The familiar saying “failing to plan is a plan for failure” is spot on, especially for construction companies facing a transition in leadership. Without enough time to plan for the owner’s exit, any of the following scenarios can easily lead to a construction company in chaos:
- If you become suddenly disabled and unable to work;
- If you experience a sudden catastrophic event that leads to your untimely passing;
- If you decide that you want to retire in a year or less;
- If your heirs are unsure of their roles and/or have different expectations for their inheritance; and/or
- If there aren’t any employees who are being groomed for leadership.
Unfortunately, the end result of any of these scenarios is often a company with less value, in addition to negative tax consequences.
Effective succession planning requires time and carefully considering all options. In Part 1 of this series, we explained how succession planning in construction has changed over the years and what questions owners need to think about to get the process started. In this follow-up post, we lay out four common transition options.
Succession Planning Options for Construction Companies
There are multiple options to transition the construction company, and neither one is inherently better or worse than the other, though some options are more complex.
When there aren’t suitable family members who are able to step up and lead the company, the three main options are a standard outside sales agreement, ESOP, or selling to non-family members, like a key employee or management team.
In a standard outside sales agreement, the entire company is sold to a third-party buyer. The benefits of this arrangement are that it is:
- Usually yields higher payouts, and
- Avoids issues with multiple family members.
Outside buyers will usually have the right industry experience to step in and take over with a minimal learning curve. It is possible to find a competitor, vendor, or supplier that you already know and sell to them; however, be very careful about who is approached and ensure there are strict NDAs in place to protect your company’s reputation and value. In any case, an employment contract may be necessary, especially if you plan to stay on board and help with the transition.
In an ESOP, or an Employee Stock Ownership Plan, you can sell up to 100 percent of company stock to a defined benefit plan owned by employees. The employees become the company shareholders. Benefits of an ESOP are:
- The company stays in control of the employees,
- Your legacy is better protected,
- The company is likely to grow faster in the period following the ESOP transaction, and
- You can transfer ownership over time.
ESOPs can provide a tax-advantaged means of transferring ownership and work well for virtually any size company. Construction is one of the top four industries where ESOPs are the most common, so it’s a proven transition solution.
A third option that deserves considerable attention is selling the construction company to a seasoned employee or management team. When a family member is not present (or willing) to take over the company, an internal sale can be done in much the same way as a leveraged buyout or installment sale. There are several benefits to this option, including the continuation of the business and management philosophy and a seamless transition of leadership.
The transition will probably take place over several years, as key employees often lack the capital to purchase the business outright and might not have access to lines of credit. Sale proceeds usually come from the construction company’s future earnings and will be paid out over time to the exiting owner. This succession planning option has been gaining traction in recent years and can be a better solution than a standard ESOP, depending on the situation.
When there are family members involved in the business, there are two main ways to transfer your business, including gifting stock or buy/sell agreements. Within each type of transfer, there are many nuances to the transaction.
Thanks to the Tax Cuts and Jobs Act, the annual gift and estate tax exclusion is increased to $10 million, adjusted yearly for inflation, until December 31, 2025. The annual gift tax exclusion amount is $15,000. Adjusted for inflation, in 2020 this amount is $11.58 million per individual. After 2025, the exclusion amount will revert to $5 million, also adjusted for inflation, and a reason that utilizing this strategy should begin sooner rather than later.
That means you could shield a significant portion of your business assets from federal estate tax by selling the company stock to your heirs. That means you could shield a significant portion of your business assets from federal estate tax by gifting company stock to your heirs
Even if you don’t plan to retire right away, strategically gifting your company assets over time will lower your estate’s taxable assets and help your gifts grow over time for your heirs. You effectively freeze the value of company stock at the date of the gift so future appreciation is theirs.
Sometimes, a qualified family member can take over the business from a management perspective but cannot afford to buy the company. Two options to consider are either a leveraged buy-out or an installment sale. In a leveraged buy-out, your heir(s) borrow(s) money from a bank to buy the business, then pay back the loan using profits from the business. You still get a lump sum payout.
In an installment sale, you would sell the business over time and with interest. This works well if you don’t want to retire right away, as there won’t be any lump sums. Be mindful to put in place the right contracts and work with an outside advisor; even though you are selling to family, it is still a business transaction and should be treated as such.
Entity structure can have an impact on what type of transition plan is best. For example, an LLC will make succession planning somewhat easier, and a C-Corporation will involve more tax planning and legal implications. Also keep in mind that when family members are involved in succession planning, whether they work in the business or not, there is usually some level of gifting strategy involved.
Before any type of sale or transition occurs, construction company owners will need a business valuation performed by a credentialed evaluator.
Contact Jennifer French, Partner and Team Leader of the PBMares Construction and Real Estate team, to begin a conversation about your company’s options based on your desired transition plan.