attorneys, accountants, investment bankers, insurance and surety companies, and consultants with experience in succession planning for construction company owners. To preserve the value of the hard work of building a successful construction company, the sooner that team is assembled, and a plan is put into place, the better.
Stephen Katz is a partner and the Chairman of the Corporate Law Practice Group at Peckar & Abramson, PC. He represents both public and privately held companies in all matters of corporate law. Katz’s background includes mergers, acquisitions, public offerings, private placements, venture capital, securities regulation, formation and organization of corporations, partnerships and limited liability companies, joint venture agreements, licensing, corporate governance, and general commercial agreements. He can be reached at firstname.lastname@example.org or 201.343.3434.
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For more information, access these NASBP Virtual Seminars: https://learn.nasbp.org/p/SuccessionDeepDive; https://learn.nasbp.org/p/SuccessionDeepDive; and https://learn.nasbp.org/p/SuccessionPlanning; and https://learn.nasbp.org/products/succession-planning-a-priority-for-your-agency-and-for-your-clients-too. Access more NASBP Virtual Seminars here: https://learn.nasbp.org/. Access free NASBP Podcast episodes here: https://letsgetsurety.org/episodes/.