Companies in the construction industry often have succession challenges that make Employee Stock Ownership Plans (ESOPs) a good fit. However, once a contractor determines an ESOP is right for their company, extensive planning and careful consideration are required to ensure the ESOP is structured appropriately, implemented successfully, and that the plan benefits are maximized in the long run.
One important consideration for construction companies is their ability to obtain surety bonds. In essence, construction surety bonds work to “prequalify” the contractor, demonstrating to project owners that the contractor’s business is stable and that they are capable of handling contracted work. Surety bonds help transfer the project owner’s risk of financial losses due to unforeseen factors or project delays. As surety bonds are required for most government projects and also used in many private projects, it is vital that contractors make efforts to maximize their surety program and maintain a strong relationship with a surety.
When structured appropriately, an ESOP can have a positive impact on a construction business and even enhance its surety program. Here’s what contractors should consider with respect to their surety program and ESOPs.
Construction Surety Bonds
A construction surety bond is used to provide assurance to the project owner that the contractor can and will complete the job and perform according to the terms and conditions of the contract. Should the contractor fail to fulfil its contractual obligations, the surety is required to step in to satisfy the obligations.
Before a surety company issues a bond for a contractor, they must be satisfied that the contractor runs a profitable, well-managed business, has positive equity, and performs obligations as agreed. The surety will conduct an extensive and ongoing underwriting review that analyzes the contractor’s finances, organizational structure, prior experience, and capacity to perform the specifications of the contract. To ensure that their contractor clients can support their business plan and corresponding surety program, the surety’s underwriting considerations typically include working capital, net worth, cash flow, and the continuity of the contractor’s principles and management team.
If the contractor fails to meet the surety’s standards, its bonding capacity and ability to obtain surety bonds may be limited, which could severely impact day-to-day operations. Additionally, most bonds have a term between one to four years; contractors must maintain the surety’s standards to be able to renew their bond when the term ends.
ESOPs and Contractor Surety Programs
ESOPs can bring both advantages and disadvantages in the eyes of the surety. In terms of advantages, a well-designed ESOP shows that the contractor has a continuity plan in place, as well as a way to retain and incentivize key employees. These factors tell the surety that the contractor will have long-standing and highly motivated individuals to manage and complete their bonded projects, even if something should happen to the owner. Additionally, the significant tax advantages provided by the ESOP may lower the contractor’s corporate income tax burden, thus boosting cash flow and net worth, which are important for bonding capacity.
On the downside, since ESOP transactions are often leveraged up to 100% of the fair market value of the business, the transaction is likely to have a significant impact on the company’s balance sheet and result in negative equity post-transaction. So, without preplanning with the bonding company, their bonding capacity could be negatively affected. In most situations, a discussion with the bonding company ahead of the transaction and the use of seller notes (which will be added back to equity in most cases) will allow the surety company to become comfortable with the transaction post-transaction. It is also important to partner with an experienced ESOP advisor, who knows how to structure the transaction appropriately, so the benefits are maximized for the contractor and surety alike.
Helping You Get There…
An ESOP may not be right for every construction firm, but for many, it could be a valuable tool to enhance their business and surety program. ESOPs are typically most beneficial for contractors that have a large non-union workforce, consistent revenue, and growing but stable earnings.
As you consider whether an ESOP is right for your construction company, an experienced ESOP advisor can help you create a solid plan for how your company will remain profitable after the transaction. The right advisor will also provide realistic projections and develop a smart buyback plan that allows the company to purchase shares of departing employees back over a longer term, easing the cash flow burden for the company. Your plan can then be provided to your surety, so they’ll be confident in your financials going forward.
To discuss these matters further, connect with Boulay’s ESOP advisory leader, Dan Markowitz, today.