Today, most contractors are facing the reality that a significant percentage of their management teams will hit retirement age during the next five to 10 years. After years of dedicating their time, energy and resources toward building a successful operation, the principals of construction firms must deal with the challenge of perpetuating their company. Who will carry on their legacy, and what’s the best way to structure the transition of ownership?
Transition Options
It seems that fewer contractors have children or other family members interested in going into the business. At the same time, owners typically want to benefit from the equity that they’ve built up in their business.
Some may simply wind down the operation: complete the remaining work, sell the equipment and walk away with the proceeds. However, for most, this option won’t generate a sufficient return.
Selling the company outright may seem like a logical choice, but there is still the challenge of finding a suitable buyer willing to pay the right price. Nor does this option guarantee that the company will continue to operate in its current form and with its employees protected.
During the past few years, two ownership transition options have gained increased attention: employee stock ownership plans and private equity investment. Both potentially address perpetuation of an organization; however, their structures can vary greatly, as can their impact on the company’s balance sheet. This, in turn, can have unforeseen consequences on the contractor’s surety credit.
Private equity investment involves the contractor being purchased by an investment management company. Private equity firms raise the necessary funding through outside investors, and the acquisition is often structured as a leveraged buyout. The existing executive team typically remains involved in running the day-to-day operations, with investor oversight and ultimate control.
The firm uses its financing, strategic planning and management resources to help improve performance and returns. Once this objective has been achieved, investors often will look to capture a return on their investment through a sale of the company.
An ESOP is a vehicle by which a firm’s workforce gains an ownership interest in the company. The company sets up a trust fund into which it contributes shares or cash to buy existing shares. A contractor can then reward employees with stock ownership through various means.
When participating employees retire or otherwise leave the company, their shares are bought back at market value. An outside valuation must be done annually to determine the shares’ market price.
A benefit of an ESOP is that ownership and control stay within the organization. ESOPs can help preserve the company culture and encourage employees to focus on the organization’s performance.
Surety Challenges
ESOPs and private equity investments give the departing owners a built-in market to sell their shares. With that said, both methods can create challenges from a surety perspective.
The debt required to finance both transactions appears on the contractor’s balance sheet, whether financed institutionally, by outside investors or through the departing shareholders. This liability can heavily leverage the company and negatively impact its tangible-equity position, pushing what was previously a very strongly capitalized company into a weak equity position.
Any excess cash in the company is usually contributed to the transaction, significantly reducing working capital. This new debt generally will need to be serviced regardless of whether the contractor is profitable.
The extent to which the transaction is funded by shareholder or “friendly debt” may give the contractor the ability to mitigate the financial impact some in the surety’s eyes. Flexible payment terms can be established in the event that earnings do not keep pace. The notes can be subordinated to the surety, allowing it to consider all or a portion of the debt as equity.
The formulas used to annually value company shares can be aggressive, sometimes increasing the share price as much as 50 percent in any given year. These outside valuations are based on how the company itself performs, but also include other factors such as market comparisons with economic data and valuations of publicly traded companies.
The result can be an inflated share price even in years where a contractor generates minimal profits or retained-earning growth. These annual, accelerated share price increases can significantly increase the eventual repurchase price of future departing shareholders beyond original expectations and possibly result in additional debt needed for the transaction.
With both ESOPs and private equity investments, the compensation paid to departing shareholders can include warrants or “earn outs” that vest at a future date. The value of this deferred compensation is based on annual share price evaluations. The company remains responsible for absorbing the resulting deferred compensation, which can be substantial if third-party valuations result in the share price outpacing earnings. Any deferred compensation needs to be structured so that meaningful financial targets must be hit before the target price can be paid out.
Transitioning ownership of an organization is never an easy decision. Often, the impact on surety credit is the last thing considered when structuring ESOPs and private equity investments. Important transactions such as these should be vetted with the surety before it is too late in the process.
If the proposed structure restricts the ability to continue with the same surety program, the return assumptions to justify the transaction could be dramatically altered. Surety firms should be seen as partners and can be valuable consultants. Establishing expectations early on as to what the balance sheet should look like post-transaction can prevent difficult discussions later regarding bonding limitations.
