It is inevitable that, as a contractor, you will one day will have to leave your company. Will you be prepared to capture the maximum value for the business that aligns with your personal and financial goals?
Historically, less than 25% of contractors sell successfully to an outside third-party buyer. This is because their companies tend to be personality driven, have thin management, are highly cyclical, and have bonding requirements – all of which reduce the pool of qualified buyers. Most do not sell at all, and many of those who do receive disappointing prices. Additionally, as a highly cyclical business, business value can be lost quickly, and once gone it make take years to recover. In order to position yourself to get the value you need upon exit, it is best to keep all exit options open, which requires proper planning along with relentless execution.
Build a Valuable Company
Regardless of your exit option or path, you should integrate a process of value acceleration as part of your day-to-day business strategy as successful exits are based on what you do every day. Value acceleration is a plan that addresses three things: (1) maximizing the value of your business; (2) ensuring you are personally and financially prepared, and (3) ensuring you have planned for life after you exit. In the exit planning world it is referred to as the “three legs of the stool.” If you don’t take care of all three, your planning will fail.
A valuable company is one that produces repeatable profits and is transferable to a buyer. In this case, a buyer could be a family member, a partner, or your key employees, not just an outside third-party buyer. A valuable company is one that is not owner dependent, has a strong and engaged management team, and has internal systems and processes that can be purchased and repurposed. It is highly profitable and has a strong balance sheet.
Having a valuable company opens up a variety of exit options for contractors, including:
- Transfers to insiders (management and/or children),
- Sales to an employee stock ownership plan (“ESOP”), and
- Sales to an outside third-party, such as a strategic buyer or private equity group. Let’s discuss these in reverse order.
Sale to Outside Third-Parties
As previously mentioned, this exit path is not very successful for most construction companies. However, if you wish to pursue this option be sure you align yourself with a team of professionals with a proven track record of success. You may need to replace many of your current professionals to make this successful as they may lack the expertise and experience to make this happen.
ESOPS
An ESOP is a complex hybrid retirement plan where you sell your company to a trust for the benefit of your employees. It is highly tax-advantaged and complex, so if you are interested in this option, you should explore it with the help of an expert.
Insider Transfers
The most likely exit path for contractors will be one where the business is transferred to children and/or members of a key employee group. There are three methods of executing this: gifting; the “two-step exit plan” over time, and the old company/new company technique.
Gifting-Family Succession
If you have a family run business, you may wish to transfer ownership of the business to the next generation via gifts over time as your transfer business responsibilities to them. As exit planners we recommend that the initial gifts be on non-voting shares with appropriate buy back agreements in case this strategy does not work out. Only when you are comfortable with the transition and have achieved all of your personal and financial goals would you then transfer the voting shares.
Since this strategy is not a sale where you will be paid for your ownership interest, you must be sure you have analyzed and quantified your personal and financial goals prior to embarking on this option. You should work with your financial and tax advisors to ensure that enough money will be available for you to retire in style. Strategies often deployed involve the use of qualified retirement and non-qualified deferred compensation plans, as well as many estate planning minimization vehicles such as sales to defective grantor trusts. It is essential when embarking on this strategy you work with an estate planning professional in addition to your other financial advisors. In addition to the financial and tax considerations, transition the business to the next generation is often complicated by family dynamics and issues of “fairness” to children who are not active in the business. Oftentimes a family succession counselor is necessary to work thought the issues.
The Two-Step Exit Plan
A successful insider transfer – the sale of a company to key employees (who may also be family members) usually over a predetermined number of years – has two key requirements:
- The insiders must be willing to take on the risks of being an owner, which may involve personally guaranteeing bonding lines, bank loans, leases, and other business obligations; and
- The plan must incentivize the insiders to grow company cash flow to fund the transfer. This “new” cash flow – not existing cash flow – will provide for the owner’s exit. This is because key employees typically don’t have the money to do so, and they cannot borrow funds to cash out the owner.
To minimize the double tax associated with transfers to insiders, (once on the business income used to fund the transition, and then on the owner upon the sale of his shares) many exit planners use a “two-step” process that minimizes taxes and reduces risk. In this process, a sale of stock at market value (the lowest defensible value) is combined with direct payments (such as deferred compensation or S-corporation or LLC distributions). If company cash flow is a source of payments to the owner, having most of it taxed only once enables the owner to quickly get what he or she needs with less risk to the business.
Step 1: Sale of Non-Voting Ownership Interests
First, the company is recapitalized to have voting and non-voting shares. The owner will typically make a pool of approximately 40% of the non-voting shares available for current and future purchases from key employees, 5-10% of which is sold to one or two key employees. For this buy-in and others, including any future repurchases of that stock, the shares are priced at the lowest defensible value – that is, the minimum value that can be placed on your company as determined by a valuation professional.
The use of lowest defensible value makes the purchases affordable for the key employees and provides an incentive to remain with the company. The initial purchase price is paid in cash. If the one or two initial key employees need to borrow funds to secure the necessary cash, the company can carry their notes or guarantee the key employees’ promissory notes to a bank.
Even though the key employees will not receive voting stock, the ownership of non-voting shares offers them significant benefits and opportunities:
- Share in the stock appreciation
- Receive S corporation or LLC distributions on a pro-rata basis
- Receive full fair market value for shares if their stock is sold to a third-party
- Be more involved in day-to-day decisions
- Participate in determining which additional key employees will be offered stock out of the balance remaining in the 40% pool
This last point is critical. Shares are only sold if the key employee group produces increased cash flow to finance its purchase. Otherwise, the owner uses his money to buy himself out. For this reason, it’s critical to design incentives that motivate the insider purchasers to grow company cash flow and execute the buy-out plan.
As previously stated, 40% of non-voting shares are sold to insiders over time as cash flow benchmarks are met. These non-voting share transactions are vested over a set timeframe to motivate key employees to stay; if they leave the company, then they also leave value behind.
Further, each key employee who purchases stock enters into a stock purchase agreement with the company that provides for the repurchase of his or her stock in the event of death, long-term disability, or termination of employment, often at the same price that was paid for the shares. The stock purchase agreement also restricts insiders who leave the company via non-compete agreements, non-interference agreements, and confidentiality agreements – all of which serve to protect the company’s interests.
Step 2: Sale of Remaining Voting Interest and Direct Payments
After the 40% non-voting shares are sold (usually 3-7 years) and the business continues to be successful, the insiders would then purchase the remaining 60%, preferably with the proceeds of a bank loan. Only upon making this payment do the insiders get those voting shares. At this point, the key employees should be fully vested in the non-voting shares, ensuring that the owner remains in control until paid in full. The remaining 60% could also be paid out with cash from company profits or another investor.
Keeping the owner in control until he accumulates the money necessary to retire is a critical part of a successful insider exit plan. It also provides the owner with maximum flexibility. For example, instead of selling the remaining 60% to the insiders, the owner may decide to sell to a third-party, with the non-voting shareholders often following suit. Or, the owner can decide to sell his interest to an ESOP. And, if the non-voting shareholders leave the company, the owner still has control and can easily take over the reins again.
Concurrent with the aforementioned stock sales, a large portion of the owner’s retirement money comes from direct payments in the form of annual S-corporation or LLC distributions, compensation payments, and deferred compensation, all from the increased cash flow generated by the insider group; at this stage, the owner is stepping back and working part-time. As stated previously, this income is taxed only once.
Old Company/New Company
This is not a sale of an interest in the existing company at all. Rather, a new company is set up with new owners (children or key employees) who are given an ownership interest that is vested over time. The old company maintains the voting or managing ownership interest in the new company that will eventually be sold to the new owners’ once new company is successful on its own. Unlike the “two-step” process, this technique allows the new owners to have the benefits of ownership now and facilitates the existing owner to exit the business almost immediately.
The old company provides goods and services (equipment, facilities and employees) at market rates to the new company, which includes guarantying bonds for new company work. The old company completes the work in has in process with all new work being done by new company. The benefits of this structure are: it separates future business liabilities and risk from existing assets in old company; it minimizing taxation on the transfer of valuable assets; it provides financing to the new owners of the new company; and it rewards and/or motivates the new successor owners.
Over time the old company has cash in it and the new company has all of the valuable assets as ownership has shifted, with no tax paid on the transfer. The old company then liquidates with the liquidation proceeds being distributed to the owner. This technique is a much under-utilized technique and will often be superior to a sale to family members or key employees.
As with the other exit options, it is important that the construction contractor know how much money he needs in order to retire in style and that this plan is designed to get him there.
These exit options have advantages and disadvantages. It is imperative that you first perform both a business value and personal and financial assessment with your professional advisors to ensure that you choose the best exit option that meets all of your needs.
