ESOP: An Independent Alternative to Mergers & Acquisitions

Independence drives the construction industry. Builders and skilled tradespeople constantly go out on their own and take big chances, because they believe there is a better way to get things done. Rugged individualism helps create better processes, more ambitious projects and durable businesses.

Why do many firms bury that independent streak when they plan a business transition?

Private equity and publicly traded companies continue to drive construction mergers and acquisitions (M&A), according to PwC. Although transaction volume has softened in the past year, built environment firms continue to trade in historically high numbers. It’s fair to assume that the number of privately held firms will decline again in the year ahead.

Fair compensation for a lifetime’s work is critical, but a liquidity event shouldn’t obligate a founder or shareholder to surrender their values. Third-party sales are solid strategies for those seeking to monetize, cut ties and never look back. Owners who prize autonomy and have strong loyalties to employees and relatives in the business should aspire to something more.

There are middle-market construction firms nationwide with proven records, eager next-generation management and owners who would love to see their businesses perpetuate. For these companies, employee stock ownership plans (ESOPs) are compelling M&A alternatives.

Of the nearly 6,000 private, ESOP-owned companies tracked by the National Center for Employee Ownership, nearly 1 in 5 is a builder or contractor. When you include architectural and engineering firms, you end up with the most well-represented industry segment in employee ownership.

Simply put, an ESOP is an employee benefit plan that invests in company stock.

A construction firm’s equity can be sold directly to a plan at fair market value. This effectively enables an internal buyout of one’s own company. Rather than opening the door to outside investors, an employee trust holds the stock on behalf of full-time employees.

The company arranges financing so that staff do not pay out-of-pocket for stock, and selling shareholders receive cash upfront. Sellers can also defer and potentially eliminate capital gains burdens on the transaction. This benefit, known as a 1042 rollover, is unique to ESOPs and can increase a seller’s after-tax proceeds by up to 38%.

There are costs associated with ESOP formations and plan maintenance, but corporate tax incentives offset and often eclipse these expenses. Their companies gain income tax deductions equivalent to the ESOP sale amount and can become tax-free entities. The cash flow boost provided by these benefits can give employee-owned companies a sizable competitive advantage and spur future growth.

An employee-owned business is led by its board of directors.

Instead of third-party corporate oversight or unwanted consultants, the company’s destiny lies with its handpicked leaders. Selling shareholders can maintain meaningful roles and take comfort in knowing that their vision, and their company’s identity, will outlive their direct involvement.

Although employee trusts require fiduciary oversight, trustees typically do not play management roles. Instead, they serve as shareholders of record on behalf of plan participants. Trustees understand that strong company performance translates to financial gains for employee owners. As a result, they appreciate the specialized expertise of a construction firm’s leadership.

ESOPs efficiently move equity to rising leaders.

Traditional buy-sell arrangements are tax intensive and often require significant seller financing. It can take years for a selling shareholder to get paid, de-risk and diversify their personal wealth. That’s a big reason why many owners punt on management buyouts and family succession plans.

Because ESOP sales mimic leveraged buyouts, a well-crafted strategy can level the playing-field with private equity. As mentioned, sponsor companies arrange financing to deliver sellers cash at close and to facilitate the transfer of stock to an employee trust. Shares are then allocated to plan participants over a period of years and are subject to vesting rules. This provides for an orderly transfer of equity, without imposing an undue financial burden on any one stakeholder.

Key contributors can receive additional equity value, in the form of stock appreciation rights (similar to phantom stock) or warrants (similar to stock options). Either can be allocated or sold at a company’s discretion. These mechanisms create targeted leadership incentives alongside broad-based wealth opportunities for rank-and-file staff.

Independent, employee-owned firms are free to customize plans and change course.

Selling shareholders determine the amount of equity sold to an employee trust. Partial sales are common. An owner can unlock wealth while maintaining equity upside and a meaningful role at their companies. Over time, they may elect to sell additional shares to the employee trust. That gives owners a “second bite at the apple,” potentially at a higher valuation than the initial transaction. It is a meaningful phase-out strategy for shareholders with longer runways.

If a company has multiple shareholders, an ESOP can buy out individual parties. In situations where members of a family business or partnership group are seeking to retire or divest, employee ownership can provide an orderly liquidity event, without the need for outside investment.

ESOPs can also be unwound. Sponsor companies may elect to repurchase stock or terminate their plans altogether. Employee-owned companies can also make acquisitions and entertain offers from third parties.

Employee ownership is a proven value creator.

Decades of research demonstrate how ESOP benefits appeal to prospective talent and help companies retain current staff. That holds outsized importance in the construction industry’s competitive job market. Employee owners’ overall job satisfaction consistently outpaces that of non-ESOP peers.

Increased productivity translates to financial gains for companies and team members. On average, plan participants have higher median incomes, greater household net worths and more extensive benefits than workers at large. The social and economic ripple effects often extend beyond an employee-owned company’s doors. These businesses stay rooted in their communities, keeping dollars and opportunities local.

ESOPs create liquidity, give back, pay forward and help construction firms stay independent.

An employee stock ownership plan is not necessarily the conventional path forward, but neither is founding or leading an independent construction firm. So why not give a leveraged ESOP a look? It isn’t always the right strategy, but it might be the best option for your company.