As baby boomers continue inching towards retirement, the continuity plans of construction companies is becoming an increasingly common topic. There are many ways to transition ownership of a business, and this article will address one specific method we’ve seen used by several of our clients when selling their business to key employees, which many call “Oldco/Newco”.
How Oldco/Newco Works in Construction
Under the Oldco/Newco model, the individual(s) that are taking over the operation form a new entity “Newco”, and the owner(s) of the existing company retain their ownership of “Oldco”. From there, new work is funneled all or in part through Newco with Oldco providing the support of labor, equipment and financial backing including bonding capacity. Newco generally receives a small portion of the profit to start while the rest is passed onto Oldco. This profit percentage gradually shifts over time to be weighted more towards Newco from Oldco, which is in effect a buyout through sweat equity. Often people structure the transition over 5 to 7 years from the time Newco begins participating in the profit to the time they are self-sustaining receiving 100% of the profit/revenue.
Newco often sets up a name very similar to Oldco to retain the industry reputation. Pre-qualifications with owners or general contractors will also need to be explored to ensure the experience of Oldco isn’t lost using this method.
3 Ways of Structuring Oldco/Newco
There are essentially three ways we typically see the Oldco/Newco arrangement structured although there are many options that can be explored depending on that parties’ circumstances. In some situations, the Oldco/Newco may decide to set up a joint venture through which all work is run. In this scenario, all of the labor, equipment, and capital may stay with Oldco initially, so that the parties can test the arrangement before committing fully. One of the advantages of using a joint venture is it allows Oldco to be privy to the contracts in the event there becomes any issues between Oldco and Newco along the way.
Others choose to have Newco take on all the work directly. This may mean Newco is subcontracting the work to Oldco for a period of time and again Oldco may retain the labor, equipment and capital for an initial period of time. While it can provide that same flexibility the joint venture option does of trying the arrangement to make sure both parties are satisfied, Oldco is technically not a party to the contracts that Newco takes on. This means if there is an issue on a project, Oldco may not be allowed to step in and take over.
A third option is to have all the administrative and field labor shifted to Newco while Oldco simply provides financial support and indemnity for bonding. This is probably most similar to your standard stock purchase arrangement. Obviously, it requires a full commitment by both parties upfront, and we often see it used by family to transfer a business from one generation to another.
In any of the scenarios, equipment and real estate can either be rented from Oldco by Newco for a period of time or at some point Newco may have the option to purchase them. The indemnification of the surety by Oldco is an important aspect of the arrangement, because it allows Newco to continue to secure work at a level they may not otherwise qualify. That said, Oldco and its owners are continuing to take on liability with the surety that needs to be taken into account with the price that Newco is paying. It is possible for Oldco, and its owners to reduce their indemnity over time as Newco builds up its balance sheet. There are a few different ways this can be done, and it should be part of the plan that is put in place.
There can be several advantages to the Oldco/Newco method and at the top of that list is the ability of Newco to qualify for the surety bonds it needs to operate, because Oldco continues to indemnify the surety.
Control and Liability Run-off
Another benefit to the seller is the ability to maintain control for a period of time when using the joint venture method. This is particularly valuable during the time which the existing bonds that are indemnified by Oldco are being runoff. As the capital is built up in Newco and Oldco is able to lower or event eliminate its indemnity with the surety, it provides the exiting owners the ability to have a clean break without continuing liability of ongoing bonded projects that they indemnified for.
Financial and Tax
Since there is no actual stock purchase of Oldco, there is no need to get an appraisal or valuation of Oldco, which can be time consuming, expensive and potentially subjective. It essentially allows the existing owners and new owners to agree on a buyout that they believe is fair rather than a third party forcing them to base it on their valuation, which helps speed up the timeframe in which the transition can be put in place. There is also no tax paid for gain on the stock since none is technically being sold although there will be tax owed on the income earned from the Newco projects.
Some owners may look at this model and wonder what’s in it for them since they get no payment upfront and their stream of income is dependent on the performance of the new owners running Newco. Those are certainly valid concerns. For this model to make sense, it has to align with your personal objectives for selling the business and definitely requires a high degree of confidence in the new owners. It’s also important to keep in mind that the reality is many construction companies are not readily sellable for a big check upfront. Potential acquirers are few and far between and many will only target large companies with substantial infrastructure. For the rest, the best they can look for is to receive their equity from the business plus a stream of income for several years based on the hard work of the new owners.
As with any continuity planning, you should involve your entire team of advisors, particularly your attorney, CPA and surety agent, and have them work together to help you formulate a plan. Each will need to coordinate to make sure your objectives are met and the transition is successful for all involved. Continuity planning takes time and effort, but as with most other things, what you put into it can pay off in the long-run by lowering your risk and increasing your return if you find and train the right individual(s).
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