reprinted with permission from Sax, LLP
Many business owners know they need to make formal plans for a successor, but planning can easily take the backseat to the immediate need of managing daily operations, people, equipment, credit, cash flow, business development, and the next big project.
Many construction companies are family-owned and operated — some for generations — and have had a substantial impact on their local communities over the years. In addition, many of these companies are smaller, and therefore highly dependent on their owners to manage day-to-day issues.
Unfortunately, these are often the same companies that have no succession plan to prepare for future leadership, ownership, and management once the owner retires or is unable to manage the business.
This situation, combined with the importance of management quality, makes succession planning critical to the future success of a construction business. During such transitions, it is vital to have the surety provider’s support and confidence in the contractor’s financial strength, technical execution capabilities, and management quality and character. While it may come as a surprise to some financial purists, quality of management is one of the most important factors when determining the appropriate level of surety support to a contractor.
Types of Ownership Transfers
In the event that a contractor would prefer to transfer or sell ownership of their company to employees and/or family upon exiting their business, several alternatives exist for supporting the ownership transfer.
One approach would be to treat the related party as an external third party and to then sell ownership interest to that same third party, leaving the financial position of the underlying concern unaffected by the transaction. The usual obstacle here, of course, is the lack of external funds to support the transaction. For this reason, related party transfers are usually facilitated using other methods.
Other related party scenarios include:
- Traditional external financing to support the company’s buyout.
- Injection of capital for a certain period by an alternative financing method such as private equity.
- Ownership transfer through an existing or new Employee Stock Ownership Trust.
According to the Philadelphia Business Journal, some 70 percent of family-owned businesses fail or are sold before the second generation gets a chance to take over. While many owners prefer to pass the business on to family or staff, the failed transition is often due to a lack of trust and communication between the owners and successors, and the successors not being adequately trained with the right management skills.
There are various types of business transition methods, and the following are the most popular in the construction industry:
- Internal sale. The company, under the new ownership structure and management team, secures funding from a bank in order to buy out the current owners, or the existing owners provide self-financing of the transaction.
- External sale. An external (third-party) sale is typically the best opportunity for the company’s shareholders to maximize value and liquidity while minimizing deal risk. However, the external sale creates the most exposure to future change.
- Recapitalization. The current owners identify a financial partner who is willing to acquire a majority of the stake in the company. The financial partner typically invests heavily in the company and ultimately seeks a premium with a three- to five-year exit window.
- Employee stock ownership plan (ESOP). An ESOP trust is formed in order to acquire stock from the selling owners in exchange for liquidity. Shares are then allocated over time to the accounts of eligible employees based on various factors. The ESOP offers the opportunity to create significant tax savings to the selling shareholders as well as to the company, if the company makes an S corporation election.
- Old company and new company plan. The old company ceases to build up value and essentially ceases its operations while the new company finishes out the work of the old company under a project completion agreement. The old company guarantees the bank debt and bonding line of the new company for a period of time so the new company can establish its financial strength. After a period of time, the old company is liquidated.
Formulate a Plan
Open communication is vital to any succession plan. Start the process by talking to family and staff who can objectively discuss your vision for the future — for yourself and your company.
Once you have shared your ideas you can formulate a plan by focusing on the following steps:
- Identify financial conflicts:
- Expected versus real value of your company
- Personal needs after retiring
- Management’s acceptance of risks associated with a change in ownership
- Credit capacity of the company, and impact on ongoing operations after the transition
- Decide which family and/or key manager(s) you want to be part of your ownership and management succession plan.
- Make sure your key players understand the responsibilities and risks associated with their role in the succession plan. Alignment of all stakeholders regardless of their role is essential for your vision to be realized.
- Evaluate your successor owner/manager’s dynamics in anticipation of how he/she will respond to a change in management.
- Assess the near and long-term development needs of the company.
Valuation & Financial Reporting
Key factors to consider when attempting to value the company upon transfer of ownership include:
- Market and customers. What is the potential for your company’s growth — is there a market of expertise or specialization to enhance its operations? Do your employees have adequate knowledge of this specialized area, or do they need more resources?
- Infrastructure. What is the quality of your assets, such as real estate and equipment? Do you have adequate management information systems, and is your management team able to maintain your company’s infrastructure?
- Financial performance. What are your company’s earnings, and what is your company’s bank and surety credit without your involvement as a founder?
Maximizing value of the company is the obvious goal of every business owner who looks to sell or transfer their ownership. The value of a construction company can be maximized if the company has four fundamental strengths.
The first is a strong financial condition. This includes a healthy balance sheet, strong working capital, minimal line of credit borrowings, positive bank and bonding company relationships, and minimal historical and prospective exposure to sever job losses and contract litigation.
The second fundamental strength is a strong backlog. Look at the quality of backlog projects. Does the construction company have the right experience to tackle those projects? Are they within favorable geographical performance zones? It’s also important that the projects in the backlog will yield quality gross profit margins with minimal “booking risk” and “profit erosion risk.”
The third fundamental strength is having strong executive and field personnel. It’s critical to invest in seasoned leadership and strong talent.
And finally, strong financial systems. Construction companies with proven fiscal controls, established reporting and budgeting systems, and credible and timely financial reporting are seen as more valuable than companies without those systems in place.
Financial reporting is also vital to a transitioning construction company as it is imperative the company properly reports its earnings. It is just as crucial that the company report any unusual transactions or financial terms of operations that may impact the intrinsic value of the business. Examples of unusual financial transactions include, but are not limited to:
- one-time construction project gains, losses or other unusual items;
- excess or insufficient salaries or benefits that are paid to owners, family members or executives;
- excess family or executive perks;
- non-market rental or lease arrangements with related parties;
- non-recurring professional fees; and
- non-recorded financial transactions, including contingent gains and losses from construction litigation.
The Surety’s Point of View
Equally important as the overall financial performance of the company, if not more so, is confirmation that the new leadership team has the capabilities and a mindset that is consistent with the previous, successful management team.
A surety’s assessment of management capabilities is more art than science, as nearly all sureties recognize that the contractor, rather than the surety underwriter, is the true expert in the construction business. As a result, the surety’s assessment is based primarily on overall comfort with the management team’s attitude towards financial and operational risk; a realistic attitude towards technical capabilities; and consistent transparency and responsible engagement with owners, subcontractors and service providers. Of course, a track record of successful project execution is the foundation of the management assessment.
There are several best practices that the sureties will look for when supporting a contractor who is in the process of transitioning the company:
- Full commitment to succession planning – Top companies of all sizes view succession planning as part of their core responsibilities rather than as periodic events. Once top candidates for future leadership roles are identified, the leading contractors spend considerable time developing the capabilities of their high-potential candidates.
- Ongoing evaluation – Rather than identifying candidates for a “just in case” checklist, top organizations assess potential and performance on a continual basis when evaluating the readiness of leadership candidates. Further, rather than relying on performance in an employee’s current role, additional “bolt-on” responsibilities are given to stretch a future leadership candidate and determine his or her ability to operate at the next level. In this regard, a safety net is usually provided in order to limit the tuition cost of the education.
- Transparency – The pros and cons of transparency with succession plans are often debated. Full transparency can lead to the unintended consequence of resentment from less successful leaders, while limited transparency can result in mistrust within the organization. While there are merits to each argument, our observation is that top contractors tend to have a high level of transparency with leadership succession plans within their organizations. In addition to the internal transparency, the top companies also share their plans early and regularly with their service providers to ensure support for future changes.
- Planning with no immediate event on the horizon – Leading companies have made succession planning and leadership development an essential part of their core business activities. This approach results in an “always ready” environment that can make future planned or unplanned succession events less daunting and risky when the time comes.
- Depth of planning – When speaking of succession, we often hear people refer to the top jobs within an organization. Leading contractors go beyond senior management jobs when looking at their succession plans and then commit to an ongoing plan to identify and develop talent for positions that are well below the executive level. Over time, these companies have found that the process ultimately results in an extremely strong commitment to the organization’s success, as staff members feel they are part of a well-developed and strategically aligned plan for future growth and continuity.
- Attracting and retaining talent – Along with providing clear benefits in preparation for eventual management or ownership transitions, embedding succession planning into a contractor’s culture can help attract and retain staff in today’s highly competitive labor market. An absolute priority for attracting new talent is an environment of frequent feedback and well-developed career plans. A strong succession-planning culture facilitates the environment demanded by the new workers entering the workforce and the future leadership pool.
Overall, it is very important to decide what the best course of action is in order to ensure the goals and objectives of the selling shareholders are met. If there is one industry that understands the need for planning, it is construction. Timelines, deadlines and changing conditions are factors that construction leaders deal with on a daily basis. The companies that are strategic, realistic and committed to a successful transition will be the ones positioned for positive results.
Remember, you don’t need to execute a plan all at once, but by setting interim goals, you can have a solid plan in place before you’re ready to pass on the business. The sooner you start discussing your succession with those you trust, the sooner you can feel secure about your company’s legacy and your personal future.
Top contractors are ahead of the curve in making succession planning part of their core management and leadership activities, and those organizations will be better prepared for when the inevitable decision to transition occurs.
Angelo Straface, CPA, is a Senior Manager at Sax, LLP. He is a member of the firm’s Construction Practice and manages the audit and review engagement teams. He can be reached at email@example.com.