For the near term, today’s construction landscape appears to be stable. However, with the recession still in our rear-view mirror, a relatively slow recovery underway, an aging workforce, limited numbers of younger folks joining the trades, and many construction company owners nearing retirement age - the smell of transition is in the air.
From tax consequences and cash flow models to family dynamics and management prowess, there is no shortage of challenges for owners who are exploring options for exiting a construction business. Each situation is unique. If you are looking to exit, it is imperative to understand the potential consequences. Your chosen path will impact you personally, your company’s ability to survive, and your employees. Often, running behind the scenes, is the effect of the chosen transition plan on your surety support. Understanding the variables and involving your surety agent and underwriter early in the process, will make the transition smoother.
Do you remember the “3 C’s of Surety”, or in this case, the 4 C’s?
- Character – Does your organization, its owners, and key employees have the background and history that support being a good risk for the work involved?
- Capacity – Does your organization have the necessary experience, knowledge, manpower, equipment, and time to perform the contract?
- Capital – Does your organization have enough financial wherewithal to take on the project in question and also fund other work and current obligations? What about surprises? Can the financial data be trusted and is it signed off on by a knowledgeable CPA external from the organization?
- Confidence –The surety ultimately must be confident that everything makes sense and the organization will not fail in performing the contract. Surety is not insurance where losses are anticipated. Sureties do not expect to have losses. If they do, they expect to be reimbursed from the organization for costs they incur.
Exit Strategies To Consider
Internal Sale – Selling to an employee, a group of employees, or to an already involved family member. Your company is likely the same after the sale. It just has someone new at the helm. Have these people been part of management in the past? Have they been involved in meetings with the surety? Is there a level of confidence built between the new owners and the surety?
Although this exit strategy often provides the best opportunity for the seller to maximize the value of the company, there could be a significant impact on the financials of the organization after the start of the deal. Surety is driven by financial strength so a deal’s financial impact must be considered. However, capacity is also about the surety’s confidence in top management. It is important to build a relationship between new leaders and the surety early in the transition discussion.
Employee Stock Ownership Plan (ESOP) – ESOPs can provide a great vehicle for ownership transition. Typically they involve an entire class of employees or the entire employee base. They are complex and come with initial and on-going administrative costs. They need stable or growing net income in order to fund debt payments.
The “business” is likely the same, but its governing structure will be different. There will be a fiduciary responsibility that management has to the employee owners. With everyone understanding their roles and responsibilities, this can be a good thing from the surety perspective. Most ESOP structures will wreak havoc on a balance sheet in the near term, significantly increasing debt and reducing equity. Work with a surety who understands ESOPs. Stability in projected profits and anticipated future work can provide confidence in the ability to meet ESOP debt and transaction obligations, administrative requirements, and responsibilities to the surety.
External Sale – An external buyer, either a strategic buyer or private equity firm, can provide immediate cash flow. It can also leave your company with a balance sheet that is significantly different. Most deals engage the seller for a period of time after closing. After cash flow, the seller’s biggest worry is often the company’s ongoing reputation and stability of jobs for employees. This determines the success of the transaction.
From a surety perspective, the structure of the deal is key. It’s possible your company is rolled up into a larger contractor. If it remains a stand-alone entity, the financial structure and the efforts to retain critical management expertise become key elements in the surety’s assessment.
Liquidation/Wind down – Typically not the most attractive option, closing your business can be effective if done properly. It is best not done in an emergency. Surety considerations in this strategy can still be important. Existing bonded jobs need to be completed successfully. An orderly wind down may require maintaining critical staff, and with that, a certain number of additional short duration bonded jobs. Surety capacity may still be required, although at a different level than before.
What’s the Risk?
Any ownership transition has risks and rewards. Each plan will produce different challenges. Keeping your surety agent and surety carrier in the loop is the best way to structure a deal that does not have unintended, or at least unexpected, consequences.