Family-owned or partner construction and engineering (C&E) companies don’t just lay the groundwork for their clients. Many are actively participating in this decade’s trend of using employee stock ownership plans, or ESOPs, to retain employees and retirement assets while increasing their founders’ wealth transfer options.
Primarily family-owned or partner-owned, C&E companies have a long history of using employee stock ownership plans. About 20% of Engineering News-Record’s Top 100 Entrepreneurs and Top 100 Design Companies for 2021 use an ESOP as part of their capital structure and benefits.
As veteran ESOP advisors, we see this movement continuing into 2022 and likely beyond. In fact, we just announced the closing of a 100% ESOP transaction for BNBuilders of Seattle, a 22-year-old construction company with over 1,000 employees. What we’ve discovered is that during the COVID-19 pandemic, many homeowners in their 50s and 60s have started wondering “what’s next.”
Establishing an ESOP can make the difference in succession for both the owner and the next generation of leaders. This allows them to retain a family’s legacy while transferring ownership to employees, thereby maintaining the company culture without selling to another entity.
We advised W&W Glass, one of the nation’s largest structural glass system providers, on ESOP transaction alternatives, leading to it becoming 100% ESOP-owned in late 2019. Managing Partner Jeff Haber (whose grandfather laid the foundation of the company more than 70 years ago) describes it, an ESOP “is…the best of all worlds.” Haber explains that an ESOP helps the company reward employees “who have helped us get to where we are,” while providing a tax benefit not otherwise available, allowing the founder and family members, if they want to, receiving their product over time, and inspiring “the next level of leaders to stay and grow the business”.
Lorne Rundquist, CFO of Rosendin Electric Inc. – the nation’s largest private electrical contractor is now celebrating its 30and ESOP Anniversary – argues that many owners are not in favor of the private equity route because the debt required generally limits what can be used to fund business growth. Rundquist cites a third-generation owner with no family members to take over the business who opted for an ESOP structure, convinced that his well-trained and deserving professional staff would have the ability to continue to grow the business and its legacy if he was not burdened with debt – private equity funded buyout.
My longtime friend, William McDermott, is currently a director of five ESOPs in the construction industry and a former CEO of a mature ESOP. Bill notes that “there is a growing understanding that the ESOP structure allows individuals to live the American dream, while allowing selling shareholders to be fairly compensated for the business they have created.”
The ESOP tax benefits can be substantial. Since the value of the company is transferred to employees through a qualified pension plan, there is no immediate tax impact and any accumulated amount is tax deferred. In addition, selling shareholders of a corporation that is a C corporation may qualify for §1042 tax treatment if at least 30% of the corporation’s stock is sold to the ESOP and certain other criteria are met. There are also substantial benefits for an S corporation owned by an ESOP, which pays no federal income tax if the ESOP owns 100% of a corporation’s stock.
This is an opportune time to consider an ESOP. Many established C&E ESOP companies have done surprisingly well during the pandemic. While earnings were hit for some, access to capital remained strong for many companies, as did cash flow and liquidity. For C&E family businesses considering an ESOP, here are our tips to make the experience smoother:
1. Use realistic projections. Sometimes, to maximize the selling price, selling shareholders are overly optimistic in their projections. Later, this can burden the company with insufficient funds to grow the business while paying off its ESOP debt. Due to the cyclical and project-driven nature of the industry, it is important to highlight how the backlog and project pipelines were used to develop the projections.
2. Determine how and what to communicate to employees. Haber and Rundquist admit that they initially didn’t spend enough time determining the best way to explain what an ESOP is and how it works. McDermott advises hiring an external communications professional if there is no internal communications group. “Explaining the deal is as important as closing the deal,” he argues. “It’s common for C&E companies to already have a culture of direct ownership, so it’s important to communicate early and often with those who are already in the game and invested in the business. Making sure they understand the benefits of large-scale employee ownership through an ESOP can help smooth the process and build buy-in. Similarly, a communication package should be developed for all employees affected by the transaction.
3. Remember bonding requirements. Since many construction companies have significant bonding requirements, a proper ESOP structure must be in place. Delays in approving an ESOP transaction can occur if the bond is provided too late, as their own approval process takes time.
4. Spend time researching who to hire to help you through the ESOP process. Haber notes that it may require an investment banker, attorney, accountant, trustee, archivist (for required Department of Labor compliance), ESOP advisor, and other professionals, but “the benefits the outweigh the costs”. It’s also important to find advisors who know the industry well. C&E companies have unique stakeholders, including unionized employees and surety companies, that must be considered in an ESOP process.
5. Talk to others in the industry who have completed an ESOP – McDermott says the construction ESOP community is “very accessible and gives advice” to those considering an ESOP, and he speaks frequently to companies considering them, as does Rundquist at Rosendin.
Allow me one final observation: having advised hundreds of companies undergoing a recapitalization or change of ownership, don’t let the seemingly complicated ESOP structure and transaction keep you from considering it. The success rate of ESOPs in the construction industry is very high, given that they represent the largest percentage of ESOPs among the top 100. They include Hensel Phelps (Greeley, Colorado); Sundt Construction (Temple, Ariz.); Swinerton Builders (San Francisco); JMT (Hunt Valley, Md.), all with ESOPs created 40 or more years ago.
Having an ESOP has worked really well for these long-term industry leaders, and it could also be the case for your business.