When planning any business venture, it is important to think with the end in mind. Considering your exit strategy does not mean you are not committed to your business. It shows you care about the business and brand you have created living on into the future after you have decided to cease involvement or are unable to continue in day-to-day operations.
Many construction companies are closely held family businesses, often with ownership residing with one or two founding members. In my experience, continuity discussions can be challenging primarily due to the daily demands of running of the company taking energy and focus. Secondarily the discussion of exiting the company due to death or retirement can be a sensitive topic not easily discussed, especially with outside vested interests like banks and bonding companies.
Current ownership has held important operational roles during the inception and growth phases of the company, so it is important to identify the next generation of key leadership and involve them in the planning process and development of a timeline.
In a situation involving death, disability, or retirement of a shareholder, management can rely on terms outlined in a Buy-Sell agreement to transition ownership to other existing owners or key management. In the event of death, this is often funded by a life insurance policy. In the event of disability or retirement, acceptable financing terms should be outlined in the Buy-Sell agreement.
5 common transition methods:
- Employee Stock Ownership Plan (ESOP). ESOPs can have tremendous tax advantages and might be a great option for your company. As it relates to continuing bond credit, key areas to concentrate on are high costs & fees, over-valuation (linked to next point), overleveraging the balance sheet, and possible loss of personal indemnity.
- Private Equity. Also referred to as recapitalization, is when a financial partner is brought in to acquire a majority stake in the company. From a bonding perspective, private equity sales can over leverage the balance sheet depending on how the purchase is structured, siphon off a significant amount annual profits from the Company, offer too short of an exit horizon for the investor, and may not continue to maintain culture or retain key employees. The private equity firm also represents inactive shareholders lacking in construction industry knowledge.
- External/3rd party sale. This is often the best way for shareholders to maximize value and liquidity while minimizing ongoing risk. Some downsides to external sales are the buyer may be a competitor and require burdensome non-compete commitments, as well as exposure to future change in operations and culture.
- Old Co/New Co plan. This is a good option when the goal is maintaining financial strength for bonding. The strong existing company would remain in place while a new company is formed by the new shareholders. Oldco maintains an agreed upon amount of financial wherewithal and indemnifies the surety while Newco closes out existing backlog via subcontract agreements or assignments. New contracts are signed and executed by Newco. Over time, Newco’s balance sheet is built up via retained earnings so that is can stand on its own allowing Oldco to distribute capital to outgoing ownership.
- Internal Sale. This is a common structure for family-owned construction companies needing to maintain banking and bonding credit. The next generation of competent key employees and/or family members are identified, and a bank loan or seller financing is structured to purchase the stock from exiting ownership. The balance of the note and interest is paid down using future cash-flows. A bank loan can be obtained by the new ownership group. This is a good option when favorable terms and flexibility can be negotiated. Seller-financing can often offer a greater level of flexibility including more creative responses to poor performance and changing market conditions. To comfort the bonding company during this period of transition, the seller can subordinate the Note to the surety allowing them to view the Note balance as equity in their analysis instead of debt. As part of this structure the seller can maintain personal indemnity to support the bond program during the first couple years of the transition. For his or her indemnity the seller often receives additional fee compensation.
Ongoing success of the company is of paramount importance when developing your continuity plan and that means preserving bonding capacity to bid and secure profitable work. Please remember to involve all appropriate advisors in your continuity planning, like your attorney, CPA, tax advisor, banker, and bonding agent.
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Schmalz & Associates is an agency exclusively supporting contractor’s bonding needs. Eric Schmalz was an underwriter and manager for over 15 years working for Top 10 surety companies and now helps his contractor clients establish and maximize their bonding. Please call 512-640-6444, email firstname.lastname@example.org or visit the website at www.schmalzsurety.com