Contractors using employee stock ownership plans (ESOPs) as a business strategy are on the rise. Fifteen percent of all employee stock ownership plans are sponsored by construction industry companies. That gives contractors comfort and confidence in the viability of ESOP-led business transitions.
One driver of the trend is demographics. Construction business owners, on average, are getting older; they’re in their fifties, sixties and beyond. Many are saying, “I need to do something with the business.”
Doing nothing means an uncertain and potentially costly future. If we look at a business and say, “Let’s model out the next decade and look at the amount of cash flow consumed by income taxes,” it’s usually a sobering number. An owner might pay as much in taxes over that period as his entire company’s worth now.
THE ESOP OPTION
Traditional M&A (merger and acquisition) transactions carry many challenges. Even if a company can find a buyer, a selling shareholder will lose a substantial amount of their sale proceeds to capital gains taxes. There’s also no benefit for the management team and employees, and a lot of my clients really want to take care of their team.
Many contractors also consider internal buyouts. They say, “I’ll sell the company to my management team, and we’ll just use the cashflow of the business to buy me out.” The problem: A business uses after-tax cash to fund the buyout, and the selling owner then pays capital gains taxes. When you model it out, the tax losses can sometimes reach 60 percent of the sale amount, and there’s often not enough cash to go around.
While an ESOP doesn’t make sense for every company, construction industry owners either thinking about exiting immediately, or in the next five to ten years, should explore the strategy. One major difference from other transactions is that an employee trust is the buyer in an employee ownership sale—not an outside party.
ADVANTAGES OF AN ESOP SALE
In an ESOP transaction, stock can be sold in stages or all at once, so there’s significant flexibility—especially for owners seeking to diversify but stay with the business. Post-sale, the business remains independent, with its board of directors maintaining oversight. Family businesses can even utilize an ESOP to sell a retiring owner’s equity and enable younger family members to maintain equity upside.
A host of tax incentives encourage this form of employee ownership. From the owner’s perspective, they can sell to an ESOP and defer or eliminate capital gains taxes on the transaction. For the company, it receives income tax deductions equal to the sale amount, and depending on how the transaction is structured, the business can be turned into an income tax-free entity if the business is owned 100 percent by an ESOP.
When we consider all the cashflow a business would otherwise distribute to its owners for tax liabilities, an employee-owned company can use that cash to first pay down the transaction debt and then grow the business. Over a 10- or 15-year period, the tax advantages of an ESOP can dramatically change a business’s dynamics because you’re able to accumulate capital, make acquisitions, and grow the business.
For employees, they can earn stock in the business over time. The longer they’re employed, the more shares they get. If we model out the value of equity an employee would typically get over an extended period of time, those numbers are often dramatically superior to anything another retirement account would provide. When you think about the brutal competition for construction industry talent, this benefit can be a difference-maker for firms. So, in addition to liquidity for the owner and all these tax savings, now the company is getting equity and incentives in the hands of employees.
WHICH COMPANIES SHOULD CONSIDER?
An owner should consider exploring an ESOP if they are thinking about liquidity and diversification, even if this is within the next several years. Secondarily, their company should be generating taxable income. If you have a business that doesn’t pay taxes for a variety of reasons—maybe depreciation or just tax losses—that can make an ESOP transaction sort of a square peg in a round hole. It’s partially a tax-driven strategy.
When we look at the size of companies, there is certainly no hard and fast rule that says, “If you make this much in earnings and revenue, you can do an ESOP, and if don’t, you can’t.” But a rough rule of thumb is that a business should have EBITDA earnings of at least a couple million dollars. There’s no upward limit. Some of the largest contractors in the nation are employee-owned.
The other component of this is philosophical. Many owners, all things being equal, would like to maintain the legacy of their business, create ownership opportunities for their management team, and reward their employees. They believe in the power and potential of employee ownership.
GOOD ADVICE
The first thing for contractors is to make sure you have the right advisors. There are so many ways you can structure an ESOP. In addition, construction companies have unique issues, whether it’s bonding, pre-qualifications, or intensive working capital needs. Those considerations must be factored into the design and financing of an ESOP strategy.
An experienced advisor can help you run the numbers. It’s important to have a detailed understanding of the company’s fair market value, structuring options, available tax incentives, potential costs, and post-transaction cash flows to all stakeholders. This should all take place well before a deal is set in motion.
A comprehensive analysis can help answer the question, “Does an ESOP make sense?” Because sometimes it doesn’t. And then, if an ESOP does make sense, what structure makes the most sense? An employee ownership strategy is highly customizable; you shouldn’t simply be placed in a box.
A properly structured ESOP sale can have some truly eye-opening outcomes. Some of the most rewarding days of my job are when I watch a company roll out an ESOP transition and announce to its employees, “There’s a new owner of the business, and it’s all you guys.”
About the Author
George Thacker is managing director of CSG Partners, an ESOP advisory firm. For more, visit www.csgpartners.com.