ESOPs in the Construction Industry: Issues for Contractors and Others

Robert Wrixon

A number of companies have implemented employee stock ownership plans (ESOPs) to increase productivity and profitability, to grow the company, and to cash out shareholders. However, companies in the construction industry have used ESOPs somewhat infrequently compared to other industries. Contractors generally have different characteristics than companies in other industries. The construction business is very competitive and very cyclical, with many companies regularly leaving the market for reasons within and out of their control. Therefore, the use of an ESOP as an investment vehicle may not be a prudent tool for one's retirement investment. Given the right circumstances though, an ESOP can be beneficial to a contractor.

An important part of a contractor's business is the ability to obtain surety bonds, especially for firms working on public works projects. Their relationship with a surety company is vital, and contractors often must make efforts to maximize their surety program. This is more important than ever given the current hard surety market. With the proper application, an ESOP can have a positive impact on a business and even enhance its surety program.

Construction Surety Bonds

A construction surety bond is a three-party instrument whereby a surety company joins with the contractor to guarantee to a project owner that the contractor will comply with the terms and conditions of the contract. Should a contractor fail to fulfill its contractual obligations, the surety must step in to satisfy the obligations. Surety bonds are provided by licensed surety companies possessing the financial strength to provide the guarantees, and since they back their guarantees with their own assets, they write bonds very cautiously. Before surety companies issue bonds for a contractor, they conduct an extensive underwriting review of the contractor and continue to do so on an ongoing basis. The underwriting review is a thorough analysis of the contractor's finances, organization structure, previous experience, and overall capacity to perform the specifications of the contract.

Before a surety company will issue a surety bond, it must be satisfied that the contractor runs a well-managed, profitable enterprise, deals fairly, and performs obligations as agreed. Underwriting considerations include the capital and cash flow of the business to support the surety program as well as the continuity of the principals and the management team. Sureties require that their contractor clients maintain a certain amount of working capital and net worth to support their business plan and corresponding surety program. The amount of surety credit is determined by this analysis; if a contractor fails any of these standards, its ability to obtain surety bonds may be limited. Generally, a surety will structure a surety program based on a percentage of the company's analyzed working capital and net worth. The general rule of thumb is a 5% working capital-to-backlog and a 10% net worth-to-backlog ratio. For example, a contractor with analyzed working capital of $250,000 and tangible net worth of $500,000 would qualify for an aggregate surety program of $5,000,000 of total backlog (backlog is costs-to-complete and includes bonded and non-bonded work). Generally, the more working capital and net worth you have the more surety capacity is available, provided there is capacity to process the work.

Each surety company has its own underwriting standards and requirements and will vary depending on the industry, type of work, experience, whether the company is prime or a subcontractor, and other considerations. Financial statements are vital to any business that grants credit, and sureties are no exception. Sureties prefer financial statements from a construction-oriented CPA on a review or audit basis. The CPA will prepare a schedule of work in progress that lists each project and provides a status of the project at that time. Underwriters track the projects on an ongoing basis to see that the projects are progressing on schedule with no profit or billing issues. Also, complete and accurate cost recording and accounting systems are extremely important to surety companies. Without these systems, the contractor may not be able to identify and correct problems before they become too severe.

Because surety bonds guarantee a firm's performance and payment of bills, the surety company expects that the contractor will live up to those obligations. Therefore, a contractor will be required to execute an indemnity agreement, which obligates the named indemnitors to protect the surety from any loss or expense. The indemnity will be required of the contracting firm and any closely held subsidiaries or affiliates. Personal indemnity of all major shareholders, including spouses and trusts, is usually required as well except for some large, well-capitalized firms. In some instances, personal indemnity can enhance a surety program, should there be significant personal equity. There are alternatives if the company's financial condition warrants limited surety support. There are some surety markets that will take collateral to support a surety program. Collateral can be in form of a secured interest in property or an irrevocable letter of credit. Another option would be to bring in a third party to indemnify on behalf of the company.

ESOPs in the Construction Industry

Some of the benefits of an ESOP in the eyes of the surety include the use as an ownership transfer vehicle that is part of an continuity plan, an incentive plan to retain key employees and work crews, and the potential to enhance the financial wherewithal of the contractor.

Continuity

Many closely held companies have no plans or incomplete plans for business continuity after the departure or retirement of the founder or major shareholder. This is an important consideration for sureties because the majority of their clients are relatively small companies that may have only a few key people. The surety needs the assurance that if something happens to the owner or a key person, existing bonded projects will be completed. An ESOP can solve this problem by establishing a readily available market for the purchase of shares from controlling shareholders as part of a business continuity plan. If there is a need to purchase the shares of a major shareholder, and there is liquidity or debt capacity in the ESOP, then the financial impact to the company is minimized.

Employee Incentive

An ESOP is designed to provide employees with the incentive of a "piece of the action" and to enable employees to share in the capital growth of the company. The retention of key employees and work crews is important for sureties as it provides comfort that their bonded projects will be properly manned and managed. Given the cyclical nature of the industry, labor shortages are common, and other firms can woo key people. Employee ownership is a good tool to lock in a work force. The goal of employee ownership is to align all of the employees' interest in the business so that everyone is motivated to achieve higher profits. This incentive can produce very positive benefits for the company's bottom line profits and surety program. In addition, a business owner can reap the added benefit of increased profits and stock valuation for the owner and his or her company. The ESOP can be particularly advantageous for companies whose rapid growth has required the reinvestment of profits, resulting in a shortage of cash available for employee benefits. A collateral benefit is that the ESOP often serves to diminish employee interest in unionization.

Cash Flow and Net Worth

An ESOP can be an effective tool for increasing cash flow and net worth. A contractor can reduce its corporate income taxes and increase its cash flow and net worth by simply issuing treasury stock or newly issued stock to an ESOP. Using this approach, a company may drastically reduce or even eliminate its corporate tax liability. The cash flow impact can be dramatic. If the contribution to the ESOP is made in lieu of cash contributions to a profit sharing plan, the cash flow savings are even more dramatic. This has obvious advantages to contractors, as it will enhance their financial wherewithal by creating additional cash and capital to finance their projects, and consequently improve their surety program.

Disadvantages

If a company borrows money and then lends this money to the ESOP to enable the ESOP to make a leveraged purchase of company stock, the accounting regulations require that the bank loan be recorded as a liability on the company's balance sheet, and a like amount debited to the equity account. The net effect is to reduce the company's net worth by the amount of the bank debt. This reduction in net worth could impact the company's ability to obtain surety bonds should the tangible net worth fall below the underwriting requirement established for the surety program. In that case, a gradual implementation of the plan may be ideal. If not, then additional capital infused into the company may be necessary to meet the underwriting requirements. The shareholders can inject additional paid-in-capital, or they could loan funds to the company and then subordinate the loan to the surety. Since subordinated debt is not to be paid back without the permission of the surety, they generally do not consider subordinated debt as a liability, thus increasing net worth by the amount of the debt.

Also, if the value of the stock appreciates substantially, the ESOP and/or the company may not have sufficient funds to repurchase stock upon a shareholder's retirement. Ideally, the ESOP will maintain a portion of the fund in liquid investments in order to provide liquidity for retiring or terminating employees. If the stock of the company appreciates dramatically, the liquidity needs will increase correspondingly. Conversely, if the value of the company does not increase, the employees may feel that the ESOP is less attractive than a profit sharing plan, and the incentive attributes may be minimized.

There are some positive attributes about an ESOP that a surety will consider when underwriting an account. An ESOP may not be appropriate for all construction firms, but for some, it could be a good tool to enhance their surety program. It is most beneficial for mature contracting firms with a large non-union workforce, a consistent source of revenue, and growing but stable earnings. A company must consider the implications of instituting an ESOP and what it will do to its surety program. If there is no immediate need to cash out a major stockholder, it may be beneficial to gradually increase ESOP ownership to reduce the financial burden and any impact it will have on the surety program. Companies should discuss the implications of instituting an employee stock ownership plan with their surety broker as well as with their other business partners.