ESOP Transactions for Contractors: Essential Surety Considerations
BY WILSON DENARI
It’s no secret that many owners of companies in the construction industry face an unclear future as it relates to succession planning. With nearly 1,000 active Employee Stock Ownership Plans (ESOPs) in the construction industry—and over 70 new ESOPs formed in the industry just in the past year1—there’s a clear history of long-term success when employee ownership is implemented for contractors of all sizes.
Why ESOPs are a Favored Exit Strategy for Contractors
Many exit options, such as sales to a third party, management buy-outs, or private equity funding, are often not the right fit for construction companies. An attractive alternative for shareholders involves selling the company, in whole or in part, to their employees in a tax-advantaged ESOP transaction. This trend has caught the attention of many sureties in the industry who recognize that a sale to an ESOP ensures the same company name, reputation, and employee base will be executing on existing and future bonded projects for years to come.
Importance of Early (and Regular) Communication
To ensure a construction ESOP formation goes smoothly, all stakeholders of a given company should be well versed ahead of the transaction as to what an ESOP will mean for them going forward—not the least of which includes the surety team. “Early and often” communication between the construction company management (and the construction company’s advisors) with the surety team (the bond producer and surety company underwriters) is key to ensuring all parties are aware of their respective considerations and requests (such as addressing personal guarantees to the surety, confirming there are no post-transaction changes to the bonding program, etc.) heading into the deal execution phase. In addition, up-front communication provides ample time for necessary discourse between the construction company’s transaction advisors and the surety regarding potential ESOP transaction terms and structures and their impact to the construction company’s financial statements.
Gaining Comfort Leading Up to and After an ESOP Transaction
Sureties will want to understand any changes to a construction company’s operations and cash flow generation ability after sale to an ESOP, and what that ultimately will mean for the bonding program going forward. ESOPs bring the potential for significant corporate income tax savings, including (i) deductibility of the internal ESOP loan principal and interest and (ii) tax-free treatment of earnings attributable to S corporation equity ownership held by the Employee Stock Ownership Trust (ESOT). These savings can then be used to bolster working capital, pay down transaction debt obligations, fund the ESOP repurchase obligation, or reinvest into the construction company to foster future growth (organically or through acquisition).
A construction company and its financial advisor should prepare a robust cash flow feasibility analysis, inclusive of all anticipated deal terms layered into the existing operations, to instill confidence that the company will be able to absorb the contemplated transaction by maintaining sufficient operating cash flows. The addition of the long-term ESOP retirement benefit, which incentivizes employee retention2 and high-performance,3 often serves to mitigate the risk of the company achieving future cash flows.
To supplement this analysis, a pro-forma balance sheet should be prepared to outline the company’s expected balance sheet composition directly before (inclusive of all pre-closing cash flow items, such as shareholder distributions) and directly after (layering in the effects of the transaction funding and purchase of shares by the ESOT) the contemplated ESOP transaction. This will instill confidence that the construction company will satisfy any new or existing financial covenants (such as net working capital or equity requirements) included in the bonding program. Although most ESOP transactions result in a sizeable amount of balance sheet leverage post-closing, transaction financing often includes a large portion of seller financing. which should, for all intents and purposes, be treated as equity.
Value of Experienced ESOP Transaction Professionals
It’s widely recognized that any well-planned corporate transaction requires a host of qualified professionals to get the deal past the finish line, and an ESOP transaction is no different. As such, professionals with extensive, hands-on experience with ESOP formations (including financial advisors, legal counsel, lending partners, surety professionals, and third-party administrators, to name a few) are vital to facilitate transactions that will position the construction company for sustained success. There are many unique aspects and nuances of ESOP transactions—these qualified professionals will be there every step of the way to expertly guide the selling shareholders and provide a clear understanding of deal terms and conditions for all stakeholders.
Wilson Denari, CPA, ABV, is a manager in CBIZ’s (www.cbiz.com) New Haven, CT office. He has performed valuations of business interests for a variety of purposes including, but not limited to, employee stock ownership plans (ESOPs), gift & estate tax, mergers and acquisitions, shareholder buy-sell agreements, and healthcare transactions. Denari primarily specializes in completing valuations for buy and sell-side ESOP transactions as well as annual valuation updates to ESOP trustees with existing ESOP clients. He can be reached at [email protected] or 203.781.9842.
End Notes
1 Source: https://www.nceo.org/member/nceo-member-exclusive-research-and-data/state-and-industry-esop-fact-sheets. Most recent data as of 2022.
2 ESOP share allocations to eligible employees are typically subject to a multi-year vesting schedule.
3 ESOP participant account balances fluctuate based on the fair market value of the underlying company.