Many construction companies have a strong reputation and long-term relationships with clients, that are keys to their success. Though positive, such factors can create challenges when it is time to transition company ownership. For construction company owners looking to exit the business but desiring to maintain these values and reward longtime employees, an Employee Stock Ownership Plan (ESOP) may be the right tool.
There are numerous ways construction companies may benefit from an ESOP. ESOPs serve as:
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- A way to overcome the struggle to find buyers
- A way for management to benefit from ownership without having to inject their own capital
- A tax-advantaged ownership transition vehicle
- A tool for maintaining company legacy
- A method to boost retention and recruitment
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Read on for a description of these advantages and how construction companies can build a successful ESOP.
ESOP Transaction Basics
An ESOP is a qualified retirement plan, meaning it is governed by the Employee Retirement Income Security Act of 1974 (ERISA). Like other ERISA-governed plans, it is designed to provide retirement income to participating employees. However, an ESOP differs from other plans in that it also serves as a vehicle for transitioning company ownership.
When an ESOP is created, owners are selling the business to an ESOP trust, which holds the shares of the company for the benefit of the plan participants (or employee-owners). The ESOP trust is subject to ERISA’s regulations and reporting requirements. The owners can sell as much of their ownership interest (shares) as they’d like. Most ESOP trusts own between 30 to 100 percent of the company’s shares.
ESOP Tax Advantages
An ESOP is among the most tax-advantaged ownership transition vehicles available to company owners today. The sponsoring company and selling owners can experience these tax benefits in several ways:
- S-Corporation companies may pass through income to the ESOP trust via a Form K-1. As ESOP trusts are tax-exempt entities, the percentage of stock owned by the ESOP trust is not subject to federal income tax. Thus, an S-Corporation that is 100% ESOP-owned is exempt from all federal income tax
- ESOPs that acquire at least a 30% block of stock from the seller, and are tax-paying C-Corporations, can benefit from “1042 treatment.” The seller can elect Section 1042 of the Internal Revenue Code, under which they can defer capital gains taxes on the proceeds of the sale to the ESOP as long as the proceeds are invested within one year of the transaction in Qualified Replace Property
- If the Company is a 100% S-Corp, the transaction financing is paid for with pre-tax cash flow
- There is an opportunity for employees to experience tax-deferred growth on their ESOP retirement benefits
Legacy, Recruitment and Retention
Construction companies often find it challenging to find buyers when the owners are ready to exit. This shortage of buyers may stem from the cyclical nature of the industry, low barriers to entry, low industry concentration, or the long-term legacy relationships cultivated by the owners, upon which many companies depend. These factors make it difficult for many buyers to meet their investment objectives. Selling to an ESOP eliminates this challenge to find a buyer, as the ESOP is the buyer.
Typically, a buyer will have certain investment objectives when acquiring a company. For example, a financial buyer may be driven to achieve a certain rate of return, and thus may try to reduce overhead and fringe benefits, to the detriment of employees. When the buyer’s objectives clash with those of the company and owners, a third-party sale may put a construction company’s legacy at risk.
An ESOP has no such objectives. Selling to an ESOP ensures the interests of the company, management and plan participants are aligned—each prioritizes the long-term success of the company. By selling ownership interest to an ESOP, construction company owners may eliminate the challenges of finding buyers whose intentions are aligned and focused on maintaining company legacy.
An ESOP also serves as a method to boost employee retention and recruitment. Not only will an ESOP provide retirement benefits that attract talent, but assuming the company achieves their projections, the value of this employee-owned stock will increase year-over-year. Additionally, the vesting schedule is often set so if an employee leaves the company before vesting, a portion of their shares are forfeited and recycled back into the ESOP. This creates loyalty for many employees—it is difficult to abandon the significant long-term retirement benefits they have accumulated.
Other ESOP Considerations
Construction company owners must take several other factors into account when considering an ESOP. ESOPs work best for businesses who have a strong employee-ownership culture, with employees who are strong candidates to be developed for leadership. Selling owners commonly stay involved in the business for a period of time, in order to help new leaders transition into their roles. An ESOP is typically not a quick exit strategy, and therefore not a fit for those looking to transition ownership immediately.
Beyond strong leadership, an ESOP requires a strong advisory team to perform fiduciary, financial, legal and administrative duties. The advisory team should include an independent trustee, plan auditor, recordkeeper, valuation experts, legal counsel, and tax and accounting professionals. After assisting with the initial transaction, a strong advisory team ensures the ESOP’s success in the long term by helping to maximize the plan benefit and resolve any issues that arise.
Construction companies also must consider the bonding requirements that are common in the industry. A construction bond is used to ensure the construction company can complete the project according to the contract, and typically states requirements the construction company must meet, such as certain levels of net worth, net working capital and minimum cash requirements. ESOP transactions may impact the company balance sheet, so for construction companies considering an ESOP, upfront conversations with the bonding company are essential.
Helping You Get There
ESOPs may be a good fit for many companies in the construction industry. Once a construction company owner determines an ESOP is the right ownership transition strategy, extensive planning and effort is required to ensure the ESOP is structured appropriately, implemented successfully, and that the plan benefits are maximized in the long run. For guidance on all stages of your ESOP, click here to contact Boulay’s ESOP leader, Dan Markowitz, today.