Interest in employee stock ownership plans (ESOPs) has surged significantly within the construction industry. Where this was once a niche strategy for business owners seeking liquidity or an exit solution, the concept is now trending among construction firms.
I connected with George Thacker, Managing Director at CSG Partners, the nation’s largest ESOP investment banking practice, to gain his perspective.
Q. Why do business owners consider ESOPs?
George ThackerCSG Partners LLC
Some companies consider a management buyout. This can be inefficient because the company uses after-tax cash to redeem the owner, who then pays additional taxes on the sale. In general, that’s only feasible if an owner sells for less than market value or is paid out over an extremely long time period.
Private equity has been another alternative. In most of these transactions, a financial buyer leverages your balance sheet to acquire your company. A PE sale may make sense if an owner is ready to exit immediately and doesn’t have the patience for a multi-year payout. However, an owner will pay capital gains taxes on the sale proceeds, employees probably won’t benefit from the sale, and the legacy of the business likely ends.
An ESOP offers a powerful alternative. For business owners, these transactions can provide liquidity events while preserving the independence and legacy of their firms.
Our construction clients typically pay substantial income taxes. An ESOP can create significant tax advantages for selling owners and companies.
Finally, ESOPs can offer meaningful benefits to the company’s employees and management team. As one of my clients said, “There’s a war for talent among contractors.” A well-designed ESOP helps recruit and reward employees.
Q. Say someone owns a business with 50 employees. He’s getting ready to retire, but doesn’t have a successor waiting to buy the business. He’s received private equity offers but worries about the future of his employees. How does an ESOP provide a pathway for him?
An employee stock ownership plan is a retirement plan. What makes it unique? An ESOP acquires stock in the same company that forms the plan. Privately held contractors utilize the strategies to sell shareholder equity to an employee trust. That creates liquidity for owners, retirement benefits for their employees, and tax breaks for their companies. ESOPs are comprehensive corporate finance tools.
In our example, an ESOP can be formed to buy some or all of the owner’s shares at fair market value. One big misconception is that the employee trust won’t be able to pay as much for that stock as a private equity buyer. In reality, an ESOP is considered a financial buyer, just like a PE firm. As a result, there should be no difference in what either party can pay in a sale.
If the owner has some runway and is seeking a gradual exit, or if he has a solid management team that lacks the means to purchase his business, an ESOP sale can make a lot of sense. That’s especially true if he’s focused on his employees' well-being and the company's continued independence.
Q. What are the tax advantages?
Employee ownership has been a bipartisan cause since Congress formalized ESOPs in 1974. Since then, lawmakers have created various tax benefits to encourage companies and their owners to establish employee stock ownership plans.
One of the most unique and valuable incentives can be found in Section 1042 of the tax code. It permits business owners to defer or eliminate capital gains taxes on their ESOP sale proceeds.
ESOP-owned businesses also receive tax benefits. The easiest way to think about it is that when stock is sold to an employee trust, the company gets a pool of deductions equal to the sale amount. Those deductions can be used to offset the business’s taxable income for the next several years.
Firms that sell all outstanding shares to an employee trust – either all at once or in stages – can eliminate their Federal income tax burdens altogether. That’s because an ESOP is a tax-exempt entity. A 100% employee-owned S-corporation is effectively a permanent, tax-free structure.
Q. How does an ESOP pay for an owner’s stock?
Typically, the company will go out and borrow some traditional senior bank financing. The ESOP will use those funds to pay the owner some cash at closing. If the loan doesn’t cover the full sale amount, the owner will take a what's called a seller note back for the balance.
The employee-owned company’s tax advantages can help it quickly pay down these loans. Cash flow that was previously used to cover income taxes can now be used to pay down debt or grow the business. It may take an owner three or four years to receive full payment following an ESOP sale.
Q. How is ESOP stock allocated to employees?
Following an ESOP sale, the shares are held within the employee trust. Every year, some of that stock gets allocated to employees. These allocations often take place over a 15-to-30-year period. The longer someone works in the business as an employee, the more stock they receive.
Allocations are based on wages and proportional to an employee's percentage of the company’s overall payroll. If you have one employee owner making $100,000, and another makes $50,000, the first person will get 2x as much stock as the second person.
Q. Does everybody start from scratch at the time of sale?
Not necessarily. All stock allocations are subject to a vesting period. But let's say you have an employee who has been working at the company for 10 years, you can give them credit for prior service and either accelerate their vesting or eliminate it altogether.
Although ESOP stock is subject to specific allocation rules, a company can also create more flexible benefits alongside an employee stock ownership plan. Stock appreciation rights and warrants (which are similar to stock options) are often used to create added incentives for management and other key employees.
Q. What is the investment banker’s role in an ESOP transaction?
Many owners are familiar with M&A investment bankers, who approach companies with the intent to sell those businesses to third parties. They’ll take a company out to market, find a buyer, and broker a sale.
For an ESOP, our role as an investment bank is to quarterback and run the transaction from beginning to end. That includes structuring an optimal deal, lining up financing, and leading all negotiations on the company’s behalf.
Q: What’s step one?
It usually begins with conversations between our team and a business owner. We’ll explain the nuances of ESOPs and get a better sense of the motivations and what’s driving their interest in an ESOP. Sometimes a transaction makes sense on the surface, but sometimes it doesn't.
When it does, we put together an extensive financial analysis. We assess the fair market value of a company and model out various ESOP structures and strategies. This report gives a clear picture of the cash flow and wealth-building implications for all stakeholders – owners, the company, and employees.
If a hypothetical ESOP can produce substantially greater after-tax cash for the company, meaningfully satisfy an owner’s liquidity needs, and support a firm’s long-term strategy, we’ll move ahead with a transaction.
Q: What should any construction industry owner take away from our conversation?
We always hear about companies starting from humble beginnings: a bucket of tools, a truck, and the drive to succeed. With hard work, careful planning, and a little luck, the businesses grow into real enterprises.
Owners used to hand these companies down to their children. Many of those kids had worked in the business since they could manage paperwork or pick up a shovel. That’s not necessarily the case anymore. Many owners either don’t have children interested in taking over or a legacy plan in general. For them, the “what’s next” idea can be overwhelming.
ESOPs offer a flexible, independent path forward. Owners can get fair market liquidity for their hard-earned equity, eliminate taxes, and offer their employees stock in the business (without them having to pay for it). It’s a tremendous incentive structure all around, which is why you see so many construction companies forming ESOPs.
