Selling to Your Employees: How ESOPs Work for Construction Company Succession

0:00Kelly Finnell: Expertise. It's something that is won and developed over years of experience. Think about the expertise you have in construction. You've probably forgotten more than you could ever recall about how to build projects successfully. And it's that expertise that sets you apart from your competition and enables you to succeed at the levels that you do succeed. Today, we have an expert on construction genius, and his name is Kelly Finnell, and he is an expert in ESOP transactions. And the reason why it's important to have an expert on the show is because ESOPs are complicated. but they are the fastest growing succession trend in construction right now.

0:57Kelly Finnell: They're complicated because you've got fiduciary duties, annual valuations, trustees, seller notes, bank debt, surety implications, repurchase obligations, and if you get an ESOP wrong, it's disastrous. Kelly understands how to get an ESOP right, how to explain it in terms that you can understand so that you can judge for yourself whether it's the right choice for your business. And so for the next 35 to 40 minutes, we're going to be talking to an expert on ESOPs. My hope is that it gives you insights that will help you to come to a decision. If you're at that point in your business where you're thinking about passing it on, come to a decision about whether or not ESOPs are at least worth exploring.

1:47So let's dive right in.

2:20Kelly Finnell: Kelly, welcome back to Construction Genius. Thank you very much, Eric. It's great to be with you. Yeah, you know, you spent four decades helping owners figure out how to get out of the company they built. And for the contractor listening who's 55 or 60 with no kid taking over, no partner who can write the check, when he or she calls you, what's the first thing you tell them? I tell them that there are other options that leaving the business to a child or selling it to an employee or even private equity or selling to a strategic buyer are not their only options. Those are the most common options.

3:02Those are the ones that most people know the most about. But the world that we live in is an option to those strategies that works very often for business owners, especially those in the construction industry. So over the last few years, Eric, we've done 22 ESOPs for general contractors and specialty contractors.

3:32Kelly Finnell: And that's not just a trend in our practice. That is something that we're seeing nationwide within the ESOP community. Construction industry ESOPs are the fastest growing trend that we see in our world. And so as more construction company owners learn about ESOPs, their tax benefits, their planning benefits, the industry is really adopting ESOPs at an unprecedented rate. Why do you think that is? Well, I think that for construction companies, there are limited options. There's a general rule, private equity is not interested. Strategic buyers, such as their competitors, often are not interested.

4:19And so if you're in a world where there are fewer potential buyers, then the ESOP often rises to the top as they consider options. So an ESOP gives a business owner an opportunity to create a buyer where one might not otherwise exist.

4:39Kelly Finnell: So walk me through the money. When an owner sells to an ESOP, where does the cash to buy him out come from and how long until it's actually in his pocket? There are usually three sources of capital in an ESOP transaction. The first would be a bank loan. And so that loan would go from the bank to the company. The company would then relend that money to the ESOP. The company would add to that cash a promissory note. In our world, we call that a seller note, an IOU that promises that the company will pay the business owner the balance of the purchase price over time. And then we often see companies that have excess cash, cash that's not needed.

5:27for day-to-day operations. And that can be the third source of capital. The bank loans are almost always for a five-year term. In our practice, we see those bank loans often being paid off in three to four years. At that point, one of two things happens. Either the company pays off the seller note according to the original amortization schedule, or more likely what happens is that the company goes back to the bank that borrowed or that loaned the first tranche of debt and says to them, look, this works so well, let's do this again. Let's do a second tranche of debt. And that may be able to pay off 80 to 100 percent of the remaining balance on the seller note.

6:19And so it is not unheard of for a business owner to be fully paid off in four to six years in an ESOP transaction. Okay.

6:30Kelly Finnell: So obviously then we're not expecting someone to cut us a check right out of the gate. It takes time in most cases. Yes. I've never seen a situation where a company was able to borrow 100 % of its value. Okay. So I'll often say that ESOPs work well for business owners that want a glide path to an exit. But if a business owner has to have the money to run, then an ESOP's probably not the appropriate strategy. So that glide path analogy is interesting because many times owners find themselves wanting to begin to exit, but not prepared to do so. And from that analogy of the glide path, It sounds like perhaps someone could begin the ESOP process and then have time, so to speak, to be developing the next generation of leaders to take the company over by the time that glide path is completed.

7:24That's exactly right. Like you, we often find that the glide path is completely consistent with the business owner's goals. They usually have devoted so much of their time to the company that they would not want an immediate exit because they don't know what they would do with themselves. And so if they can cut back to four days a year or a week and then three days while they're developing that successor management team, maybe the successor management team is already developed. All they need to do is observe and offer periodic coaching to them. Then that's a situation where an ESOP works great.

8:08Kelly Finnell: Walk me through why some people only sell a portion of their business to the ESOP and then retain control of a portion. How often do you see that and is that common? The statistics indicate that about 80 % of all new ESOP transactions that are done are 100 % sales. So 8 out of 10 business owners are doing a 100 % sale right off the bat. We did an ESOP for a contractor, a grading company in Charlotte, North Carolina last year, and we showed the business owners three options, selling 25%, 35%, or 100%. And that business owner decided to sell a portion of their business. He told the employees at the rollout meeting that at some point in the near future, this was going to be a 100 % ESOP owned company, but he wanted to stick his toe in the water rather than jumping in the deep end.

9:09So he opted for that initial sale. And then in a few years, once that first ESOP loan is paid off, he'll do the second transaction where the company will become 100 % ESOP owned.

9:23Kelly Finnell: And what was his logic behind that? Was it just getting a comfort level with it? That's all it was, was getting a comfort level. This was something that was new. People in your industry are used to cyclicality. Yes. And they want to make sure that they can handle this new debt burden that they're putting on the company. Yes. They're often very conservative as a result of the cyclicality. And, you know, almost everybody in your industry has near death experience. Yeah. Their business due to some unforeseen change in the economy. And so by nature, they're conservative. And so to address that need to be conservative, they can do a partial sale or oftentimes we'll see them do a sale with a very extended payback period.

10:17So maybe they think they can, when we do the financial modeling, reasonably expect to be able to pay back the debt in six years. And we might do a 15-year term on the debt just in case they hit one of those down times, which almost always happens. They have the flexibility to pay a nominal amount. And while business is good, they can prepay the seller debt to cut out any kind of prepayment penalty. And so that's two different options for them to be able to protect against the downside.

10:57Kelly Finnell: Going back, you said you've done 22 ESOPs recently with contractors. Can you give me a general idea of the size of the contractors in terms of their revenue? And then a little more detail, if you're comfortable, on the markets that they're in. I'm particularly interested in the specialty contractors. Yeah, I'm glad to. We often think our big financial metric, our key financial metric is adjusted EBITDA. So we often think in those terms. And so this specialty contractor, the grading company that I mentioned in Charlotte, they had over$300 million of revenue and about$30 million of adjusted EBITDA.

11:40And so that would be one of the bigger contractors that we've worked with. We did two last year that were almost identical. One of them was a general contractor located in the Nashville area. The other one was an electrical contractor located in the Dallas area. They both had about$3 million of EBITDA. I don't remember what their revenue was, but they both had about$3 million of EBITDA and both did 100 % sales with that combination of financing that we discussed a minute ago, bank debt, seller debt, and the company cash, where the Charlotte grading contractor only did about a 35 % transaction.

12:29Kelly Finnell: So then the electrical contractor and the GC that you mentioned there, they're not necessarily massive companies then? Correct. We usually see ESOPs are in the middle market, which I define as companies with 2 million to 10 million of EBITDA. That is where most ESOP transactions happen. But there are huge ESOP transactions that happen. We're seeing multiple ESOPs every year now where the sales price to the ESOP is over$1 billion. And so that's not uncommon. But our market is, on average, companies with$4 million of EBITDA. And that is pretty consistent throughout the ESOP world. So the range might be 2 million to 100 million, but the average, the mean, would be more like 4 million of EBITDA and 95 employees.

13:34Interesting.

13:35Kelly Finnell: As manner as possible, why is that? Why is it that type of company that's ideal for an ESOP as opposed to either a smaller or much larger, even though there are exceptions? I think that those are companies where we find that culture is often the key to the company's success. Those companies often are operated like a family business. Generally, there aren't any family members involved in the business. Yeah. But the owner takes pride in the way they take care of their employees. Yes. And they're concerned that a sale to a third party will result in a change of culture. Yes. Which it almost certainly would.

14:19And that's to the detriment of not only their employees, but also their customers. Right. Their customers are used to being treated in a certain fashion. And the owner built the culture that defines how those customers are being treated. And if there's a sale to a third party, that goes away. So I think company culture is a key. Also, ESOPs offer tremendous tax benefits. Yeah. And we find that owners of those types of companies, companies that are that size, 4 million of EBITDA, are very motivated by tax savings.

15:01Kelly Finnell: Sure. And so when they see the tax benefits of an ESOP and it's consistent with their planning goals, then it often becomes a no brighter. Yeah. Quick break here in the middle of the interview to talk about my succession planning guide. Whether you do an ESOP or whether you sell your company some other way or pass it on some other way, succession planning is essential. And I've got you covered with a comprehensive guide that can help you plan out that succession. You can define future performance, identify roles for succession, develop and test candidates, get a clear organization chart, process mapping, capturing key knowledge, addressing flight risks.

15:45Kelly Finnell: All of it is in the succession planning guide, and it is free to you to download. Link in the show notes. So check that out. And now let's get back to the conversation with Kelly. It's interesting. ESOPs come with a lot of structure with fiduciary duty, annual valuations, things like that. Can you help us understand what all that machinery is actually for and who it protects? And what is the owner getting from the compliance that comes with an ESOP structure? Yeah. So let's talk about the two teams of advisors that are involved in an ESOP transaction. There is the company team, which is going to be the business owner, the company counsel, and the company CPA.

16:34and then there is going to be the trustee team. And the trustee is going to be the purchaser in the transaction. And that trustee is going to have its own financial advisor, much like the business owner has its CPA. But the trustee is going to hire a valuation advisor. And speaking of fiduciary responsibilities, The primary fiduciary responsibility of the trustee is to not pay more than fair market value for the stock that it purchases. And at the end of the transaction, the trustee's valuation advisor is going to issue a fairness opinion that says that the trustee did not pay more than fair market value.

17:24And so it protected the financial interest of the company's employees. And that fairness opinion also is going to say that all of the terms of the transaction were commercially reasonable. And then the trustee is going to have its own legal counsel. So those are the parties in the transaction. And the job of the trustee is to represent the interest of the employees. And that benefits the business owner because the business owner, if the trustee wasn't there, would have that responsibility himself. Yes. He doesn't know how to execute those fiduciary requirements. The professional trustee does, and the professional trustee has insurance to protect himself if there's a mistake where the business owner likely doesn't have that insurance.

18:20Kelly Finnell: Let me ask you, in that process of evaluation and valuation, in your experience, how often does that get into sort of a protracted negotiation and creates potentially bad blood and just a challenge as you're kicking off the process? Yeah. The valuation process begins when we do a feasibility analysis for a business owner. In that analysis, we give them an estimate of what we would expect the trustee to pay for the stock that it purchases in this transaction. And having done this for 45 years, we get really close to that expected amount. We're usually within 10%. And so the business owner knows going into the process what they can reasonably expect.

19:12And then our experience is the trustee always meets that expectation because we've established very conservative, reasonable expectations for the business owner. So there is an arm's length negotiation process. But I say that in an ESOP transaction, even though it's an arm's length transaction, unlike a sale to a third party private equity or a strategic buyer with an ESOP, there aren't any sharp elbows. And so everybody is working towards the same purpose. They're working toward a transaction that's going to benefit the company's employees. That's consistent with what the business owner wants and what the trustee wants.

19:57And so everybody's interests are aligned to make that happen while complying with all of the fiduciary requirements. So in that process, if one picks an ESOP structure, can we assume that an owner is potentially leaving some dollars off of the table because they could have, if they did a private sale

20:21Kelly Finnell: or a private equity sale, they might have been able to negotiate a better deal and they have to have that understanding going in? Absolutely not. That's probably the most common misconception that we run into. Oh, cool. So let me give you two concrete examples that have happened within the last 12 months. I already mentioned the general contractor in the Nashville area and the electrical contractor in the Dallas area. Both of those companies were referred to us by an investment banker who had taken those companies to market. And then he called us and said, look, we weren't able to meet the seller's expectations when we took these companies to market.

21:05These companies had, each of them, almost exactly$3 million of adjusted EBITDA. And the best offers we were getting was in about the four times valuation multiple range. So we were getting offers of$12 million and that just wasn't acceptable to the business owner. And so each of those, when they sold to the ESOP, sold for approximately$25 million. And so ESOPs often, especially in the construction industry, greatly exceed owner's expectations in terms of value. So the owner can do what they want to do in their heart to protect their employees and to provide for the future success of the company without sacrificing anything.

21:58And in fact, getting more than what they were expecting to get in a sale to a third party. Excellent. I appreciate that clarification. Bonding capacity is the thing that lets a contractor bid work.

22:12Kelly Finnell: When an owner sells to an ESOP and puts acquisition debt on the balance sheet, how does the surety look at that? It depends. There are sureties out there that have experience dealing with ESOPs. And there are sureties, more sureties don't have experience than have it. So we take one of two approaches. We will talk to the incumbent surety, and if they don't have any experience, try to do everything that we can to get them up to speed in understanding the nature of the debt and the impact that it has on the company's balance sheet. We're generally successful with that, and the company maintains its existing surety relationship.

22:56But sometimes we aren't successful. Sometimes the surety digs its heels in and says, essentially, we don't want to understand this, and we don't want to be a surety for ESOP companies. And so then we take them to one of the other surety companies, and there are probably half a dozen of them that we've worked with consistently that understand bonding ESOP companies. And there is actually a brokerage firm that we work with that is 100 % ESOP owned. Oh, interesting. It specializes in construction companies. And when they go to the bonding company, they know which ones to go to and they're able to get the transaction done very efficiently.

23:47So we've never had a situation in the 22 that we've worked with where that became an insurmountable obstacle. We have had, and I don't know the number, Eric, I should have gotten it before our conversation, but my guess is we've probably had four or five times where the company had changed sureties in order to be able to do the ESOP. Interesting.

24:11Kelly Finnell: Okay. So same question for the bank. Construction lending is personal. The lender backed the owner, not a trust. When the ESOP owns the company instead of the person they've known for 20 years, how do those credit relationships carry over? Again, there are banks that are experienced in ESOP lending and they understand. And one of the most important things for your listeners to know about an ESOP loan is that the business owner is not going to have to give a personal guarantee on that ESOP loan. And when I tell business owners that, they say, oh, you seem like a credible guy until we get to this point.

24:51I've been in business for 50 years. And every time I've gone to the bank or the company's gone to the bank to borrow money, the bank has said, no problem, as long as we get your personal guarantee. Right. And so bankers want and bankers deserve to have the owner's skin in the game. Yes. And so the most common way to have skin in the game is via a personal guarantee. But in an ESOP, the bank gets owner's skin in the game through a different structure, and that is the seller debt. The seller debt is going to be deeply subordinated to the bank debt. And so the bank's thought is, if we loan 35 % of the value of this transaction, I mean, no business owner in the world is going to throw us the keys and walk away when their seller note is 65%.

25:45That business owner is going to make absolutely sure that we get paid off so that then he or she can get paid off. Yeah. And so it's just a different form of skin in the game. And there are even lenders out there that specialize in doing ESOP loans in the construction industry. And so that is a very micro specialty. But those folks exist.

26:12Kelly Finnell: Let me ask you a question about when the ESOP is fully owned by the employees, who is signing the contract when they get a new project? And what kind of guarantees are in place there once the ESOP is fully owned by the employees? The CEO of the company is signing the contract. And so the ESOC trustee will be the legal owner of the shares of the company. From an operational perspective, the trustee will not be involved. The trustee will be essentially a passive investor. And they will have the company revalued each year, and they will monitor the company's compliance each year with the terms of the stock purchase agreement.

27:02They will not be involved in the operational aspects of the business. That will remain with the company's board of directors and executive team. So what almost always happens is that the owner who has sold becomes chairman of the board of the company. A successor management then moves up and there might be two of those folks that are on the board. And then there might be one independent director that's on the board. And so that board is going to be responsible for strategic decisions. But all of the operational decisions are going to be made by the company's executive team. Okay.

27:44Kelly Finnell: And so the classic line from a construction company owner is, yeah, my people think that I make a bunch of money, but they're not the ones that have to put their house on the line every single time we do a project. Yes. So in an ESOP, whose house is on the line, so to speak? Well, we don't see that. I mean, the companies that we see are big enough that they're not having to do that. They're almost always out from under the personal guarantee on the surety. But if they haven't got to that point in their company's development, then this is the occasion for that to happen. Because your instinct is exactly right, Eric.

28:25Nobody's going to sell if they have to be personally liable to the surety. Yes. And so either the company has already grown to the point where it's out from under that, or this is the occasion for that to happen. which I agree with you completely, that no owner is going to sell to an ESOP and take on bank debt if, on top of all of that, they have to be the guarantor on the surety.

28:55Kelly Finnell: Okay. So the repurchase obligation often gets called the biggest long-term risk in an ESOP. And like we discussed earlier, construction is cyclical. Walk us through what the repurchase obligation means for a contractor in a down year and how owners plan for it so it stays manageable. So the repurchase obligation, that term refers to the fact that the account value of an ESOP participant in a company stock, which is an illiquid asset. It's the stock of a closely held company. And so the law under Section 409H of the Internal Revenue Code requires that a company convert that stock into cash when an employee has what's called a distributable event.

29:48And so those distributable events are death, disability, retirement, or termination of service. Same distributable events you would see in a 401k plan. In a 401k plan, you've got a liquid asset in the employee's account, so there is no repurchase obligation. Here, we have an illiquid asset that the company has an obligation to convert to cash. If the company had to do that within 90 days of the time the employee left, then that would present a terrible financial risk. But the law allows, and we advise all of our clients to take advantage of the maximum payout period that the law allows, which says that if someone leaves as a result of death, disability, or retirement, those first three distributable events, then they don't get paid anything until they've been gone one year.

30:48And after that, they get paid out at the rate of 20 % a year over a five-year period. So there's not a lump sum payment that's due within 90 days. And they have a one-year breathing period. Then you pay them out over 20%. And then if someone leaves for that fourth distributable event, which is the most common reason people get paid, And that is termination of employment, which means you get fired or you quit. And then the company doesn't owe them anything for five years and then still pays them out at the rate of 20 percent a year over a five year period. So the first key to reducing the risk of repurchase obligation is plan design, making sure that your plan document takes advantage of this ability to pay people out over a period of time.

31:47The second key is that after the ESOP debt is paid off. So let's assume that a company's been paying$2 million a year for its ESOP debt. That's gone after six years. Now the company has$2 million and it asks us the question, what are we going to do with this? So that's what's called a first world problem. Sure. More money than we need. You invest that in a way that it is going to be available to pay participants when they leave. And so you set up an informal funding structure, a sinking fund to meet that repurchase obligation. So those are the two keys to minimizing that risk.

32:34Kelly Finnell: And then just touch on the valuations. Instruction valuations are lumpy. You know, you get a disputed change order or one by a job and you can swing the whole year. An appraiser sets the share price annually with an ESOP. How should an owner think about that number and how is it kept fair on both sides of the deal? Yeah. The number is set at the beginning through this negotiation process that we talked about, where the trustee receives all the company's financial information, has a due diligence meeting, spends about a month analyzing. And then in an ESOP transaction, the seller always makes the first offer in terms of sales price.

33:17And then you go through a four to six weeks negotiation process and the parties agree on a price. And the trustee takes into account in an historical financial data with its inherent ups and downs so that it's sure that it's not overpaying for the stock. Because if it does, it's reached its fiduciary responsibility and their government penalties for the trustee and the valuation firm for doing that. So they're going to take that responsibility very seriously. Then on an annual basis, you're right, valuation firms are going to come back and meet the past year's performance and then revalue the stock.

34:01And again, the valuation firm always does that on a very conservative basis. Okay. Excellent.

34:09Kelly Finnell: So when the owner's listening right now, let's say he's 58, he kind of falls in that range of revenue and EBITDA that we've been talking about, that middle market range of$2 to$10 million of adjusted EBITDA. And he wants out in five years. What does he do Monday morning? And what's the first mistake he should watch out for as he's beginning to consider perhaps the ESOP path to go down? I think one of the keys is for business owners to educate themselves. As we've discussed, ESOPs are the least known succession strategy. And so I think education is extremely important. So they can go to our website and you're going to provide notes, how they can access that.

34:58And we've got lots of educational material there. I've written a book called the ESOP Coach, which is designed to be a book for business owners in business owner language. So there are lots of books out there about ESOPs written for lawyers and CPAs and investment bankers. There was nothing out there, the market, written for business owners. And so that was my mission with the book, to explain this in business owner language. And we've got, I think, six or seven case studies. Yep. And that's how business owners can really relate. Yes. And also industry associations, just like the construction industry has its association.

35:44The ESOP world does too. So go to those websites. Yep. The ESOP or rather the NCEO, the National Center for Employee Ownership, their website is nceo.org. They have the best educational materials of any of the ESOP associations. So go there. Look at their library of information that is available. And so after that education process, then contact somebody who does what we do and has lots of experience doing it, specifically in this industry and have a feasibility study completed. And that will show all of the general concepts that they've learned and how they apply specifically to their business.

36:33Excellent. Excellent.

36:35Kelly Finnell: We are going to have links in the show notes, but just for the benefit of the audience. What's your website, Kelly, so people can contact you? It is www.execfin.com. Okay. Excellent. We will have links in the show notes. You know, Kelly, I'm impressed by your expertise because you can answer these questions so clearly without a lot of, for lack of a better word, BS, which I really appreciate. And I think that's a real testament to the time that you've taken and the experience that you have working with these types of transactions. So I appreciate the insights you've given us. Thank you so much for joining us here again today on Construction Genius.

37:16Thank you very much, Eric.

37:17Kelly Finnell: Hey, this is Eric. Thank you for listening. Hope you enjoyed my discussion with Kelly. Lots of great takeaways. And if you want to take advantage of Kelly's expertise in a deeper way when it comes to ESOPs, look at all the links in the show notes to his book, to his website, connect with him on LinkedIn. I know that he will be able to help you. Thanks again for listening. Share the episode with other people who you think would benefit from the insights and also subscribe to the podcast and give us a rating and review wherever you get your shows. Catch you on the next one. Thank you for listening to this episode of Construction Genius.

37:55Kelly Finnell: Hope you found that 1 % of inspiration to help you in the next few days. If you like the show, please give us a five-star review on iTunes, share it with other construction leaders who you think would benefit, and always remember that the show is brought to you by Kick-Ass Meetings. I've been working with construction leaders since 2004, teaching them how to run extremely effective problem-solving meetings that gets their people collaborating, taps into their creativity, and to get yourself a free copy of the Kick-Ass Meeting report, go to www.ericanderton.com slash kickassmeetings. Grab yourself that free report, read it, use it in your business.

38:38Kelly Finnell: You'll find it extremely useful. And thanks again for listening.