The construction industry is second only to the restaurant industry in business failures. In fact, from 1990 to 1998, a period of relative strong economic activity, more than 91,000 construction businesses failed.
The grim odds faced by leaders in this industry often result from poor transition of management along with failure to see the risks inherent in the business.
Proactive management of ownership transition risk will help “ensure a graceful exit” and future business continuity, says Marc McKerley, partner, construction services at Crowe Horwath LLP.
Smart Business learned more from McKerley about managing the risk associated with ownership transition.
What risks are posed by an ownership transition in the construction businesses?
Succession planning can pose special challenges for construction companies. Risks are high, the entrepreneurial spirit thrives, and the owner’s financial and emotional attachment to the company is often very strong. Because of these ties, owners often put off succession planning, concentrating instead on today’s pressing issues. More forward-looking owners, however, will proactively plan for the next generation of ownership — to the benefit of everyone involved.
How can the transition be approached successfully?
While some construction companies are sold to private equity firms or strategic buyers, the more typical transition involves transferring ownership to an internal management team or members of the owner’s family. The first step in planning for such a transaction is to address some basic questions.
For the exiting owner: What type of retirement plans does he or she have in mind? What cash stream will be needed to support his or her lifestyle? Has the owner built wealth outside the business to help finance it?
For the buyers: What is the business worth? What kind of income does it generate? Will the transaction be affordable to the company?
Underlying both sets of questions is one fundamental fact: For any succession plan to work well, the company must be generating stable profits from operations.
How can owners address financing issues?
In most instances, a group of employees who plan to buy out the owner will not have enough personal wealth for an outright purchase. That leaves two sources to fund the sale: bank debt or owner financing.
Bank debt is often problematic because of surety constraints. Bonding companies are keenly interested in the company’s financial stability, and adding sizable bank debt to the balance sheet will create a high debt-to-equity ratio, making it difficult to obtain bonding for larger jobs.
Debt to a previous owner, on the other hand, is generally off the balance sheet. Owner financing raises other issues, however, such as how the transaction is structured, how long the payout period will be, and what level of control the exiting owner will retain.
Typical payout periods for owner-financed sales range between seven and 12 years, but clearly every transaction is different. The ‘right’ answer will be determined by an affordability analysis, which considers the company’s estimated profitability, its expected tax burden and other upcoming obligations. The payout must be quick enough to protect the departing owner, yet not so aggressive that it cripples the company or makes it unattractive to the buyers.
In almost every instance, the exiting owner will want to maintain some level of control during the payout period. This usually is accomplished by splitting the stock into voting and nonvoting shares. The retiring owner can then turn over majority ownership, but still retain all or most of the voting stock — and control of the company — until the payout is complete, which helps mitigate the risk of nonpayment. The alternatives are to simply liquidate the company — which would almost certainly provide a much lower return — or sell to an outside buyer, in which case the ultimate value is still predicated on retaining key members of the management team.
How can everyone’s interests be protected?
A carefully prepared purchase agreement is essential, and all parties to the transaction should consult closely with their legal and tax advisers. For the exiting owner, a key concern is enforcement, and the remedies that are available if the note isn’t paid. The new owners will want some flexibility in the payment schedule, so that a few bad months during an economic slowdown won’t cost them their ability to ultimately acquire full ownership.
All parties should work together to develop a detailed shareholder or ownership agreement that defines the new management policies and procedures. A well-crafted agreement not only ensures fairness, it also adds value and stability to the organization. The new owners will need to start considering how they will respond to unexpected contingencies, such as a disagreement among shareholders or the death of a shareholder.
As with any significant financial transaction, tax consequences must also be considered, as they can have a significant impact on both the seller and the purchasing shareholders.
How can businesses avoid common pitfalls?
In any business transition, owners can hang on too long or fail to delegate authority. Employees who enter into ownership may be risk averse. There may be a lack of trust between parties, or an unwillingness to negotiate.
However, with effective planning, careful consideration, and clear communication, ownership change in a construction business can be carried out as efficiently as any other complex project. The ultimate goal is for the exiting owner to enjoy the economic rewards he or she has earned, and for the buyers to feel they made a good transaction that will enable them to succeed on their own.
Marc McKerley is a partner in construction services at Crowe Horwath LLP in Dallas, Texas. He can be reached at (214) 574-1009 or [email protected]