Liquidity for Contractors – “Internal” Transfers

Editor’s Note: This is the first of three articles by PCE Investment Bankers, LLC. on the subject of liquidity. To read the next article in the series, click here.

Despite the current market turmoil, cash liquidity is, and will remain, an objective for business owners.

For many, the majority of their accumulated wealth is tied up in the private stock of the company. Accessing all, or a portion of that wealth, converting it into investable and spendable dollars, is a prudent goal consistent with the diversification advice of every private wealth manager.

The timing of an owner’s desire for liquidity does not always conveniently match the peak of the market value cycle of construction companies.

Part of the challenge of “market timing” is to accurately identify where you are in the cycle, especially when the industry is experiencing volatility. The second challenge is that life’s circumstances, which play so prominently into the decision to sell a business, are typically unrelated to the rise and fall of a company’s value.

Once an owner thinks of selling the business, it makes sense to understand the options and to position the company accordingly, even if the execution is years away. Further, if a contractor regularly bonds some portion of the work performed, then special attention must be paid up front as to how bonding would be impacted by the transaction to ensure the smooth functioning of operations after closing.

Why “Internal” Transfer of Ownership?

Several factors typically play prominently into an owner’s decision to pursue an internal approach to liquidity:

• High value placed on perpetuating the culture and independence of the company and its place in the community
• Desire to reward those who helped make the company successful
• Interest from family members in running the company complete with the acumen to do it well
• Concern over confidentiality and reluctance to approach competitors who could be logical buyers

If some or all of these factors are present, then the exercise of comparing the approaches to an internal transfer will be productive. These alternatives generally fall into the following 3 categories:
 

1. Selling to senior management
2. Family-selling and/or gifting to children or relatives
3. Employee Stock Ownership Plans (ESOPs)

Selling to Senior Management

Business owners often feel a sense of loyalty to the management team that helped the company achieve success.  From a continuity standpoint, there is no better group to take over the company than senior management.  Selling to management presents two distinct challenges:

• How does the owner set a fair value without marketing to outside buyers?
• How does the management team find the money to purchase the company?

The solutions to these challenges may also require a patient seller who is willing to receive the proceeds over time and to retain some business risk during the years of the transfer.

Determining the transaction price may require a qualified third party to set the range of value. This can help avoid the often awkward negotiations amongst co-workers and friends.  Having set the value range, the simplest solution is for management to find a lender willing to use the assets of the business as collateral for the loan, essentially recapitalizing the company’s equity with debt and allowing the selling owner to receive all of the proceeds in cash at closing.

In today’s credit environment, an owner will rarely find a lender willing to advance the entire or majority of the purchase price, especially in a construction company due to the cyclicality of the business, bonding requirements and usually lean balance sheets.  In most cases, a bank will lend a portion of the value with the seller retaining some stock or selling the rest of the stock in exchange for a seller note.  This scenario still leaves the seller with risk exposure to the company’s performance as the seller note is likely subordinated to the bank and the surety, but this does accomplish the intended task of transferring ownership to the management team.

Another sell-to-management approach involves setting up a new company (owned only by senior management) that then enters into a joint venture (JV) with the old company (owned by the selling shareholder).  If the new company starts with a 20 percent share of the JV in the beginning of the partnership, the new company will roll all its pro-rata, after-tax profit back into the JV to help build up the equity and increase the new company’s ownership.  The old company will contribute just enough of its share of the profits to sustain bonding capacity, owning less and less of the JV each year as the new company rolls more of its profit in and the old company takes more of its profit out. This strategy helps keep the surety relationship intact during the ownership transition.  However, the transfer can take a number of years, especially if the company is in a growth stage.

Family

Family-owned companies are a significant force in the construction industry and present unique challenges when approaching liquidity issues.

• 1.5 million construction companies are family-owned and operated (National Family Business Council)
• 40 percent of all family-owned companies will face the generational transition in the next five years as baby boomers retire (Massachusetts Mutual survey)
• Only 30 percent of construction firms will stay in family hands after the founder leaves the helm; of the firms that make it to the second generation, only 12 percent pass into the third  (Family Firm Institute)

While all of the strategies for selling to senior management can equally apply, the unique aspect of family transfers is that charitable instincts may play more powerfully than profit incentives. Tax treatment, rather than market valuation often becomes paramount, and free-and-clear cash proceeds at closing may be either reduced or eliminated altogether.

There are several tax efficient strategies for transferring wealth:

• Family Limited Partnership (FLP) or Limited Liability Company (LLC) – In a two step process, the ownership of the operations is transferred into an FLP or LLC, and then over time and in small pieces, the ownership units of the FLP or LLC are parceled out to the family members. This process allows significant discounts to be taken from its proportional value because of the lack of control and the lack of marketability associated with non-controlling interest.
• Trusts – The idea behind the use of trusts (typically Grantor Retained Annuity Trusts, or GRATs) is that assets can be transferred to a family member at today’s base valuation or lower if a discount applies. However, the income remains with the seller while the subsequent increases in stock value pa ss to the trust beneficiaries tax free.
• Sales and Notes – One effective and simple way to transfer wealth is simply to sell portions of the company, taking advantage of discounts, and hold a seller’s note for the value sold.  The note can have an interest rate as low as the Applicable Federal Rate (AFR), currently at historical lows-2 percent for February.

Employee Stock Ownership Plans (ESOPs)

ESOPs are a liquidity structure that has the flexibility to blend the attributes of the strategies outlined above while delivering favorable tax treatment both to the shareholders for their proceeds and to the corporation by reducing or eliminating the tax obligations of the business going forward. Partial sales to ESOPs (typically 20 to 40 percent initially) are prevalent today, allowing owners to retain significant equity upside and enhancing the surety’s comfort with the transaction.

The tax legislation enabling ESOPs was originally introduced in the 1970s and significantly expanded in the late 1990s. By all counts, the approach has been quite successful:

• More than 9,700 ESOP-owned companies;
• More than 11 million workers have come to own employer stock via an ESOP
• ESOPs own more than $900 billion in employer stock
• Some very high profile and successful construction companies are ESOP owned:

• Sundt, Inc. in Arizona
•  McCarthy Building Companies, Inc. in St. Louis
• The Haskell Company in Florida
• The Williams Company in Florida

There are two core tax incentives:
 

1. Shareholders – When stock held longer than a year is sold to the ESOP, the proceeds qualify for long-term capital gains tax treatment (15 percent vs. 35 percent for ordinary income-under the current federal tax brackets). Under certain circumstances, a C-corporation or a conversion to a C-corporation would allow the selling shareholder to defer even the 15 percent capital gains tax.
2. Corporate – There are two corporate tax tools, the combination of which can substantially reduce or in some cases eliminate federal income taxes going forward:

• Contributions to the ESOP as tax deductible, reducing the company’s taxable income. The ESOP returns the cash contribution to the company by servicing its debt incurred as part of the initial sale transaction.
• If the company is an S-corporation, the portion of the company’s annual income owned by the ESOP is exempt from federal income tax.

Significantly, in the most efficient structures, an ESOP construction company can have 35 percent more debt service capacity since dollars are not leaving the entity to pay federal income taxes. Debt is serviced with pre-tax dollars. This cash efficiency factor weighs prominently in the surety’s evaluation of the ESOP transaction for bonding purposes going forward.

ESOP plans require broad participation across the employee base but include vesting schedules that drop employees who don’t stick with the company long-term and allocate shares generally in proportion to payroll. Operational control remains with the board of directors, and disclosure of operating performance is discretionary.

Every owner has a unique and very personal set of objectives and each company presents its own case specific profile. Careful attention to balancing the owner’s objectives with the company’s capabilities will deliver the best liquidity strategy. An owner may find that an external transaction, explored in next month’s article, is the right fit.

Disclaimer – * Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained in this communication (including any attachments), unless explicitly provided otherwise, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Construction Business Owner, February 2009