Best Practices for Understanding & Implementing ESOPs

When it comes to deciding on an exit strategy, construction company owners have a lot to think about: They’re faced with the prospect of turning over the business that they have worked so hard to build to new ownership. Selling the business to a third party isn’t always a welcome or viable option, and considerations such as company legacy, employee welfare, and local community may be important. These qualitative factors can be an excellent setting for constructing an Employee Stock Ownership Plan (ESOP).

What Is an ESOP?
Similar to a profit-sharing plan, an ESOP is a trust set up by a corporation to allot some of its stock to its employees over time. It’s a unique combination of a tax-efficient leveraged buyout and an employee benefit plan. Shares are allocated to individual employee accounts based on their compensation levels as well as how long they have worked for the company; as employees accumulate seniority, they become increasingly vested in the account.

Benefits of ESOPs
An ESOP can help ensure the continuation of the business, which is important to many construction business owners. An ESOP is scalable over time and offers a great degree of flexibility and advantages, such as short implementation periods, flexibility in liquidity, and benefits to employees (i.e., allowing them to contribute to the company’s success).

Tax Benefits
ESOPs also offer a number of tax incentives for the company, owner, and participants alike:

  • The principal amount of an ESOP loan can be tax-deductible, so a loan used to finance the ESOP transaction can be repaid by the company with pre-tax dollars.
  • A selling shareholder can elect IRC §1042 tax deferral treatment and may be able to indefinitely defer capital gains taxes associated with the sale of his or her shares, upon the satisfaction of certain requirements.
  • For companies that elect S corporation status, the ESOP’s share of recognized earnings is usually exempt from income taxes.
  • An ESOP retirement account is non-contributory and tax deferred, which benefits employees.

Challenges
Although ESOPs offer numerous benefits, they do require an understanding of business valuation, transaction dynamics, tax law, regulatory compliance under ERISA, and more. Even the perceived complexity of an ESOP can prove to be a detractor when deciding whether or not to implement an ESOP. If selling 100% of the company, outside lenders may be unwilling to finance the full purchase price of the company stock, which may require seller financing to cover the balance. In addition, ESOPs require ongoing administrative costs, including annual valuation, plan administration, legal, and possible trustee fees.

Laying a Good Foundation
A well thought-out ESOP implementation process will enable the resulting transaction to create strong value for the employees, the company, and the seller. The structure of the ESOP transaction should be tailored to meet the needs of the selling shareholder and stakeholders. Laying a good foundation for the ESOP begins at the onset of the transaction and should include the following:

Selecting a Strong Advisory Team
Selecting a team of advisors that include fiduciary, financial, legal, and administrative professionals is key for a successful ESOP transaction and for the ongoing sustainability of the ESOP.

Conducting a Feasibility Study
During the ESOP exploration process, a feasibility analysis should be performed to test various assumptions regarding the value of the company, the size of the transaction, financing options, and the expected ESOP benefit delivered to employees over time. ESOP transaction financing is non-productive in that it does not enhance the value of the business or provide growth opportunities. It is important that the management team understands the capital requirements necessary to operate and grow the business going forward.

Structuring the Transaction
Construction companies must take a number of factors into consideration before implementing an ESOP. Most construction companies have bonding requirements in order to bid certain projects, and leveraged ESOP transactions can negatively impact shareholders’ equity. For this reason, it is important to discuss the transaction with the company’s bonding agent beforehand to ensure that the appropriate bonding levels are maintained post-transaction and ESOP transaction dynamics are understood by all stakeholders.

Management Transition
Developing the next generation of management is important to maximize value and perpetuate any business. Identifying, grooming, and transitioning senior management takes many years to accomplish. As such, it is a great practice to be constantly searching for and identifying future company leaders.

The Bottom Line
ESOPs can be a highly effective tool for ownership transition with a host of advantages for construction business owners. Most often, the tax, financial, and cultural advantages far outweigh the effort and cost of implementation.

Franco Silva is a Vice President at Prairie Capital Advisors, Inc., an employee-owned company offering investment banking, ESOP advisory, and valuation services to support the growth and ownership transition strategies of middle-market companies. He advises clients in a variety of industries with particular emphasis in construction businesses. He can be reached at 630-413-5584, fsilva@prairiecap.com, or www.prairiecap.com.

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