Not a New Idea, but A New Trend – Employee Stock Ownership Plans

The following article originally appeared in the February 2024  issue of Contractor’s Compass. 

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 members and of course key employees as well as company legacy all play critical roles in success when considering the options for a business transition.

Creating and implementing a formal transition plan helps to ensure the selling party’s goals and objectives are properly documented and addressed. Without a formal plan, the chances for a successful transition could be greatly reduced.  But as important as it is to design a meticulous plan, it’s also important to choose which kind of sale to pursue. A new trend that is being evaluated as part of an exit strategy is an Employee Stock Ownership Plan, commonly known as an ESOP. An ESOP is a tax qualified retirement plan that gives workers ownership interest in the company in the form of shares of stock. ESOPs are authorized and encouraged by federal tax and pension laws and, depending on the company’s specifics and succession goals, can be a viable option to be considered.

But before we dive into ESOPs, it’s worth examining the best ways to begin the succession process and ensuring the plan is settled. 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
• Ensure the business operates as if a sale will not take place.

While construction company owners have 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, but he or she must also be prepared to address and resolve any unanticipated issues, including that the transition plan may fall through.

Even if the transition is properly contemplated, planned, and executed, companies will still 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 and their contributions to the company, financial incentives should be considered for these key individuals.

The transition team must consider the company’s responsibility to its stockholders. Respect should be given as to whether the position of the company will be better off if sold to a third party rather than internally to the family or key employees. Leadership should also think about the pros and cons of selling to a competitor, strategic buyer, 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 and maximizing financial return to the owner.

Value the Company Fairly

A successful sale, whether to family members, employees, private equity or to an ESOP will ultimately depend on and determining the value of the company and cost of the transaction. A construction company valuation can be tricky and there are several key factors that can impact that process. Construction companies will be evaluated based on their ability to bid work successfully and identify high-risk cost areas upfront in the bid process. 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 and resolve field issues.

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! A company’s employees are the key to value, so it is essential to ensure the employees who are critical to business development, estimating, operations, and field support continue to run a successful construction company.

Deciding to Sell With An ESOP

Because retaining great employees is so vital to any business’ success, particularly construction firms, the aforementioned ESOPs are a compelling opportunity to show appreciation for the team and keep them motivated to do well. After all, if the company does well, the ESOP gets stronger. But that’s just one of many reasons to consider an ESOP. Let us review why they’re gaining traction and also explore why they can fail to take hold.

Why are ESOPs Gaining Traction:

Seller’s Tax-Deferred Rollover

One potential advantage is the ability to structure the sale of C-Corporation stock to the ESOP and the gain on the sale can be tax deferred under the IRS rules around code section 1042. While there are certain stipulations to qualify for the tax deferred rollover, the current tax savings are typically very significant.

ESOP’s Ability to Not Pay Income Tax

Specifically, an ESOP is considered a tax-exempt pension trust that does not pay income tax on its share of the S-Corporation income. While ESOPS’s provide potential tax deferred savings to owners of C-Corporations, there are tax savings advantages for owners of S-Corporations too.

ESOP Owned S-Corporation’s Ability to Pay-Off ESOP Debt:

Assuming the ESOP is the owner of an S-Corporation and pays no current income tax, the owner can use the cash savings on taxes to help fund the ESOP liability that is created because of the initial transaction.

ESOPs are Great Employee Retention Programs:

ESOPs will reward employees for contributing to the success of the business as they will begin to earn ownership in the ESOP owned Company. For the construction workforce, creating retirement wealth via traditional 401k programs is daunting and the ESOP plan can provide a great opportunity to help employees build their retirement nest egg.

What Stops the ESOP from Gaining Traction:

ESOPs are Complicated

To consider, evaluate, form, and live in the ESOP world, everyone needs to have a very clear understanding of all the nuances and complications it can entail.  Professionals, including lawyers, accountants, valuation experts, trustees, consultants, and others will need to be heavily involved with the ESOP- and it is not cheap!

ESOPs are Expensive

ESOPs in general incur significant professional costs which can burden the Company’s cash flow. Currently, professional fees have gotten very expensive. Not only are ESOPs costly to form, the on-going legal, valuation, third party administrators, trustees and more. 

ESOPs are Cash Drains

Yes, ESOPs can certainly be expensive, but in addition to these cash demands, the ESOP will need to generate enough cash to service the redemption debt and fund eventual shares of stock from the ESOP plan participants.

ESOPs are Monitored Very Closely

There are great reasons for a business to be privately owned and typically the owners of these companies enjoy the fruits of the efforts, but the main reason is that it is private!  But once the ESOP is formed there is enhanced scrutiny by lots of different parties.  ESOPs are monitored by plan trustees, plan participants, auditors and just as important, the IRS and Department of Labor will now provide review and oversight. Privacy becomes a thing of the past.

When a contractor is seeking an exit plan, it is imperative to consult with a team of professional advisors who can evaluate all the options. This includes financial, tax, and legal experts who are experienced in construction sale transactions. If a contractor is considering a sale to an ESOP, it is imperative to be fully educated on the pros and cons. While there are potentially significant tax and employee benefits, the complexity of an ESOP’s structure and the uniqueness of specialized tax considerations make it imperative to approach the sale with careful planning and professional guidance.