Succession Planning: The Potential Impact on Your Surety Program

Jase Hamilton, CPCU, AFSB
All contractors start their business with a common vision:  To create a successful construction company.  However, once this goal is realized, many owners fail to properly and strategically create a succession plan that not only guarantees their own continued prosperity, but also the prosperity of their company. This is because most business owners lack the incentive to develop a plan until it becomes an immediate need. Unfortunately, this reactive approach, more often than not, results in a poor, costly and ineffective plan.

When developing a succession plan, there is one important question you must ask yourself: Who will my successor be? The answer to this question becomes even more critical for a public works contractor, as it not only has a lasting impact on the legacy of your company, but also an impact on the company’s ability to obtain surety credit once you transition out.

Finding a Successor

Finding a successor for your plan can be difficult. The three most common sources are family members or key employee(s), company employees through an employee stock ownership plan (ESOP), or an external party.  Regardless of your situation, identifying a successor and transitioning the company is a critical milestone that takes years to properly plan.

Family Member or Key Employee(s)

Most small- to mid-size construction companies are family-owned and operated. The transition of ownership to a family member or key employee(s) seems like a natural choice. It not only ensures the company is being transferred to a trusted individual but, in most cases, has the least impact on the company’s surety credit.

Although the most natural, transitioning to a family member or key employee(s) is also one of the most difficult succession plans to develop. Current ownership must invest a significant amount of time and energy in grooming the next generation to lead the company. The earlier ownership can identify a younger family member or key employee(s) as an apparent heir, the better. This allows current ownership time to appoint the heir as “second in command” in the early growth stages of the company. Not only giving the heir valuable hands-on experience but ensuring he/she will operate the company the way current ownership wants it operated and lead the company the way current ownership wants them to lead. This will also give ownership the opportunity to fully evaluate the capabilities of the heir and consider a different direction in the event the heir is not a fit.

It’s also important to involve your trusted advisors early in the process.  From a surety broker perspective, it is critical to evaluate a succession plan to help develop and prepare for milestones during the process. This also provides the opportunity to educate the heir apparent on not only the importance of surety credit for the operation, but also the personal guarantees and obligation that are inherent with ownership.

If properly planned, the transition to a family member or key employee(s) can be very rewarding and seamless. The goal is to preserve the financial strength of the company so that it may continue to obtain surety credit, and to fulfill the personal financial goals of the transitioning ownership.

Forming an ESOP

In the event transition to a family member/key employee(s) is not an option, another succession strategy that is increasing in popularity is the formation of an ESOP. Much like a 401K plan or profit-sharing plan, an ESOP is a vehicle that allows for employees to invest in a company’s stock through the purchase, a loan or gift.  Essentially it allows an employee to obtain shares and become a shareholder/owner of a company.

Outside of incentivizing or rewarding faithful employees, one of the more appealing benefits of forming an ESOP is that it gives current ownership the opportunity to quickly liquidate their shares in the company to the ESOP. However, this liquidation or structural shift can have significant impact on a company’s ability to obtain surety credit.

Typically, when an ESOP is formed, the company takes on a loan or other form of liability to initially purchase the stock from the existing shareholder(s). Over time, the debt is paid down; however, the immediate liability usually has a negative impact on the company’s financial condition and could reduce the company’s overall bonding capacity. Successful ESOPs prepare for this potential shift on the balance sheet by maintaining personal indemnity of previous owner(s) to ensure high levels of cash flow, and taking advantage of the various tax benefits to provide an immediate stimulant to bottom-line profits.

From a surety perspective, another potential risk with an ESOP is adequate transition of leadership. In contrast to transitioning ownership to a family member or key employee(s), formation of an ESOP usually requires less effort grooming a successor and leader for the company. This can lead to potential operational issues and concerns over perpetuation. To lessen these concerns, invite you surety partner to participate in the plan early and illustrate the continued involvement and long-term commitment of key employees under the plan.

Forming an ESOP may not be for every company but, if thoroughly planned with the advice of a CPA and surety partner, it can be an effective succession plan for any business owner.

Third Party

Venturing into the merger and acquisitions market may be intimidating or a less desired succession plan for some, especially when talking about legacy or employee assurance. However, much like the other succession strategies and if properly planned, selling your company can be very profitable and still ensure specific commitments are supported.

The first thing to do is partner with a business broker. Just like any advisor, it’s important to interview multiple candidates to ensure you find the right partner that understands your business and succession plan. The next step is to work with your advisors to determine what valuation approach makes the most sense.

There are various elements to consider when evaluating your company, from current market conditions to cost-base analysis and future income projects. Understanding these and other valuation methods are critical to maximizing the value of your company.

Finally, an agreement that defines your desires and demands needs to be formalized.  Some examples include:  Whether there’s a commitment from you to oversee operations for a period of time after the sale, guaranteeing specific key employees maintain their roles within the organization; how the purchase is realized over time; and if the purchase incorporates additional future profit sharing or other considerations.

When discussing the prospect of selling with you surety partners, it’s important to fully disclose your plan and utilize them as a resource to analyze the viability of the sale and the potential buyer. Many contractors undervalue the resources their surety partners can provide during this process, which ultimately can hurt the company’s ability to obtain surety credit after the sale.

The End of a Journey

Succession planning is a topic most owners like to avoid. For many, it signifies the culmination of your life’s work and it’s easier to ignore and put it off until it’s absolutely necessary. However, failing to effectively develop a detailed plan can have grave consequences, not only for your company but for yourself and your family.

Work with your advisors to develop a well thought-out and comprehensive succession plan. The process may take years, but if done right, it can ensure the continued success and legacy of your company for you and your family.