Construction Industry ESOPs

Construction M&A volume is soaring, and valuations are breaking records. Demographic shifts are driving these trends. More and more business owners are reaching retirement age, and many are considering exit strategies.

Family-focused succession plans were once the norm among contractors and builders. But today, far fewer companies are passed to the next generation—or even trusted managers. Private equity has largely filled the void.

PE firms first turned their attention to the built environment industry in the early 2000s. Since then, platform transactions and "add-on" deals have steadily gained favor. But the PE model isn't always a best fit for middle-market firms, especially when those companies prioritize business independence and legacy preservation. Under these circumstances, employee stock ownership plans (ESOPs) offer a meaningful shareholder liquidity alternative.

Why do construction industry firms consider ESOPs?

A sale to an employee stock ownership plan actually shares similarities with private equity. It's effectively an internal leveraged buyout. But whereas a PE firm relies on outside investors to acquire a business, ESOP financing is arranged by the company itself. In addition, the buyer is a single, known party—an employee stock ownership trust.

The closed-loop nature of an ESOP sale also protects a construction firm's confidential information. There are no disclosures to or negotiations with competitors. All stakeholders are intertwined and incented to work in each other's best interests. Those incentives are a unique mix of hard and soft benefits. 

Tax-Advantaged Liquidity

Most construction business owners have a lot of financial eggs in a single basket: their companies. ESOP sales can help them unlock and diversify their wealth. A shareholder's stock is sold at fair market value in a transaction that can yield considerable cash up front.

Sellers can defer capital gains taxes on those proceeds. The tax tool that makes this possible is dubbed a 1042 rollover. It's reminiscent of a 1031 real estate exchange and equally powerful. Compared to a M&A deal, an ESOP can yield an after-tax savings of up to 35%. 

The fact that leveraged ESOPs are stock sales (rather than asset sales) is also advantageous. Many built environment firms use accelerated depreciation to lower their tax liabilities on equipment and real estate. In a third-party sale, this accounting technique can trigger an added tax burden known as depreciation recapture. That can take a notable bite out of a seller's proceeds. An employee stock ownership plan transaction enables construction companies and their owners to sidestep this depreciation liability altogether.

Flexibility and Continuity

ESOP formations can be structured to satisfy a number of use cases. Partial sales, management buyouts, and targeted shareholder exits are all feasible. That gives construction firms and their owners the flexibility to build liquidity events and succession plans that meet multiple stakeholder needs.

Post-transaction, employee-owned companies retain their independence. A board of directors oversees operations, and selling shareholders often play meaningful roles. Sellers can also maintain equity stakes and benefit from potential future gains. This is crucial for owners who have a deep connection to their businesses and no desire to leave.

Sustainable Succession

Despite the impending "Silver Tsunami" of aging construction business owners, many dismiss the thought of an early retirement. A partial ESOP sale enables those shareholders to take "chips off the table" and phase out their roles (and full ownership stakes) over a five- or 10-year period.

A staged approach often paves the way for a hand-off to management or family members. An initial, minority sale offers employees skin in the game and encourages emerging leaders to step up and take companies to the next level. If all parties rise to the occasion, shareholders can sell the balance of their holdings to the employee trust and step aside when they see fit.

ESOP-led succession strategies can also be enhanced to incentivize top managers beyond their standard share allocations. A synthetic equity plan (including warrants and/or stock appreciation rights) may be negotiated as part of an employee ownership transaction. It's a way to help the next generation of company leaders, who normally could not afford to buy the company outright, acquire an outsized portion of an employee-owned business.

Competitive Advantages

The fight for construction talent is fierce. Poaching is commonplace, and overall it's costly to hire and train staff. ESOPs are a proven differentiator. Employee ownership not only encourages retention, it drives productivity. That's because loyalty and hard work can translate to tangible employee retirement benefits.

In addition to cultural advantages, ESOPs offer corporate tax breaks that can meaningfully enhance cash flow. When stock is sold to an employee trust, that company receives income tax deductions equivalent to the sale price. In other words, a firm can earn $10 million in state and federal deductions on a $10 million ESOP sale. 

And if a company is 100% employee-owned, it can be exempt from corporate income taxes in perpetuity. That offer an enduring financial advantage—one that may enhance a firm's ability to bid on projects and stockpile growth capital.

Ample Transaction Financing

Although ESOP transactions may be seller-financed, a commercial loan can help provide selling shareholders secure cash at close. Fortunately, many financial institutions view employee-owned construction firms as good credits (thanks in part to the aforementioned tax benefits and workforce advantages). This desirability helps companies secure favorable loan terms from multiple lenders, often without personal guarantees.

Employee ownership plans are also compatible with bonding agreements. It takes proper communication, and at times negotiation, to secure alignment with surety partners, but well-managed ESOP processes can help overcome most hurdles.

Exploring Employee Ownership

An employee stock ownership plan isn't right for every construction company, but it may represent a meaningful private equity alternative for successful middle-market firms. That’s especially true for owners seeking to gain liquidity and reward employees for their help in building the business. In the end, employee ownership has the power to preserve legacies built over years of hard work.