This is the second article in a series designed to help construction company owners understand the options for exiting their business. As we discussed in our first article Figuring Out How to Exit Your Construction Business Part I, there are 4 main options that contractors have, which are outlined below:
- Sale to inside party – This includes a key employee or group of employees.
- Sale to third party – Can include private equity companies, competitors, roll ups, or a company in a different trade looking for a strategic acquisition in your particular construction specialty.
- ESOP – Short for Employee Stock Ownership Plan is a qualified retirement plan that enables employees to own stock in the company.
- Wind down – With this option, the departing shareholder(s) wind down the company’s operations and once all of the work is complete, close the doors.
In this article we are going to focus on key considerations when selling to people within your construction company. The company’s surety bond program and ability to continue to obtain the bonds required to operate is a major component and will be interwoven throughout the article.
How will the employees pay for the company?
This consideration is listed first, because it is such a significant element of selling to employees. Afterall, very few employees have the ability to simply write a check to the seller for the entire purchase price, and some may not even have enough to make a meaningful down payment.
Banks will typically only loan a portion of the purchase price. Some banks, using the Small Business Administration or California state guaranteed loans, will lend up to 65% of the purchase price on a term of 7-10 years. They require the buyer to put down 10-15%, and the seller has to take a note back for the remaining 20-25%. The seller note is often required by the bank to be interest only until the bank loan is paid off.
Because the bank and shareholder loans become new liabilities to the company, it can create challenges for that surety company. Part of this can be alleviated by the seller subordinating their loan to the surety. What this means is the seller agrees to put the surety as a creditor ahead of themselves and not pay back the shareholder loan until the surety approves it. This allows the surety to treat the shareholder loan as equity for the time being.
As a result of this dynamic, owners that want to sell their business to key employees often have to finance the transaction by taking back a loan for a significant portion of the purchase price. There is obviously a risk with this structure that the seller may not be repaid the entire note, but there are ways to mitigate the risks which will be discussed later in the article.
Is the goal to maintain the same size operation?
Every construction company has a unique situation when it comes to a transition. Some companies have a lot of long-term employees that started with the company early on and will be retiring at the same time as the selling owner(s), which can provide the employees purchasing the company the opportunity to potentially shrink the operation and build it back over time with their own key people. This will obviously influence the bonding capacity that the business will need going forward and the amount of capital that is required to maintain that bonding capacity and run the business.
Other times, the plan is for the construction company to continue at the same level or even perhaps grow. In these situations, the amount of capital left in the company for operations and the company’s surety bond capacity becomes critical.
As you can see, these dynamics can significantly influence the terms of the sale, and may require the selling owners to keep capital in the company. This in turn necessitates the selling owner(s) to have sufficient assets personally to retire, and it potentially exposes them to higher risk of non-payment of their capital in the company.
Has the new management been properly trained?
Often the key employee(s) being considered to purchase the company have worked in the organization for many years in various roles, so they have a strong grasp on operations. However, they may not have been exposed to higher level management functions like strategic planning or the financial aspects of the company such as accounting, banking, or surety bond relationships. It is critical to bring these key employees into these areas to give them the necessary experience and to test their abilities before deciding whether they are capable of running the company on their own. With selling owners potentially taking on a significant amount of repayment risk for the sale of the company, they need to be very confident that the new management can be successful.
Exposing these employees to the surety company also helps the surety gain confidence, which is a key part to their ability to provide the necessary bonding after the selling owner departs. The surety’s confidence in the new management is every bit as important as their comfort with the financial structure of the transaction.
What is the timeframe for the transition?
Generally speaking, these transitions require 7 to 10 years to ensure that the debt taken on by the company or buyers of the business have manageable payment terms on the note(s), but that largely depends on the purchase price.
Sureties are keenly interested in the structure to understand the impact the buyout will have on cash flow. Since the principal on the loan is repaid with after tax dollars, it can create a significant burden on the company, and from the buyer and surety’s perspectives, the lower the interest rate and longer duration on the note, the better, because it will lower the monthly payments and cash flow required. It can also help from the buyer and surety’s end to have provisions that allow for payments to be reduced or paused if the income falls below a certain threshold.
On the other hand, if the seller is financing all or most of the purchase, a longer duration can create greater risk to the seller, but there are options to mitigate this risk. One option is for the seller to sell the company stock in increments while continuing to work. This allows the seller to maintain control of the company as long as they have 51% or more ownership of the stock. This has obvious operational benefits, but it also allows the seller to ensure the profit distributions to the buyer are used to repay the seller’s promissory note. Further, the seller can wait for the first note to be repaid before selling additional shares, which will limit the amount of the loan they have outstanding at any one time.
By the time the seller of the company sells the remaining 51% of the stock, they will have reduced their exposure under the promissory note by effectively half versus if they sold the company all at once. They will also have had several years to gain confidence in the buyer’s ability to run the company and repay the seller’s loan. If the buyer doesn’t perform well in their new role and the seller doesn’t have confidence, they can still terminate the employee and buy their stock back under the terms of a preestablished buy/sell agreement.
Selling the company in increments also helps the surety company get comfortable with the buyer. With the seller still controlling the company, the surety can rely on their proven skills and character while testing out the new shareholder.
Who guarantees the surety bonds?
A big question that needs to be addressed in any transition is who guarantees the surety bonds. Surety companies typically require both corporate and personal guarantees for bonding. There are times when a surety company will rely solely on the corporate guarantee, but it requires the company financials to be very strong and stable relative to the bonding needs. The bar to qualify is much higher than getting bonded under standard terms with personal guarantees.
Some construction companies choose to prepare in advance for a sale by building up the assets in the company, so that their surety will release the personal guarantee of the current owners. That way when a sale occurs, the owners do not have any lingering liability for ongoing projects. It’s important to understand that when a surety releases the personal guarantee of a company owner, it is typically for bonds issued going forward and not retroactive to existing bonds that are already in force. This means the owner is usually still on the hook for any liability on existing bonded projects. There can be exceptions to this general rule but they are less common.
This is another reason why transitioning shares of the company over time can be beneficial. If the selling shareholder is still guaranteeing the bonds, it helps for them to maintain control of the company. As the surety gains confidence in the buyer and the buyer chips away at the debt for the purchase, the surety will be more and more inclined to rely solely on the guarantee of the buyer instead of the seller. Once the buyer has purchased more than 10% of the company stock, the surety will look to get their personal guarantee.
There are times when a surety may want the seller to guarantee the bond program for a certain period of time after the sale. Whether this is a requirement will largely depend on how the sale is structured, the ongoing bond needs of the company, and the preferences of the parties. The indemnity by the seller may not need to be an unlimited guarantee as is typically the case and can potentially be fixed at some lower dollar amount.
Needless to say, there are many moving parts when selling a business, and the process requires time, planning, and the involvement of many key advisors.
In our next article, we will outline another structure for transitioning a construction business to employees using the Newco/Oldco method.
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