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Exit Strategies: How Construction Companies Utilize ESOPs With Private Equity

By James J. McKay

More than 40% of the current U.S. construction industry plans to retire in the next decade.

A portion of that number will include construction company ownership.

So, are you ready?

You built the company from scratch during the last 40 years, navigating shutdowns, lockdowns and a slew of macro and micro risks. Today’s top three challenges in construction persist: economic uncertainty, rising construction costs and labor shortages—according to Associated General Contractors of America’s 2023 Construction Outlook National Survey.

With more construction company owners pondering an exit strategy, ESOP plans are becoming the first step in a retirement plan with private equity being a latter consideration. Since 2016, private equity has increasingly played a bigger role in the construction industry, representing 41.5% of all transactions in 2021 from 16% in 2016, according to research from Capital IQ, Pitchbook and Capstone. There were 560 private-equity transactions for construction companies in 2021, compared to an average of 377 for fiscal years 2017-2019.

Here are four insights on how to make your construction company more attractive for a private-equity investment subsequent to the creation of an ESOP:

Start 10-Year Exit Today

Don’t wait until you are 60 years old to think about selling.

The planning should begin as soon as the owner acquires the company on day 1. Ideally, you should plot your exit before you make the investment. However, if that’s not the case, give yourself at least 5-10 years to execute the plan.

So, what should construction company owners do during those 5-10 years?

Make sure your financial statements, particularly the balance sheet, are lean and mean. Monitor accounts payable, accounts receivable and debt-to-equity, ensuring they compare favorably to your competitors. You should know the industry average and match or exceed expectations.

For midsize construction companies especially, transitioning to an accrual method of accounting will instantly make your company more attractive to private equity firms.

Accrual accounting recognizes costs and expenses when they happen as opposed to when the money is exchanged. This method shows investors the real sales and trends that the company generates. It creates an accurate picture of your company’s performance.

There is a good reason why generally accepted accounting principles (GAAP) only allows for the accrual method.

In short, get your financial house in order so you have time to take corrective action, if needed, and, more importantly, show a sustainable track record of growth.

Drive EBITA With High-Margin Work

For construction company owners, choosing the right market segment also can make your company more attractive to private equity groups.

Most construction companies think about winning the “big elephant” projects. But along with the price tag comes the logistics, workforce liabilities and your competitors trying to undercut your bid until it’s smaller than you planned.

Instead, construction companies may create a specific department for short-term work, which comes with higher margins. Day work, which is the true cost of labor and materials plus a markup, will make the company more valuable. Imagine a six-story building owner who wants an additional floor for a ballroom. That’s day work. Similarly, time and material (T&M) work generates the same outcome. A building owner wants to fix some storm damage and get the place ready for inspections. Absolutely. Labor, materials plus markup—without the competition and the seasonal business cycles.

Retrofits and public work can take a backseat when it comes to growing earnings before income, taxes, depreciation and amortization (EBITDA).

ESOP—Then Private Equity

Employee stock ownership plans (ESOPs) for construction companies have become an attractive option. An employee stock ownership plan (ESOP) is a business transition tool, an employee ownership vehicle and a qualified retirement plan. An ESOP creates a way for the owner to reap the benefit of selling the business and at the same time maintaining control and company values and offering ownership benefits to employees.

For federal and state tax purposes, an S Corporation that is 100% owned by the ESOP will not incur federal or state taxes based on a 1998 Internal Revenue ruling. ESOP’s can be structured in various ways:

  • 1042 Exchange – (tax deferral on the sale of a company to an ESOP).
    • A shareholder selling employer stock to an ESOP has the ability to defer recognition of capital gain if the ESOP owns 30% of the corporation after the proceeds from the sale are reinvested (replacement property).
    • The deferred gain will be recognized by the seller when the replacement property is liquidated.
    • It should be noted that the business owner and family members in a 1042 transaction cannot participate in an ESOP.
  • ESOP added to an existing 401K Plan (or a new 401K plan with an ESOP is created).
    • Participation by the owner is permitted.
    • The plan allows for a tax deferral retirement benefit for the ESOP ownership.
    • This plan may incorporate a pre-tax approach of a Roth account which requires the equity to be taxed on the onset, however the retirement benefit is tax free.

And your key employees, which are part owners through the ESOP during the process, are retained and focused on how they can become more productive while their own net worth grows.

The ESOP can be sold to a private equity firm when the owner decides to eventually exit.

Lock Down Business Development Officer

If a private equity firm is interested in a construction company, they may replace the CEO.

Thus, the most important individual is the business development officer (BDO). He has contact with all your customers.

You want to de-risk the CEO and you want to place a lot of emphasis on the BDO. Owners should initiate confidentiality agreements and noncompete agreements. Owners should also make certain those agreements are assignable. If it’s an asset sale, that’s where these documents come into play because you don’t have automatic assignment. So, make sure you have assignments that are in place to eliminate surprises.

In a period of transition, and there will be one once a private equity firm makes their investment, you will need to retain your BDO to hit the numbers.

(James J. McKay, CPA, MBA, is a director at CFO Consulting Partners, supporting the firm’s Construction and M&A practices with more than 25 years of senior financial management experience.)