ESOPs in the Construction Industry with Kelly Finnell

Special guest Kelly Finnell joins us on this information-packed episode to discuss ESOPs in the construction industry.

Topics we cover in this episode include: 

  • The purpose of an Employee Stock Ownership Plan
  • Sources of financing for ESOPs
  • Why ESOPs work for construction companies
  • The tax and employee benefits that come with ESOPs
  • What makes a good candidate for an ESOP
  • How to get started

LINKS

Get Kelly’s ESOP primer at https://www.execfin.com/esops/business-owners/

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Find all episodes and related links at ContractorSuccessForum.com.

FIND US ONLINE

Kelly Finnell, ESOP Coach | https://execfin.com
Rob Williams, Profit Strategist | https://IronGateESS.com
Wade Carpenter, CPA, CGMA | https://CarpenterCPAs.com
Stephen Brown, Bonding Expert | https://McWins.com

TRANSCRIPT

[00:00:00] Rob Williams: Welcome to the Contractor Success Forum. Today we have with us a special guest, the ESOP coach, Kelly Finnell. I’m saying the ESOP coach, because that’s the name of his book. Kelly Finnell, his company is called Executive Financial Services and he is with us today to talk about ESOP’s in the construction business.

And remember, the Contractor Success Forum here, our show discusses financial strategies for running a more profitable, successful construction business. And don’t forget to share this with your friends and give it a big five star review for all five stars that we can get here today. And remember our hosts. We have Stephen Brown, a construction bond agent with McDaniel-Whitley bonding and insurance agency for over 30 years underwriting and placing bonds for you as a contractor.

And in the other corner, we have Wade Carpenter, Carpenter and Company, CPAs, helping contractors nationwide to become permanently profitable for over 30 years. And I’m Rob Williams, your profit strategist with IronGate Entrepreneurial Support Systems, driving profit in your business with decades of vertical integration as a contractor, a manufacturer, an aviator, and a financial strategist in the construction industry.

So today, welcome Kelly. Thanks for coming on and talking with us today.

[00:01:35] Kelly Finnell: Well, thank you very much for the opportunity to be here. And I look forward to our discussion.

[00:01:40] Rob Williams: All right. And before we forget to do this, the way you can find Kelly is ExecFin.com. E-X-E-C-Fin.com. And we’ll remind you again later. All right, guys, anybody curious about how in the construction industry, how do you do this ESOP thing and what the hell is an ESOP?

[00:02:04] Wade Carpenter: Yeah, Rob, I’ve seen several construction companies over the years do this very well to get their owners out of the business and save some taxes and give some benefits to the owner. So, Kelly, can you just give us a little bit of about ESOP’s to start off with?

[00:02:20] Kelly Finnell: Yeah.

I think the first thing that you’ll want to know is what does ESOP stand for? And it’s Employee Stock Ownership Plan. And an ESOP has two purposes. One, it acts as a retirement plan for a company’s employees. And so it’s not too unlike a 401k plan, which is another type of retirement plan for a company’s employees.

But the big difference between a 401k plan and an ESOP is that with an ESOP, typically the only investment of the plan is stock in the sponsoring company. So my construction firm sets up a retirement plan in the form of an ESOP and that ESOP is going to purchase stock from the business owner. And so that is how an ESOP acts as more than a retirement plan.

It’s also a liquidity vehicle for the owners of the company. So they establish the ESOP, and the ESOP borrows money and uses that money to buy stock from the owners. And then that stock becomes an investment over time in the employee’s retirement accounts. So most ESOPs are financed. I said, you know, you borrow money, or the ESOP borrows money to make this purchase.

And typically there are two sources of financing. The first is a bank loan. And the second is a seller note. So a seller note is an IOU issued by the ESOP, then assumed by the company that promises to pay the business owner for the stock that the ESOP has purchased over a period of time. And that might be five to 10 years. And in terms of bank financing, that can be a challenge for a construction company. And the reason it can be a challenge is because these companies almost always are bonded. And the bonding company insists on having a first priority on the company’s assets. And so they’re going to require that the bank be subordinated and banks don’t like subordination. So it’s not impossible to get a bank loan for an ESOP at a construction company, but very often we see ESOPs in this industry being totally seller financed.

[00:04:53] Rob Williams: Yeah, that is, that is very interesting. And so that’s a big point. So you’ve actually done these with construction companies.

[00:05:01] Kelly Finnell: Well, actually, we’ll close nine transactions this year. We’ve already closed two in the construction industry. One was a very large home builder in Georgia. The other one that we’ve closed already was a commercial and industrial contractor in Louisiana. And we just got hired this week to do a commercial contractor in Tennessee.

[00:05:26] Rob Williams: Oh, wow. It’s amazing. It’s.

[00:05:28] Kelly Finnell: Yeah. So it’s a third of our business this year. And one of the reasons for that is that very often, contractors don’t have another potential buyer. It can be very difficult for a contractor to sell to private equity. And so that typically is not an option and it’s very difficult to sell to a strategic buyer, which would be a competitor or someone who wants to move into a geographical area.

Now that happens, it happens more than we see construction companies selling to private equity, but it can be very challenging. With an ESOP, a business owner has the opportunity to create a purchaser where a purchaser might not otherwise exist. And so the owner is in control of the process. They have, the company, established the plan, the ESOP plan, and that plan then becomes the purchaser of their stock.

There are lots of tax benefits associated with companies doing ESOPs. And this is true whether you’re a construction company or any other type of business. The first of those advantages is that an ESOP gives a business a way to do this leveraged transaction, this transaction that involves a debt on a completely tax deductible basis. Everyone knows that historically, a company gets a tax deduction for interest payments on a loan, but does not get a tax deduction for the principal payments on the line. With an ESOP, a company gets a tax deduction for both. And that is the only opportunity within the internal revenue code for a company to get a tax deduction for principal payments on a loan.

And it’s not literally getting a deduction for the principal payments, but it’s converting what would have been a principal payment on a loan, into a contribution to a retirement plan. And every business owner knows that when you make a contribution to your 401k, it’s a tax deductible expense.

In the same way, when the company makes a contribution to the ESOP, it’s a tax deductible expense. So the essence is a company is getting a tax deduction for both principle and interest on a loan. And that is such a rare, attractive opportunity.

The second benefit is that if you have an S corporation, which most companies are now, and if you do a 100% ESOP transaction, in other words, the company buys all of the stock from the business owner. Then in that situation, your company, after the transaction, operates as if it were a tax exempt entity. So no tax at the company level or at the shareholder level.

And so everyone’s immediate reaction when I tell them that is that’s too good to be true. There’s no way that can happen. Why would Uncle Sam let my company operate on a tax free basis?

Well, the first thing you need to know is that’s been in the law since 1998. So this is not some secret sauce. It’s something that’s well-known and has been in the law for many years. And the second thing that you need to know is how that tax-free status comes about. And there really two key factors on that.

The first factor is everyone knows that if you are an S corporation, the company doesn’t pay tax. I mean, that’s just basic tax law. It’s a flow through entity. And so all of that company’s taxable income flows through to its owner. Here’s the trick. An ESOP trust is the owner of the stock, and retirement plan trusts under the law are tax exempt entities. So I asked business owners, last year, when you got the tax reporting for your income from the year, did you get a K-9 for the earnings in your 401k plan? And the answer is no. We don’t get that because we don’t own those assets. Those assets are owned by the 401k trustee for our benefit. And that trustee is tax exempt.

Well, the same thing is true for an ESOP. You have a trustee, it’s tax exempt, so there’s no tax at the company level because it’s a flow-through entity and no tax at the owner level because the owner that the income flows through is a tax exempt entity.

And so you have Publix Supermarkets, which is this huge company and the largest ESOP-owned company in the country that has a big pricing advantage over its competitors because Publix doesn’t pay tax.

[00:10:25] Rob Williams: Oh Publix. That’s my wife’s favorite grocery store.

[00:10:28] Kelly Finnell: Yep.

[00:10:30] Rob Williams: She’s like, when we go to the beach in Alabama, if we go down there she’s like, oh my God, we get to go to Publix! Like, wow. I didn’t know. Now I can experience Publix in a, in an all new manner when I go in there with her. I’ll say, I want to go to Publix now, too,

[00:10:45] Kelly Finnell: And notice the level of service when you go to Publix compared to a competitor.

[00:10:49] Rob Williams: Oh, she does. She notices it big time.

[00:10:52] Kelly Finnell: And guess why that happens? It’s because that checker and that sacker and the guy behind the deli counter, they own a piece of that company. So they take more pride in They work harder because their financial security is directly tied to the performance of that business.

[00:11:11] Rob Williams: Wow.

[00:11:12] Wade Carpenter: Yeah. I’ve seen that in a couple of other construction companies where they’re wanting to pass it on to their management team or whatever, and their owner is looking to get out. I appreciate you going down the tax side of it. Can you talk from the employee side?

Because I think that’s a win-win.

[00:11:29] Kelly Finnell: Yeah. absolutely. And the first thing from the employee’s perspective is that if a company does an ESOP, it’s protecting their jobs. If you sell to private equity or to a competitor, they might tell you, when we buy your company nothing’s going to change. But we all know everything changes.

[00:11:52] Rob Williams: Yeah.

[00:11:53] Kelly Finnell: I’ve got a buddy who was the chairman of the board of a Fortune 300 company, and we were talking about an acquisition that he had done. And he said, Kelly, I don’t call it mergers and acquisitions. He said, I call it mergers and executions. Because when a buyer comes in, they’re looking to reduce expenses to increase the return on their investment. And the first and easiest way to do that is to terminate a bunch of employees. And so that’s the first thing from an employee’s perspective is that it protects their jobs.

The second thing that I hear from business owners a lot is that the success of our company is based on company culture that we’ve built with our employees. And so if you have a purchaser, even if they don’t terminate a lot of people when they come in, absolute guarantee the culture is going to change. And that can be very difficult for employees and it can also be very difficult for your customers, right? That’s one of the reasons they’re doing business with you is because you’ve built this great company culture and because the employees are taking care of them. If that company culture changes that dynamic of the business is going to change as well.

The next thing that an ESOP does for employees is that it provides them a much more generous contribution to their retirement account than if the company just had a 401k plan. According to the national statistics, on average, companies contribute 4% of pay to their 401k plan. On average ESOP companies contribute 10% of pay.

[00:13:40] Rob Williams: Wow.

[00:13:41] Kelly Finnell: that’s a huge benefit for employees. So 250% increase in the retirement plan contribution.

And then the final reason is that according to the statistics that are out there, ESOPs have a much higher rate of return for employees’ investments than do 401k plans because with an ESOP, the employees are able to control the performance of their account to some extent, by working harder and working smarter.

And so it’s not unusual…

[00:14:15] Rob Williams: The investment is the company.

[00:14:18] Kelly Finnell: Is the Company,.

[00:14:19] Rob Williams: Not stocks and…

[00:14:20] Kelly Finnell: Yeah. So it’s not unusual to see employees have incredibly large retirement plan accounts in their ESOP and have moderate accounts in their 401k. And so the ESOP is tremendously beneficial to the company’s employees.

[00:14:37] Stephen Brown: Kelly, at what time is it a good decision to consider an ESOP? And what elements need to kind of be in place as far as management of the construction company for them to consider an ESOP?

[00:14:49] Kelly Finnell: Let’s talk about management first because that’s a very important issue. So an ESOP is an internal transition, as opposed to a sale to a third party, which is an external transition. So if we’re going to do an internal transition, we have to have built a management company that can take over when the owners leave.

Now with an ESOP, the owners almost never leave immediately after the transaction closes because the company owes them money. We talked about the seller note. And so generally the owners are going to stick around until that seller note is completely paid off. But they have to have Management team that they trust and that they know can perform so the company can pay off their debt. And so I say that many times a company is a great candidate for an ESOP if we have a situation where the boss comes in late, takes a long lunch and leaves early. Because that’s a situation where he’s not micromanaging the business. He’s built a management team and they’re successfully running the company. So that’s a very important consideration that you mentioned.

Other indicators that accompanies a good ESOP, just from a financial perspective, the company needs to have at least $2 million of adjusted EBITDA. So earnings before interest taxes, depreciation, and amortization. And so we talk about adjusted EBITDA because often, owner expenses after the transaction are decreased– so that might be compensation, bonus, perks, all of those things. And those adjustments increase earnings, which increase the sales price.

So typically you need to have at least $2 million of adjusted EBITDA. So let me give you some metrics on our construction company clients this year. The home builder in Georgia had $25 million of EBITDA. The commercial construction company in Memphis has $8 million, and the company that we talked about in Louisiana, the commercial contractor had about $8 million as well. You don’t have to be that big, but you need to have at least $2 million in order to be a good candidate. At a minimum you probably need to have 50 employees. Most of our companies, most of our clients have many more than that, but 50 is a good minimum threshold to think about.

You need to have a business owner – I have this scale that I talk about. I call it the Mother Teresa Gordon Gecko. Everybody remembers Gordon Gekko, the guy from the movie who said, greed is good?

[00:17:35] Rob Williams: Yeah.

[00:17:36] Kelly Finnell: You don’t have to be Mother Teresa in order to be a good candidate for an ESOP. You don’t have to be looking to give away your business, but you can’t be Gordon Gekko. You have to have some concern and care for your employees and put somebody’s interest, maybe not ahead of your own. But at least as high as your own. And so you have to be somewhere on that scale, you can’t be Gordon Gekko and be a good candidate for an ESOP.

So I think those are the primary things that we look for. If owners of the company are off the surety bond on the personal guarantee, that’s tremendously helpful, but we don’t typically find that. But that would be very helpful as well.

[00:18:22] Stephen Brown: Well, also spending some time with the company. Spending some time at the job site, spending some time with management, getting to know more intimately who’s running the company and the key employees is a key to the underwriters understanding your business and extending bond credit. They don’t want to lose a client after an owner moves on. They want to keep going, and they know that you’re going to need a lot of bonds to grow that business if your business is dependent on.

[00:18:48] Kelly Finnell: Yep. So one of the key considerations is that you need to have a bond broker who has ESOP experience, because otherwise they’re not going to be able to communicate to the bonding company. And so you need that intermediary. And then you need a bonding company, a surety company that has ESOP experience as well.

And so that can take that consideration on the bond from being impossible, to being pretty easy if you have those two things come together. An experienced a broker and an experienced issuer.

[00:19:32] Rob Williams: Stephen, I think I see a new lunch in our future, of Stephen and Kelly and I going to lunch we’re all here in Memphis ,to talk about that since we have a great bonding broker right here on this show.

[00:19:45] Stephen Brown: Thank you, thank you. I think this is a great topic because every bond underwriter I know has an ESOP story and they always have an opinion on something that went well with the transaction or something that was a little tough. But you know, the bonding companies are looking for the character not only of the owner, but in an ESOP, of the company. Their core philosophy and also their business skillset.

Like you said, 50 employees usually means you’ve got a trade that’s really good at what they do. Either being heavy construction, doing a lot of pipe work, or a large subcontractor with a lot of employees. It’s just kind of a perfect fit.

[00:20:26] Rob Williams: Kelly. I had two questions that came up because I want to make sure I get these in here before we are off the show on retirement plans. Not retirement plans, but, but on selling the company and getting out. A lot of the times, we talk about funding and building this up, and a lot of times they’re using some kind of life insurance program or something like that.

I have two questions and you may want to tie these together. My other question was what if it’s a corporation and not an S-corp? So I don’t know if these have anything to do with each other, but how far in advance do you have to be planning for the ESOP to happen?

[00:21:00] Kelly Finnell: Yeah, it’s usually a six month process. There are two steps that are involved. The first step is a feasibility analysis. And in the feasibility analysis, the owners provided all the information that they need to know in order to make a decision about whether or not this is the right strategy.

So the four key questions that are addressed in the feasibility study are: first, if I as a business owner sell to an ESOP, what could I expect the purchase price to be? So that is an ESOP specific estimate of value.

Second question is how would the transaction be financed? Do you think I could get bank financing? And if so, how much? What will the seller notes, the amount of the seller notes be? And what will the terms of those seller notes be? So just to give you a little preview into that, a seller note is subordinated debt, and as subordinated debt, it’s entitled to a very high rate of return. So it is common to see seller notes with a total all-in rate of return of 10 to 12%. Initially when a business owner hears that they’re going to have to sell or finance a lot of this, their reaction can be negative. But when they find out that they’re going to get a 10 to 12% rate of return on what they view as a very safe, secure investment, they say, wait a minute. Seller notes sound better than cash at close. Because if I get cash at close, I’ve got to go reinvest that somewhere and I’m going to reinvest it conservatively. So maybe I’m going to have a four or 5% rate of return–

[00:22:43] Rob Williams: Or lower these days. And that’s…

[00:22:45] Kelly Finnell: Or on the seller notes, I’m going to have twice that or three times that amount. And so that’s a big consideration.

The other two considerations that we look at in the feasibility study are what’s corporate governance going to look like? How’s the business going to operate? Who’s going to be running the show after the ESOP’s implemented? And to give you a preview of that, nothing much changes. So there’s some more formality in terms of the way the company would operate, but the substance of control won’t change much.

And then the fourth question is essentially, our clients say all of our employees are important to us and we want to take care of everybody under the ESOP. But there are some employees that are absolutely critical, not just important, but critical. And we want to do something extra for that group of two or three or four people. How can we accomplish that?

And so another preview, the answer to that question is you can solve that via what’s called a stock appreciation rights plan, which is a plan that would just cover that group of key employees and provide them benefits in addition to their ESOP account.

[00:23:58] Rob Williams: Wow. That’s that’s really important. That’s really important. How about the question about a corporation? What if they’re already a C Corp?

[00:24:07] Kelly Finnell: Then they have an opportunity to implement a plan that is what I call the holy grail of ESOPs. So we talked about the two tax benefits that apply to S Corps. The ability to get a tax deduction for principal and the ability to have a tax-free entity. So if you’re a C Corp, you have a third tax opportunity. And that is the ability to sell your stock to the ESOP with no long-term capital gains tax. No ordinary income, no long-term capital gains.

So in 1984, the tax revision act that year added section 10 42 to the internal revenue. Your listeners know about what kind exchanges, because they’ve probably done like kind exchanges of real estate. So when you do that, you sell a piece of, let’s say commercial real estate, you get cash for that. You reinvest that cash in other commercial real estate, and you don’t pay tax on that transaction.

You get a transferred basis tax basis and the new property that you purchase, but there’s no tax on that transition. So in 1984 Congress, in order to encourage business owners to do ESOP’s added section 1042 to the code, which is another like-kind exchange. And this one says, if I sell stock in my closely held company, get cash, reinvest that cash in the stocks or bonds of a US domestic operating company, then no tax. Again, I get a transferred tax basis, but no tax on that transaction. And so, we’ve had many companies over the years who have been C Corps, they’ve sold, the owners have gotten the sales proceeds tax-free, and then at the beginning of the next year, they make an election to be taxed as an S corporation.

And the company pays no tax. So that’s kind of the holy grail of ESOP transactions. So, thanks for asking about–

[00:26:19] Rob Williams: Okay. Great. So it does not eliminate, not only does it not eliminate you, you have another advantage. If

[00:26:25] Kelly Finnell: Exactly right.

Yep,

[00:26:27] Rob Williams: Yeah. What if you’re an LLC? Do you need to convert to an S-corp or do..

[00:26:31] Kelly Finnell: Yep. You just incorporate. There’s always pre-transaction planning involved. And there was one year, a few years ago where each of the transactions that we did were for LLCs. And so it’s just a simple routine matter to have them incorporate and then do the ESOP.

But you have to be a corporation. Remember the name of this is employee stock ownership plan. So you have to be incorporated in order to have stock.

[00:26:59] Rob Williams: Wow. This, this is amazing. It’s, it actually sounds pretty complicated. So two things. First, is there a really quick, cause there’s so many details in here. Is there kind of a quick summary?

[00:27:13] Kelly Finnell: Yep. If your listeners will go to our website ExecFin.com, there’s a banner at the top of the page. And one of the items listed is Primer. P R I M E R. And then when you click on that, it’s going to show you that there’s a primer for business owners and then one for professional advisors. So click on the one for business owners, and that will give everybody a reminder of what we discussed today.

And it has charts and graphs that’ll be very helpful. And so that would be my recommendation. Go there. Because you’re right, these transactions are complex and people probably feel like they’ve been drinking water from a fire hose. Go to the primer and it’ll be much more manageable.

[00:28:01] Rob Williams: Yeah. I’ve heard this many times from you actually, a few times in our lunches, in some of your presentations where I’ve been, and I still feel like I’m drinking from a fire hose and I’ve got a background in this. Wade, how about you? What do you feel as, as a CPA? What do you say the advantages of doing the ESOP?

[00:28:21] Wade Carpenter: I’m glad you went into the C Corp because I’ve seen the C Corp thing work really well, too. I’m glad you went into carving out things for employees as well, because a lot of contractors try to do deferred compensation arrangements and they don’t fund it. And this is a great way to pass on and keep the management team together.

[00:28:40] Rob Williams: Yeah. So, so you can keep the team, you keep the culture going. Instead of selling to somebody else, you have amazing tax advantages to this. Plus you can actually have a buyer, when you were saying to Gordon Gekko, well this might even be the Gordon Gekko because this is probably your highest and best use scenario of doing any. Even though you, you don’t want to mess over the employees, having somebody outside is probably not an option to, to get as good of a sales price. So, Gordon Gekko might like it

[00:29:15] Kelly Finnell: Yep.

[00:29:16] Stephen Brown: I know of billion dollar in sales contractor who is owned by their employees. And it’s a company culture. It’s something they sell to the owners. Just like Publix, everybody has a stake in seeing that this job is successful, and that you’re happy. And they say that’s been a key point of growing their sales as well.

[00:29:37] Rob Williams: Yeah. Well, I know this has been one of the longest shows that we’ve had, but I didn’t want to stop it at all because this is so valuable. I didn’t want to miss any points. I think this will be a key resource for a lot of contractors to hear. Now, Kelly, is there anything else that we’re missing?

[00:29:53] Kelly Finnell: No, I think you did a great job, bringing out All the important points.

[00:29:57] Rob Williams: All right, man. You you’ve got this. I mean, obviously you know how to do this. Oh, the one other thing I was going to say, this sounds like a simple process that you could do yourself, right?

[00:30:12] Kelly Finnell: Yep.

[00:30:13] Rob Williams: So, I guess they would need to contact somebody if they had that. Do you have any suggestions, Kelly, for who they may contact if they’re interested in this?

[00:30:23] Kelly Finnell: You can get our contact information on the website.

[00:30:27] Rob Williams: All right. And then again, so Kelly Finnell and that website is ExecFin, E X E C F I N dot com. Well, this has been a fire hose of information, even though I’ve heard it many, many times. But it’s, it’s always very enlightening and for an exit plan, this is just life changing as a goal for a lot of these contractors. This could be what they’re striving for, the end game. This is it, baby. It actually kind of, it’s not really an end either, so you don’t have to end the game. So, I’m, I’m really excited about this episode. I’m proud that we’re going to have this on the Contractor Success Forum for, for ages and ages to listen to again and again for your pleasure.

We are the Contractor Success Forum, and don’t forget to give us a big five star rating for this amazing show. Stephen’s holding up five stars. What’d you can actually see us, too. That may be a let down. You may see what we actually look like, but you can go to our website to ContractorSuccessForum.Com or see us on YouTube or see us in a lot of places.

So thanks a lot. And we really appreciate you. And one more time, we have Kelly Finnell, Executive Financial Services- and he has a book, The ESOP Coach. We didn’t even mention that. I’ve got it right back here behind me. It’s on this shelf in all of our shows, his book is up here on my shelf. So I guess that’s still relevant.

[00:31:51] Kelly Finnell: Absolutely.

[00:31:52] Rob Williams: Great. Didn’t know if there’d been a lot of changes to that. So. And we have a Stephen Brown with McDaniel-Whitley Bonding and Insurance Agency, who may happen to be that bonding agent, if you’re interested in doing an ESOP to be familiar with it. And we have Wade Carpenter, Carpenter, and Company, CPAs, and I’m Rob Williams with IronGate Entrepreneurial Support Systems.

And everybody, thank you for listening to the Contractor Success Forum. See you on the next episode.