By David Joffe and Emily Horn of Bradley Arant Boult Cummings LLP
Originally published as a three-part series beginning January 2024.
In recent years, a growing number of construction companies have established employee stock ownership plans (ESOPs). The interest in an ESOP is often generated by the need for an exit strategy for one or more of the owners of a closely held business, a common scenario in the construction industry. In fact, the construction industry, more than most industries, seems particularly drawn to ESOPs. A few reasons for this are that private equity buyers are rarely interested in construction companies and construction companies seem less likely to sell to competitors than companies in other industries. In circumstances where the business is not easily sold to a third party and/or the owners desire to provide for continuity, an ESOP can be a great solution for the owners and the company; they can obtain liquidity, and the company can operate with improved cash flow.
There are some unique issues that construction companies need to address in implementing an ESOP, particularly with regards to sureties and any new debt that is incurred by the company to complete the ESOP transaction. This post provides a brief overview on ESOPs. In future blog posts, we will address key issues relating to ESOPs for construction companies.
Brief Background on ESOPs
An ESOP is a type of tax-qualified retirement plan that primarily invests in employer stock. Like other retirement plans, the ESOP is governed by the terms of a formal plan and trust documents. The ESOP buys shares from selling shareholders, the company, or some combination of both. In a leveraged transaction, the shareholders typically sell their stock to the ESOP. The ESOP will usually purchase the stock through a combination of seller notes and cash borrowed from the company, which in turn will borrow money from a bank.
There are several tax advantages to an ESOP. One such advantage is that repayments of the principal amount of an ESOP loan can be tax deductible. To elaborate, contributions by the company to the ESOP to enable the ESOP to repay the ESOP’s promissory note are tax deductible (up to certain limits); thus, a loan used to finance an ESOP transaction can be repaid with pre-tax dollars. Another advantage is that a selling shareholder of a C-corporation may be able to elect Code Section 1042 tax deferral treatment and defer the capital gains associated with the sale of his or her shares, subject to certain requirements. Finally, the most important tax advantage is that, for companies that elect S-corporation status, the ESOP’s share of recognized earnings is ordinarily exempt from income taxes. The goal for most ESOP-owned companies is to eventually become a 100% ESOP-owned S-corporation, thereby achieving the best possible tax status.
To start the ESOP process, companies will usually obtain a feasibility study that will consider valuation, transaction size, financing, surety program impact, and the expected benefits delivered to employees over time. The ESOP process will also ordinarily consider the long-term goals and related incentives for management, including any management transition issues.
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Following up on our first blog post about employee stock ownership plans (ESOPs) for construction companies, this post addresses surety bond requirements as well as the way in which ESOPs can incentivize employees and increase cash flow.
Satisfying Surety Bond Requirements
Construction companies are typically required to obtain surety bonds to guarantee a project owner that the contractor will comply with the terms and conditions of the contract. Surety companies will ordinarily conduct an extensive underwriting review of the contractor and continue to do so periodically while the bond is in place. The underwriting review will consider the contractor's financial condition, structure, experience, and capacity to meet the requirements of the contract. The surety company will typically focus on the maintenance of a certain amount of working capital and sufficient net worth to support the construction company’s business. Sureties may require financial statements from a construction-oriented CPA firm on a reviewed or audited basis. They will be interested in work in progress and the status on projects. A construction company will usually be required to execute an indemnity agreement, which may include a personal indemnity/guaranty by one or more of the company’s owners that obligates the indemnitors to protect the surety from losses. Existing surety bonds likely limit the ability of the company to incur debt and therefore almost definitely will require the consent of the surety for a leveraged ESOP transaction.
Construction companies considering an ESOP should begin discussions with their surety team in the early stages of the transaction. Depending on the surety’s familiarity with ESOPs, this education process can take time and is best done with the help of professionals who specialize in ESOPs and can adequately communicate the ESOP deal structure and the benefits of ESOPs.
Maintaining Continuity
Many construction companies are closely held companies that do not have a business continuity plan. They may be owned by the founder or a small number of shareholders who are not working for the company. An ESOP can provide continuity by establishing a market for the purchase of shares from the controlling shareholders.
Incentivizing Employees
An ESOP is designed to provide employees with “skin in the game,” thereby hopefully incentivizing them to increase the value of the company stock and their beneficial ownership. Given labor shortages in the construction industry, an ESOP can provide an important retention tool and incentive for employees to remain employed with the company and pursue long-term growth. An ESOP may also reduce employee interest in unionization.
Increasing Cash Flow
In certain settings, an ESOP can be an effective tool for increasing a company’s cash flow. A contractor can reduce its corporate income taxes and increase its cash flow and thereby its net worth through an ESOP structure. If the contribution to the ESOP is made in lieu of contributions to a 401(k) plan, the cash flow savings are even greater. The additional cash can be used to finance projects and the growth of the business.
All of these issues should be evaluated in deciding whether an ESOP is the right solution for your company.
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Following up on our prior blog posts regarding employee stock ownership plans (ESOPs) generally for constructions companies, as well specific issues for consideration, this blog post evaluates the pros and cons of ESOPs overall.
Pros
ESOPs provide a tax-advantaged path for an exit strategy, and they can provide liquidity for owners that may not be easy to obtain in a sale to a third party. ESOPs help build an ownership culture and incentivize employees to grow the company. As a related matter, they can be a useful retention tool. The increased cash flow generated by reducing or eliminating taxes can be critical to the sustainability of the company.
Cons
If a company borrows money and then lends this money to the ESOP to purchase company stock, the loan will be a liability that will reduce the company’s net worth, and this loan could also affect surety bond requirements. However, these issues can largely be addressed through seller financing and subordinated notes. Companies do have to be mindful of repurchase liability, but the right distribution policy and repurchase liability plan can address this issue.
Conclusion
ESOPs can be the right solution for construction companies, particularly closely held businesses where the selling shareholders have a need for liquidity and a desire to continue the business legacy to benefit employees.
Republished with permission. The article, “Employee Stock Ownership Plans for Construction Companies,” was originally published on BuildSmart by Bradley Arant Boult Cummings LLP. Copyright 2024.
David Joffe is a Partner with Bradley, practicing primarily in the areas of employee benefits and executive compensation law. He is the chair of the Employee Benefits and Executive Compensation Practice Group. He can be reached at djoffe@bradley.com or 615.252.2368.
Emily Horn is a Partner with Bradley, advising clients on clients on mergers and acquisitions, sales to and the use of Employee Stock Ownership Plans (ESOPs), commercial contracts, securities issuances and regulation, corporate governance, and general corporate matters. She can be reached at ehorn@bradley.com or 423.275.4270.