It used to be very difficult to provide surety bonds to ESOP construction companies, but fortunately that has changed. Part of that is due to the ESOP industry maturing and the structures of ESOP’s becoming much more manageable for surety companies to underwrite. Surety companies have also gained a lot of experience over the last 20 years with ESOP’s, most of which has been favorable, giving the sureties a lot more confidence in how to successfully provide bonding programs to ESOP’s.
In this article, we will review the key elements that surety companies look for when providing bonding programs to ESOP construction companies.
When surety companies evaluate construction companies to consider providing a bonding program, one of their main focuses is on the management of the company. This includes the owners, typically the president, but also other key positions like the controller or CFO, the individual in charge of operations, and estimating.
Whenever there is an ownership transition, the surety company will want to know whether the people in these key positions will remain. This is particularly true of the selling shareholder(s), but it is important for all key positions. Since these people have a proven track record of performance, it gives the surety comfort to know they will be involved going forward to get the company through the transition period. This time period is typically 5-10 years during which the debt used to purchase the company is paid off.
Terms and Structure of the Sale
The surety will be keenly interested in the way the ESOP buyout is structured, and they should be brought in early before the transaction is closed in order to provide input. Ideally this would happen as the seller is putting their term sheet together with their advisors.
The surety will review things like, is the sales price realistic or inflated? How is the debt going to be structured between bank debt and the selling shareholders taking back promissory notes? The surety will review all of these factors to determine if they believe the cash flow the company is likely to generate in the future will be sufficient to cover the debt the company is taking on. The surety company will also look to see what kind of flexibility the contractor has under the debt in the event they don’t perform up to the projections.
Consistency of the Company’s Profits
The more consistent the contractor has been in being profitable, the more confidence the surety will have that they will have the cash flow necessary to repay the debt taken on to finance the ESOP purchase. Construction companies that have big swings in profits from year to year will have a harder time convincing their surety that the ESOP will be able to succeed.
The surety company will want the contractor to keep their bank line of credit. Sometimes banks won’t maintain the same amount for the line of credit or they won’t provide one at all unless the prior owner(s) guarantee it.
Beyond the initial challenges faced by ESOP’s with repayment of the debt used to purchase the company stock, the company will have additional liabilities for things like warrants, stock appreciation rights (SAR’s), and stock repurchase obligations for retiring or departing employees. Surety companies want to ensure that these obligations are being proactively planned for, because they can have a significant cash flow impact on the company.
Surround Yourself with Experts
Forming an ESOP requires hiring multiple experts in many areas, not the least of which is your surety agent. It’s important to have a surety agent with experience in all aspects of ESOP’s to help guide you on the formation and structure of the ESOP, and maintaining the company’s bonding program. With only roughly 160 ESOP construction companies in the state of California, most surety agents have minimal or no experience.
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