All business owners struggle with these questions, and the construction industry is no exception. Most businesses do not have a succession plan and for a contractor the impact can be worse. Often the owners operate as charismatic entrepreneurs who drive the company, both in revenue and through contacts in the industry.
How Can Succession Planning Mitigate the Risks Associated With a Business Transition?
The term succession planning leads many business owners to believe the process can be daunting, confusing, frustrating and time consuming. However, having a clear vision of what succession planning encompasses will allow owners to take a step by step approach and reach their personal, company and the current management team goals effectively.
The key components of succession planning are:
- Determining how the company will continue to operate when the current owners, or leaders, exit and relinquish control of the business.
- This is accomplished by creating a plant that:
- Provides an exit strategy for the owners that includes the adequate financial resources for their retirement. This plan will consider not only the tax implications for the transition, but also the business challenges that the company may face as the leadership transition occurs.
- Allows owners to leave a legacy where they still have input into the future direction of the company considering the addition of a new leadership structure.
Options in Transition Plan
A company can choose between various paths in transitioning their business. Each path has its own set of challenges, both financial and logistical. Each option depends on various factors and needs to be tailored to the needs of the owners, business and family members for a closely held business.
- Family Transition – Family dynamics play a key role in this path. Do all family members participate in the business, and if not, how will the active member be compensated versus non-active members? In simple terms, what will be fair and equitable for all involved? Further owners will need to evaluate the need for continued cash flow versus the ability to gift company ownership to family members that will continue managing the business, unless there is a decision to sell ownership to the family.
- Management Buy-Out – As with any transition plan, financial considerations weigh heavily on this decision. Even if the financial and cash flow situation is favorable, having the right management team to continue with the growth and success of the company will be more valuable and key. If the correct management team is in place, the finances can usually be worked out.
- Company Sale – For owners that would like to leave a legacy in place, this may not be an option, but often the lack for succession planning will leave the owners no other option to monetize their investment. Questions often arise related to the sale. Should the stock of the company be sold, or the assets? What are the tax implications if the selling entity is an S Corporation, C Corporation or partnership? How should earn-outs be calculated and taxed? How are contracts in process transferred, valued and taxed?
- ESOP (Employee Stock Ownership Program) – Using an ESOP can provide substantial tax savings that will allow the company to fund the owner notes and buy out. Depending on whether the company is an S Corporation or a C Corporation, tax benefits can be obtained as the ESOP and related note obligations are funded (company benefit) to a deferral of the gain from the sale (owner benefits) if the selling entity is a C Corp the sale structured properly. At the same time not only are tax considerations key, but the culture of the company will play a pivotal role in making the ESOP a viable alternative. Human capital considerations will be just as important in an ESOP scenario. A final item to consider are bonding considerations for contractors, given that company value and equity will be affected due to the debt, or cash flow drain, the company will experience in the ownership buy out.
- Management of Company by Third Party/Absentee Owner – This option solves the current problem of allowing the owners to take a step back from day to day operations, but it may not address the succession dilemma or allow the current owners to divest their largest investment (company ownership) to other assets. If the correct management team is not hired to manage the company, the owner(s) may be forced to be engaged again in the business to keep the concern afloat.
- Private Equity – As a final option, owners may sell a portion of their business to a Private Equity Group (PEG). This generally allows the owners to diversify their holdings and often provide them ‘another bite at the apple’ by having the owners retain a remaining equity interest in the business and participate in the growth of the company as the PEG has an exit down the road. The owners will be able to participate in this second transition. It is common for owners to retain from 5% to 25% of their current ownership depending on the agreement between the owners and the PEG.
With each option above there are human capital, tax issues and family/partner dynamics considerations to balance. No option is better than another and the ultimate solution will depend on the facts and circumstances of each situation. Our professionals have extensive experience helping contractors plan and execute succession plans. Withum will be authoring a series of articles that will address each of the options outlined above in further detail discussing the pros, cons and both financial and tax implications.