Given the limited market for third party buyers of construction companies, ESOP’s present an attractive alternative, but not every company is a good candidate for an ESOP. Fortunately, there are some basic factors that you can evaluate to see if it will make sense for your company.
Do you have the key management?
Perhaps the most critical area for you to evaluate is whether the company has strong management in key positions such as operations, estimating, accounting, and someone that could take over as president to run the company. Temporarily, it may be okay to have a weakness in one of these areas, but a weakness in multiple areas could be problematic. Furthermore, it’s important to consider whether these key employees will be around long enough to ensure that the management team can continue to lead the company going forward.
What is your time horizon for exiting your business?
ESOP’s do not realistically provide a quick exit for owners of construction companies. They can take several months to set up, and it’s usually very important for the former owner to be actively engaged in leading the company through the transition. Financially, that transition can be 5-10 years before the seller is fully repaid for the purchase, and many sellers stay active in the business for that length of time. So, if retiring in the near term or getting the money upfront are important to you, an ESOP probably isn’t the way to go.
It can also be important from a surety company’s perspective to see the former owner continuing to be actively engaged, because that is often who the surety has primarily relied on in the past to lead the company. That’s not to say there can’t be exceptions to this rule where owners can exit more quickly. This may be possible where there is an extremely strong management team in place that has a proven track record. If the surety company knows the management team well leading up to the ESOP formation, that can help ensure a smooth transition for the contractor’s bonding program.
Are the company’s profits consistent?
Since the company’s future profit will be the source of repayment on the loans that would be used to purchase the company stock, it’s important that the profit is relatively consistent to ensure the cash flow will be there to service the debt. Companies that have an opportunity to grow their profits at the same or better margin without a lot of investment required into fixed assets such as property or equipment are an even better fit, because that will likely provide additional cash flow to service the debt and fund operations.
Often construction companies with a niche that generates a good portion of their work from relationships on a select bid or negotiated basis at higher margins are particularly strong candidates. Contractors that perform all low bid work can be tougher for ESOP’s to make sense, because profits can be more susceptible to variability.
How flexible are you on the repayment terms?
The more flexible you are willing to be on the promissory notes, the more manageable the cash flow will be for the company. It is common for the notes to take 7-10 years to be repaid, possibly longer. It’s important to be realistic in knowing that there will quite possibly be bumps in the road where the company doesn’t have a good year of profitability. Thus, the longer you are willing to stretch out the repayment term or build in provisions to your promissory note to allow for lower payments, even perhaps a suspension of payments if the company doesn’t have the cash flow, the greater likelihood of success. This also helps from the surety company’s standpoint, because it gives them more confidence that the contractor will be able to deal with the unexpected.
Do you think your company culture will align?
Getting employees to shift their mindset to thinking like owners is not easy. In fact, it’s one of the biggest challenges ESOP’s face. Some construction companies are well suited to make that shift, because they already have a culture where employees take strong ownership in the company’s results. Maybe your compensation system even rewards that ownership already. In other companies, it may not be so clear.
ESOP’s are complex, and it’s not easy for employees to always make the connection between how their effort will be rewarded as the company does better. If your company doesn’t already have this culture, don’t think the ESOP itself will automatically create that shift.
Conclusion
Considering an ESOP is a huge decision. Beyond evaluating the questions in this article, talk with your surety agent and other contractors that have converted to an ESOP. They will be able to share their experience and also connect you with ESOP advisors if you decide to take your investigation further.
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