The Rise of ESOPs in Construction: General Qualifications for Contractors Considering an Employee Stock Ownership Plan

Construction business owners face many important decisions about who will succeed them and lead the company they built. The process of navigating these decisions is known as “succession planning,” and it typically involves the close collaboration of business owners and their trusted advisors, who help business owners explore a variety of “exit options.” Common exit options include selling the business to an independent third-party buyer or gifting some (or all) of the shares of the business to a family member.

Another exit option recently gaining traction is selling shares to an employee stock ownership plan (ESOP) to effectively sell a company to its employees through an ESOP trust. This article will assess the profile of a strong ESOP candidate in the construction industry. The company’s size, capitalization, and free cash flow are first considered to determine the viability of an ESOP transaction. Next, the availability of external financing, the company’s culture, and the goals of selling shareholders are also examined to determine if a company is a suitable candidate to become an ESOP.

Size

While there are no strict size requirement to become an ESOP, strong candidates typically have a minimum of 20 employees.¹ Companies beneath this threshold may become overly burdened by administrative costs and challenges. In addition, the Internal Revenue Code of the IRS has stringent “anti-abuse” tests for ESOP plans that must be met for a plan to qualify. These rules ensure value is allocated fairly across a pool of potential ESOP participants. Having a small number of employees in a company could make passing these tests difficult.

Capitalization

Selling shareholders are paid for their shares during the ESOP formation process by leveraging the company. These shares can be paid for using company cash, external lending, a note to the seller, or a combination of these three options. A company’s ability to secure debt financing is important to consider when assessing its ESOP candidacy. A high level of leverage on a balance sheet could preclude an ESOP from being formed. A highly capitalized construction company is a stronger ESOP candidate by virtue of greater access to external financing.

Free Cash Flow

Companies looking to instigate an ESOP should have a minimum consistent free cash flow of $1.5 million or greater for the reasons below:

• Free cash flow is the earnings stream available to make interest payments. Naturally, debt lenders are attracted to companies with historically strong and stable free cash flow as these companies are better suited to make timely interest payments. With better access to debt financing, companies with strong free cash flow are also strong ESOP candidates.
• Due to the nature of the leverage required to initiate an ESOP, a company with fairly consistent cash flows is ideal. Volatile cash flows are a concern when making consistent payments to seller or bank financing.
• Due to the cyclicality and risks inherent in the construction industry, lending institutions seek out construction companies with diversified cash flow streams.

Culture and Legacy

The success of an employee-owned business requires an “employee-owned” mentality from its owners and employees. Companies with strong management and a committed workforce are likely to carry this mentality or be able to quickly adopt it, making them strong ESOP candidates. It is not easy to quantitatively assess “strong management” and “a committed workforce,” but some factors worth considering include management’s industry experience and tenure, employee morale, and workforce retention rates.

Selling shareholders must also consider their company’s culture as it pertains to the lasting legacy of their business. Many businesses bear the name of their founder(s). An attractive feature of business ownership is the ability to strengthen and uphold the family name through business stewardship in the community. When a business is sold to an external buyer, business owners and their descendants may lose names, branding, trademarks, and reputation. An ESOP rewards selling shareholders who have built a reputable company by providing heightened assurance that the family’s name and legacy will be preserved favorably.

Excellent ESOP candidates retain a culture of training, employee involvement, and a sense of community. Given that employees are the beneficiaries of a company’s growth under an employee ownership structure, it is prudent to identify (1) companies with a solid existing culture and (2) selling shareholders wanting to preserve it.

Financial Goals of Selling Shareholders

The selling shareholders must balance the goals of wealth maximization with the desire to preserve the business’s legacy. Trusted advisors play a critical role in this process by helping these shareholders navigate the menu of options before them.

Along with the considerations above, the financial goals of a selling shareholder are vitally important when assessing a company’s ESOP candidacy. How a selling shareholder perceives value is an important consideration. Employee stock ownership plans are qualified retirement plans governed by the Employee Retirement Income Security Act (ERISA). ERISA requires employee stock ownership plans to pay no more than “adequate consideration,”² or fair market value, as reasonably determined by a trustee of an employee stock ownership trust, when investing in employer securities. The United States Department of Labor defines³ fair market value as:

the price at which an asset would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell and both parties are able, as well as willing, to trade and are well informed about the asset and the market for such asset.”

Fair market value may be lower than the value of a business to a strategic or financial buyer. Advisors must understand these standards of value and clearly communicate them to selling shareholders. In addition, selling shareholders must be knowledgeable of all financial aspects of a transaction, including the tax benefits to both the company and the sellers.

Consideration of an ESOP for Contractors

An ESOP should be considered when evaluating all exit options for a construction company. If the requirements discussed above are met and the company passes IRS testing limits, the benefits of an ESOP-owned company are unparalleled: selling shareholders can preserve their legacy and culture (as discussed above), ESOPs are tools for cultivating strong employee retention while attracting new employees, the ESOP transaction structure can create substantial tax benefits for both the Company and the selling shareholders, and selling shareholders can expect to receive a fair market sale of their business, all while rewarding next-generation management with stock incentive plans.

In addition, an ESOP may not be suitable for all contractors. A thorough review of all facts and circumstances should be considered, and the requirements discussed above are not hard rules but general guidelines for ESOP candidacy. Selling shareholders should understand and review (i) the valuation of their business, (ii) the feasibility of an ESOP transaction from a cash flow perspective, and (iii) stringent IRS testing requirements and criteria that need to be passed. These items are beyond the scope of this discussion. Marcum can provide services that will help selling shareholders in the above considerations.

Conclusion

Succession planning is not “one-size-fits-all”. Business owners and their trusted advisors need to understand all their options as they plan for the next chapter of the business. When a company fits the criteria above, business owners and their advisors should ask themselves if an ESOP is the right path to take.

Sources

1. https://www.nceo.org/articles/too-small-for-esop
2. Section 3(18)(B) of ERISA defines the term “adequate consideration” to mean, in the case of an asset other than a security for which there is a generally recognized market, the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary. The department published proposed regulations under section 3(18)(B) on May 17, 1988 (53 Fed. Reg. 17632).
3. Department of Labor Proposed Regulation §2510.3-18(b)(2)(i) of the Act and section 8477 (a)(2)(B) of The Federal Employees’ Retirement System Act of 1986 (FERSA).