By: Todd Feuerman
This article first appeared in the May 2019 edition of Construction Business Owner magazine.
One of the most difficult processes that a privately held construction company will face in its lifetime is the transition of the business to new ownership. Family, key employees, competitors, financial investors and investment firms all play critical roles in its success. The following tips will help ensure the final outcome is beneficial for everyone involved.
1. COME TO GRIPS WITH REALITY
Creating and implementing a formal business transition plan helps the selling party to properly document their goals and objectives. Without a formal plan, the chances of a successful transition are greatly lessened. A solid succession plan should address how to retain key employees; minimize business interruption and disruption; maximize enterprise sale value; minimize tax obligations; handle unexpected life circumstances and business changes, and ensure the business operates as if a sale is not going to take place.
While construction company owners have a vast knowledge of their respective specialties, most have limited experience in the sales and divestitures of their own business interests. Not only must an owner decide on the proper course of action, he or she must also be prepared to address and resolve any unanticipated issues. Additionally, they must consider the possibility that the plan falls through.
The chances for a successful sale and transition are impacted by a number of factors, but there are four mistakes most prevalent during the transition process:
- Failure to identify and prepare the next generation of company leaders
- Failure to implement the proper executive leadership team, operating systems and advisors
- Failure to properly communicate and negotiate the long-term vision of the company with stakeholders
- Failure of the business owner to realistically view the transition process from a financial and emotional perspective
Even if the transition is properly contemplated, planned and executed, companies will likely face a variety of challenges, but a transition team can help to manage the process and support leadership. The team can be comprised of high-level current employees or family members who have served in the organization. Given the extra time and efforts on the part of the transition team, financial incentives should be considered for these key individuals’ service.
The transition team must consider the company’s financial responsibility to its stockholders and decide whether the company will be better off sold to a third party rather than internally to family or employees. Leadership should also think about the pros and cons of selling to a competitor, strategic or financial buyer.
Lastly, leadership should work with the transition team to ensure that the process is efficient while maintaining culture, philosophy, reputation and profitability to maximize the financial return to the owner.
2. VALUE THE COMPANY FAIRLY
Ultimately, a successful sale will depend on the valuation of the company. Construction company valuations can be tricky, and there are several elements that can impact that process. Construction companies will be evaluated based on their ability to bid work successfully and identify high-risk cost areas early in the bid process.
Potential buyers will also look at the company’s ability to complete projects on time and in line with profit expectations, as well as their ability to identify, negotiate, resolve and collect change orders. The same goes for field issues.
Lastly, construction companies must demonstrate their ability to manage the unique factors of the market, such as effectively negotiating material prices, controlling labor costs, addressing construction delays and contract modifications, managing construction claims and litigation, managing subcontractor performance issues, and working with poor site conditions.
Contractors with the highest value generally have a healthy balance sheet, strong working capital, minimal line of credit borrowings, strong bank and surety relationships, and minimal historical and prospective exposure to severe job losses and contract litigation. The ability to maintain a strong quality of geographically favorable backlog projects with minimal booking risk and profit-erosion exposure increases value as well.
Not surprisingly, the best time to sell a construction company is when the construction market and backlog of jobs is strong, with healthy profit margins. But what can be missed is the biggest way to measure value—people. Employees are the key to value, so it is essential to ensure that those who are critical to business development, estimating, operations and field support continue to run a successful construction company.
3. DECIDE HOW TO SELL
Leadership must consider the pros and cons of each type of sale. Many family-owned businesses prefer to keep the business in the family. Of course, when working with family members, one must be sensitive to the feelings and ambitions of those involved.
Transitioning to family members or key employees via sale, while well-intentioned, might lead to uncovering weaknesses where the company previously exhibited strength. These weaknesses may be attributed to a lack of management, financial shortcomings, poor business development, and a lack of executive leadership and/or entrepreneurial skills.
While some owners prefer to pass their business on to family members or key employees, a third-party sale generally leads to the strongest financial gain, as it’s typically the best opportunity for the company’s shareholders to maximize value and liquidity while minimizing risk. However, the external sale creates the most exposure to future change in operations, employees and culture. An investment banking firm experienced in construction-related transactions is often used to facilitate this sale process.
An internal sale requires the new management team to secure funding from a bank or investment firm to buy out the current owners. Or, the existing owners self-finance the transaction. Banks generally frown upon providing debt to be used for owner redemptions, and these transactions typically create unwanted owner exposure and an unpaid note during the redemption period.
An employee stock ownership plan (ESOP) trust is formed to acquire stock from the selling owners in exchange for liquidity. Shares are then allocated over time to the accounts of eligible employees based on various factors. The ESOP method creates significant tax savings to the selling shareholders, as well as to the company, if the company makes an S corporation election.
A recapitalization occurs when the current owners identify a financial partner willing to acquire a majority of the stake in the company. The financial partner typically invests heavily in the company and ultimately seeks a premium with a 3- to 5-year exit window. Traditionally, a financial partner is a private equity, mezzanine or financing firm that’s developed a particular niche in the construction industry.
When a contractor is seeking an exit plan, it is imperative to consult with a team of professional advisors, including financial, tax, investment banking and legal experts. Going it alone could likely be a choice business owners live to regret.