Succession Planning: Look at Things from a Surety’s Perspective

A well-designed succession plan is critical to the long-term survival of a construction business. In developing one, it’s important to consider the objectives and needs of your company’s owners as well as their family members. But it’s equally important to examine your plan from the perspective of your surety.

Bonding obligations typically last for several years, so it’s important to maintain a strong relationship with your surety. A comprehensive succession plan will instill confidence that you’ll be able to complete projects regardless of ownership or management changes. To help create or evaluate yours, let’s address a few questions your surety will likely ask.

What’s your exit strategy?

Generally, there are three types of exit strategies for contractors:

  1. Transferring the business to family members (by sale or gift),
  2. Selling the business to employees, or
  3. Selling the business to a third party.

The strategy you pursue raises a variety of business, financial, tax and estate planning issues, so you’ll need to communicate with the surety regarding the potential impact of these issues on your company’s continuity.

Regarding the second exit strategy type, one option to consider is an employee stock ownership plan (ESOP). This arrangement creates a market for your shares and transfers the business to employees (including family members) in a tax-efficient manner. (For more information, see “Should you consider an ESOP?”)

If your company has multiple owners, a surety will also want to ensure that you have a well-drafted and funded buy-sell agreement in the event an owner dies or otherwise departs the company earlier than anticipated. If you haven’t already established one, this is a must-have.

Who are your successors?

It’s critical to identify potential successors as early as possible — particularly for family-owned construction businesses. Even if your planned transition is several years or even decades away, your surety will want to see a contingency plan in place should an owner or key employee die, become disabled or leave the business.

To address these concerns, start developing the company’s future leaders now. Identify family members or other employees with leadership potential and begin to get them involved in company governance and strategic planning. Recommended steps include:

  • Establishing various leadership roles and their objectives,
  • Creating individualized development plans for each prospective leader,
  • Mapping out these development paths in as much detail as possible, and
  • Providing leadership training and educational opportunities.

As you consider successors, be sure to recognize the distinction between ownership and management succession. This is also particularly critical for family businesses. Children may view the business as their “birthright.” But if they lack the skills, experience or desire necessary to take the reins, placing them on a management track may be a mistake.

Fortunately, there are strategies available to share the wealth without sharing control. Examples include issuing nonvoting stock and buying life insurance to create liquidity for family members who won’t be involved in managing the business. Other options include using a family limited partnership, family limited liability company or trust to facilitate ownership and management.

Will key employees stick around?

A surety will want to know that an ownership or management change — especially an unexpected one — won’t compromise the company’s technical and operational competence.

Provide effective incentives that tie key nonfamily employees to the company. These might include bonus plans, profit-sharing plans, stock options, ESOPs or other benefits that vest over time.

What about cash flow?

Cash flow is the lifeblood of a construction business. Your surety will want some assurances that your succession strategies won’t suddenly endanger your company’s cash flow.

So, as you establish or re-evaluate your succession plan, consider the impact of future financial obligations. Compensation plans, buy-sell agreements, ESOP debt and repurchase obligations, taxes — all of these things will demand cash at some point. Be prepared to explain to your surety (and yourself) from where the money will come.

Extra motivation

You should already have plenty of motivation to create a solid succession plan. The future of your construction company depends on it, and the financial well-being of family members and heirs is affected as well. But your surety can serve as an extra motivator to help you determine just how solid your plan really is.

Should you consider an ESOP?

For construction companies structured as corporations, an Employee Stock Ownership Plan (ESOP) can be a powerful succession tool. An ESOP is a qualified retirement plan, similar in many ways to a 401(k), which invests primarily in the employer’s stock.

Tax-deductible contributions are used to buy stock (typically from exiting owners) and credited to employees’ accounts. When employees become eligible, distributions are made in stock or cash. These arrangements offer several attractive benefits:

  • Owners can cash out and transfer ownership to employees gradually, without immediately giving up control.
  • Owners can defer capital gains tax on their stock by reinvesting sale proceeds in “qualified replacement property,” which includes most U.S. corporate securities. (This option is available only to C corporations and only if the ESOP owns at least 30% of the company’s stock.)
  • If the company borrows money to fund ESOP stock purchases, it can fully deduct contributions to cover both interest and principal on the loan.

But ESOPs have risks, as well. For example, closely held companies must conduct annual stock valuations and participants must receive a “put” option allowing them to sell stock back to the company at fair market value. It’s important to consider the potential impact of stock repurchase obligations, as well as ESOP debt, on your construction company’s cash flow and bonding capacity.

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