Surety Considerations for Contractors Leveraging ESOPs
Many companies face the decision of how to continue their companies when their CEOs retire. Some consider Employee Stock Ownership Plans (ESOPs) in order to cash out existing shareholders and allow employees to assume ownership of the company through contributions into an ESOP trust.
Construction companies have historically used ESOPs less than other industries, but this is beginning to change. There are limited options for the succession of closely held businesses, and the implementation of an ESOP is a viable alternative. Companies that use surety credit will have additional considerations.
The construction industry is very cyclical. This alone can create earnings inconsistencies year to year as well as numerous challenges for construction company balance sheets. As surety companies are creditors and rely on the contractors’ balance sheets for repayment when they must pay claims, the addition of a poorly structured ESOP will draw an exception from a surety underwriter.
An important part of a construction company’s business is the ability to obtain surety bonds; therefore, the surety relationship is vital to the contractor and the contractor must make every effort to maintain the surety relationship and maximize surety capacity.
Surety underwriters focus on tangible net worth, liquidity and GAAP net earnings. Because sureties are essentially unsecured creditors until they perfect their security interests through UCC-1 filing, large cash distributions or withdrawals from a construction company are often scrutinized by the surety. The creation of a leveraged ESOP can impose a cash drain on the company and add additional debt to the balance sheet; however, ESOPs can be structured favorably to allow a company to continue to maintain its current surety relationship.
There are no absolute industry ratios relative to the amount of surety support and capacity that a surety will provide to a client. Commonly referred to ratios within the construction industry, as a baseline, are surety credit capacity equal to 20 times tangible net worth, or 10–15 times analyzed working capital. The ratio requirements can vary by industry segment, amount of leverage, inventory and equipment implementation. Further, surety liquidity requirements for subcontractors are generally more stringent because subcontractors typically assume greater contractual risk.
There are potential benefits to the surety that can be offered in an ESOP structure:
- ESOPs offer a transfer of ownership that ensures continuity in the company. ESOPs are incentives for key employees, members of management and work crews to make sound financial decisions that affect day-to-day operations. Retention of key management and employees is critical to demonstrate that those responsible for past performance of the entity will continue with the company to ensure future success. ESOPs offer employees a piece of the action through stock ownership, which in turn will motivate employees to be better performers.
- An ESOP can be a useful tool to increase cash flow and build company net worth. The IRS allows significant tax advantages for ESOP contributions, especially for S Corporations. S Corporations that are owned 100 percent by ESOPs have virtually no federal tax obligations on earnings. In leveraged ESOP transactions, both the principal and interest payment contributions to service the ESOP loan are tax-deductible.
Companies that pay significant amounts of income tax are good candidates for ESOP structures. Additionally, strong management, cash flow sufficient to support value and debt repayment, strong historical earnings and a sufficient employee/payroll base of at least 50 employees are also important qualifications.
It is important for construction firms and their business partners to recognize some of the challenges that a contractor may face with its surety company when considering an ESOP structure. Some of the challenges from the surety’s perspective during a leveraged ESOP transaction include:
- higher leverage on the balance sheet from the loan used to fund the ESOP affects net worth ratios. Generally, sureties begin to restrict surety capacity when debt to equity exceeds 4:1;
- fixed costs associated with debt repayment curtail earnings—especially in a down economy when it is more difficult to generate earnings;
- ESOPs can create free cash flow issues by paying the ESOP trust for the shares or paying employees for their shares upon retirement or release;
- when a contractor obtains a bank loan to fund the ESOP, the bank generally perfects its security interest first with the company stock as collateral. Since the surety is essentially an unsecured creditor, the bank has primary position to the company’s assets and the surety’s only collateral is accounts receivable on bonded projects;
- sureties rely on corporate indemnification (the ability to pay back to surety in the event of a loss) and often require personal guarantees;
- securing personal guarantees from an ESOP-owned company can be difficult due to the spread in ownership;
- an ESOP itself cannot indemnify—it is regulated by ERISA and is exempt from creditors;
- any notes receivable on the company balance sheet will be excluded from net worth and liquidity calculations which sureties use to set capacity limits;
- recessions can be difficult on a company owned by an existing ESOP. Unless the ESOP has an extended payout period, the ESOP will have to immediately purchase vested shares upon employee retirement or termination; and
- additional expenses associated with operating an ESOP each year—such as audit and administrative expenses—can be an additional strain on earnings and cash.
Potential Surety Solutions for ESOP Companies
- Identify key members of management who will lead the company into the future. Structure a five to 10-year business plan that defines the roles and expectations of those leading the company. The surety’s confidence in management will be crucial.
- Create five-year financial projections that are achievable—then meet these projections. This would include the ability to properly estimate projects as evidenced by the final gross profit meeting or exceeding the original estimated gross profit. The company’s ability to meet financial projections will be the surety’s “report card.”
- During owner-financed ESOP transactions, insist that the existing shareholders take on carryback notes that are receivable from the ESOP or company and can be subordinated to the surety. Try to negotiate a reasonable interest rate that is beneficial to both parties.
- If there is no immediate need to cash out major shareholders, structure the ESOP to buy back shares over a longer duration in smaller increments to lessen the cash strain on the company.
- Create appropriate vesting periods before employees are eligible to receive contributions for their shares.
- Structure a limited personal indemnification deal with the surety until the company equity has been replenished. Shareholders being purchased may have to provide personal guarantees to the surety until a significant part of the loan has been repaid.
- Evaluate the spread in age of management and employees to diversify the company’s ESOP repurchase obligation.
When structured properly, ESOPs can facilitate the continuity of very successful businesses. They allow for a legacy company to be created and for multi-generational succession, and they preserve culture. Owners can remain involved and in control of the company regardless of the ESOP ownership amount. Proper communication and collaboration between the surety company and the contractor’s CPA firm will help facilitate a seamless transition.