Tag Archive for 'Somerset'

ESOPs as an Exit Strategy for Owners of Construction Companies

By Chris Hirschfeld, ASA, MBA, Director of Exit Planning, Somerset CPAs and Advisors

Running a profitable business is a daily challenge for most business owners. Finding an exit strategy is a challenge that every business owner will eventually face. It is especially true for many in the construction industry. If you want to sell to management, how often do they have the funds to buyout the owner? If you want to arrange bank financing for a transaction, what impact will this have on your bonding? If you want your children to remain in the business, how willing is a buyer to honor that request? If you consider selling to a competitor, what is the risk of sharing proprietary information with your competition? What if the deal doesn’t go through? How often do Private Equity firms even look at construction companies for their portfolio of acquisitions?

The list of issues above is exactly why more and more construction companies are turning to ESOPs as an exit strategy. What is an ESOP? It stands for Employee Stock Ownership Plan. It is a vehicle by which business owners can sell their stock to the employees through an ESOP Trust. The ESOP Trust buys the shares for the benefit of all employees. Not only does it provide an exit strategy for the current owners, but it also creates an ownership mentality among all the employees because all employees will have an economic interest in the success of the business. 

An ESOP is a qualified retirement plan. Therefore, it is governed by the same rules that apply to other retirement plans such as 401k or SEP or SIMPLE IRA’s. ESOP plan documents will specify eligibility, vesting, and retirement ages, just like other retirement plans. The accumulation of value inside an ESOP grows tax deferred, just like all other retirement plans. Employees only pay ordinary income tax when they withdraw their funds from their ESOP account just like any other retirement plan. When employees retire, or leave the company for any reason, however, they must sell their stock back to the ESOP. The stock never leaves the company. The terminated employee may roll their cash proceeds into their IRA or 401k if they wish to further defer taxes on their ESOP account after retirement. The one thing that makes an ESOP unique among retirement plans is that, by law, ESOPs are allowed to hold employer stock as its only security. 

When setting up an ESOP, current owners must sell their stock at fair market value, as derived by an independent appraiser. This is a market-based price which gives owners a value comparable to what the current market would bear. Often, “fair market value” is a higher price than formulas many companies have in place within their buy-sell agreements. Once the owners sell their shares to the ESOP, the ESOP Trust will allocate shares to employees over several years. This creates a long-term incentive for employees to remain with the company. It is why ESOPs have become such a wonderful retention tool. It is like a “golden handcuff” for all employees. If they leave, employees lose their unvested balance and also walk away from the potential of future share allocations. 

One of the biggest benefits to ESOP-owned companies is that management does not have to change. Corporate governance does not have to change. The day-to-day operations do not change. The company remains local. Headquarters will not be moved out of state. The local community benefits when companies don’t sell to out-of-state companies. There is one additional benefit to the owners who sell their shares to the ESOP. If they remain employees after selling their stock, they may also participate in the ESOP to build additional wealth.

In today’s tight labor markets, ESOPs are especially attractive. Imagine being in competition for new hires. Your company can offer not only salary, wages, and a 401k plan, but also a second retirement plan that the company contributes to (not the employee). How many employers offer two retirement plans? This will make your company more attractive to potential new hires in a tight labor market.

What types of companies make good ESOP candidates? ESOP candidate companies should be profitable, with stable earnings and some growth potential. If the company has the capacity to borrow money, the selling shareholders can get more cash up front as part of the deal. Owners who want to keep the company local will find ESOPs attractive. If you already have an employee-ownership culture, your employees will treasure the ESOP benefits.

ESOPs are only available to corporations. LLCs and Partnerships would have to convert to either an S-Corporation or C-Corporation before forming an ESOP. One of the advantages of a C-Corporation that forms an ESOP is that the sellers can get tax deferral on their capital gains if the ESOP buys 30 percent or more of the ownership. One of the advantages of an S-Corporation forming an ESOP is that income taxes on corporate profits can be eliminated. S-Corporations do not pay a corporate income tax. Corporate income passes through to the shareholders who pay the tax. If an S-Corporation is owned 100 percent by an ESOP, the corporate income tax liability passes through to the ESOP, which is a qualified retirement plan. Qualified retirement plans pay no income tax. Therefore, a 100 percent ESOP-owned S-Corporation is a tax-free entity. Imagine not having to make income tax distributions equal to 30 to 35 percent of the corporate income each year or in quarterly installments. That cash can be retained and used for other corporate purposes (pay down debt, bonuses, acquisitions, etc.).

The company will incur added expenses to an ESOP. ESOPs require a trustee, an independent business appraiser (who appraises the stock each year for the benefit statements), and legal counsel. Additionally, a record-keeper/third-party administrator must be retained to administer the plan, file necessary annual tax forms and produce the employee ESOP benefit statements. The corporate income tax savings alone, however, can more than offset the increased operating costs for an ESOP.

In summary, there are several reasons an ESOP might be an attractive exit strategy for business owners in the construction industry. It allows the owners to sell their stock at a market-based price. It provides a means by which the owners can sell the company, but the company remains local. The ESOP has a built-in mechanism for buying shares when employees leave the company, so there is always a market for minority interests. ESOPs help build an ownership mentality among employees. An ESOP provides a second retirement plan for all employees that builds value over an employee’s career. This additional retirement benefit will make your company unique and creates an attractive recruitment and retention tool. ESOP-owned S-corporations can eliminate corporate taxes altogether, creating a unique source of cash flow unavailable to most other corporations. If you have a business that you would like to turn into a legacy, an ESOP just might be that vehicle. 

Numbers Tell a Story: Creating Your Story Through the Use of Ratios

By Kenneth J. Hedlund, CPA and Lindy L. Hylton, CPA, MBA

There are many challenges businesses face, especially construction companies in today’s economic environment.  It is important for a company to have a good handle on where they are today and a plan of where they are going tomorrow and beyond.  One way for a company to measure and track their progress is through the use of financial analysis and ratios.  These tools help your company plan, benchmark and monitor progress toward the goals of the company.

In setting goals for your company, you must be objective in using benchmarks and measurements.  You want your goals to be attainable to motivate action, so be realistic in setting goals.  You want to at least meet your goals, but it would be ideal to exceed your expectations.  To get the process started, identify areas of improvement and needed growth within your company and then measure progress of meeting those goals through the use of key ratios.

There are many ratios to use in measuring your company’s financial position and monitoring the progression of goals.  A great place to start is by taking the financial data from your company for the past three to four years and comparing the data over the years.  All numbers tell a story.  What do your numbers tell, and what are they telling your bankers and bonding agents?  Are your revenues increasing? Do you have a cash shortage?  Is your gross margin expected to increase or decrease from prior years?  What has changed over the time period?  What kind of changes would improve the future numbers?

Ratios are powerful in that they are able to tell you the story of your company.  They allow you to link your financial statement numbers to timely and accurate information you can use in monitoring your company’s activity.  There are many ratios to consider, but the following are more contractor-driven and may be most meaningful to you:

Working Capital is the difference between a company’s current assets and current liabilities.  It is generally thought that a higher working capital position indicates a company is better able to pay its short-term obligations within terms.  This ratio also helps evaluate the ability to fund projects.

Debt to Equity is total liabilities over total net worth.  This expresses the relationship between creditors and owners.  It indicates the degree of protection provided by the owners for the creditor.  A lower ratio generally indicates greater long-term financial safety.  Companies with lower ratios usually have greater flexibility to borrow in the future.  Generally, lenders and sureties consider a ratio of 3 or lower acceptable.

Cash to Overbillings is cash divided by billings in excess of cost and estimated earnings.  This ratio is used to identify whether the cash from “front-end billings” has been collected and spent or saved as cash.  Typically, lenders and sureties prefer this ratio be at least 1:1.

Underbillings to Equity is cost and estimated earnings in excess of billings over total net worth.  This ratio indicates the level of unbilled contract volume being financed by the stockholders.  It is usually stated as a percentage.  A ratio of 20% or less is considered acceptable by lenders and sureties.

Backlog Gross Profit is the total project profit less profit earned job-to-date.  This ratio indicates the future estimated gross margin on open contracts.  You want this to be at least the current gross profit margin on completed contracts.  Generally, backlog gross profit should exceed 50% of general and administrative expenses.

Days in Accounts Receivable is net receivables times 365 days over revenue.  This indicates the number of days to collect accounts receivable.  A lower ratio indicates a faster collection period and thus more liquidity.  A higher number of days in accounts receivable ratio may indicate a drain on the company’s cash flow.  Generally, a ratio of 60 days or less is desirable.

Days in Accounts Payable is accounts payable times 365 days over total cost.  This indicates the average number of days it takes to pay trade payables.  The ratio should be compared to the credit terms with vendors.  Generally, a ratio of 45 days or less is considered acceptable.

Gross Profit Risk Factor is the completed contracts gross profit over work-in-process gross profit.  This indicates the amount of gross profit dollars from completed contracts, which are not influenced by the estimating process, in respect to gross profit from contracts-in-process, which are based on the estimating process.  Ratios greater than 1.0 may indicate a poor backlog or a significant decrease in the company’s gross profit.

Equity Risk Factor is equity over work-in-process gross profit.  This indicates the amount of equity that is based on the estimating process and is subject to change.  Amounts greater than 2.0 may indicate a poor backlog of a company that is overcapitalized.

Estimating Risk Factor is the completed contract gross profit percentage over work in process gross profit percentage.  This could indicate that open jobs are not profitable, have lower profit margins or be fewer in number than closed jobs.  An even balance of gross profit between completed contracts and work-in-process is 1.0.  A ratio greater than 1.0 means a larger percentage of profit is taken from closed jobs and could indicate profit gain, a shortage of backlog or decreasing margin on contracts.  A ratio less than 1.0 means larger percentage of profit on open jobs, and could indicate profit fade, increase in backlog or increase in margin on contracts.

After calculating ratios, you can step back and piece your story together from the results.  Ratios raise questions, and with those questions, you can use other related ratios to help piece the story together.  For example, consider the following information for XYZ Company:

Cash $    5,000
Billings in Excess of Costs and Estimated Earnings $100,000
Accounts Receivable $150,000
Accounts Payable $  50,000
Revenue $730,000
Costs $260,715

At first glance, you may think that the overbillings have been spent.  But if you look to see if those overbillings have been collected, you may find the accounts receivable balance is three times the accounts payable balance.  Calculating the following two ratios below help in reading this story:

Days in Accounts Receivable 75 days
Days in Accounts Payable 70 days

The number of days in accounts receivable is 75 days and accounts payable is 70 days.  Now you can conclude that the cash is not spent, and the amounts are still in accounts receivable.  Now further questions can be asked.  For example, is there a problem with the job? Are there customer collection problems? Is there a lot billed but not collected timely.

This is just one example and a few of the many ratios you can utilize in breaking down your company’s story, identifying areas of needed change within your company, setting goals and redirecting your company’s story as the future unfolds.

Summary of key contractor ratios mentioned in this article:

Ratio

Formula

Summary

Working Capital Current Assets –Current Liabilities Higher working capital indicates a better ability to pay creditors and fund projects.
Debt to Equity

Total Liabilities

Total Net Worth

Indicates financial safety.  Lenders and sureties prefer a ratio of 3 or lower.
Cash to Overbillings

Cash

Billings in Excess of Costs and Estimated Earnings

Help identifies if cash from “front-end billings” has been collected and spent or saved.  Lenders and sureties prefer at least 1:1.
Underbillings to Equity

Costs and Estimated Earnings in Excess of Billings

Net Worth

Indicates level of unbilled contract volume financed by stockholders.  Ratio of 20% or less is desirable.
Backlog Gross Profit Total Project Profit –Profit Earned Job to Date Indicates future gross profit on projects in process.  This should at least be the current gross profit on closed jobs.
Days in Accounts Receivable

Net Receivables x 365

Revenue

Indicates number of days to collect receivables.  Ratio of 60 days or less is desirable.
Days in Accounts Payable

Accounts Payable x 365

Total Cost

Indicates number of days to pay trade payables.  Generally, a ratio of 45 days is acceptable.
Gross Profit Risk Factor

Completed Contracts Gross Profit

Work in Process Gross Profit

Indicates gross profit dollars from completed contracts in respect to gross profit dollars from work-in-process.  Ratios greater than 1.0 may indicate a poor backlog or decrease in company gross profit.
Equity Risk Factor

Equity

Work in Process Gross Profit

Indicates amount of equity based on the estimating process.  Amounts greater than 2.0 may indicate a poor backlog of an over-capitalized company.
Estimating Risk Factor

Completed Contract Gross Profit Percentage

Work in Process Gross Profit Percentage

Indicates if open jobs are not profitable, have lower profit margins or fewer in number than closed jobs.  An even balance of gross profit is 1.0.  Ratio of greater than 1.0 means larger percentage of profit is taken from closed jobs.

 

ACP-Somerset Contractor Best Practices. In future ACP publications, Somerset CPAs Construction & A/E Team will continue to contribute articles in the areas of contractor management best practices as well as financial and tax updates.  In addition ACP and Somerset are hosting a series of webinars—The Contractor Success Series. This exclusive industry-specific series provides participants with priceless information with practical application of the subject matter focused on: financial success, operational efficiency and risk management, optimizing employee performance, developing a culture of business development and maximizing customer satisfaction. Success in these key areas will maximize return on investment (ROI). Learn more and register online at www.Somerset-Team.com.

GThis article appeared in the June 2012 issues of the Associated Construction Publications (ACP) magazines national section.

 

Somerset ACP April Webinar Covered Employee Comp Plans

In April’s Webinar Ken Hedlund cover Contractor Performance-Based Incentive Compensation Plans

More companies are getting away from purely subjective incentive plans and moving towards performance-based plans. This is best practices and, after all, shouldn’t you reward your highest performers? The presentation included an accountability model and integrates the concept of “what you measure you can manage.” We reviewed a sample plan design considering a corporate funding formula as well as proven performance measurement concepts utilizing Critical Success Factors and Key Performance Indicators–all with practical application to the construction industry. Somerset discussed sample tools used in the design, implementation and administration of such plans. The use of such a plan will drive desired results and ultimately maximize return on investment.

In the first webinar, February 22010, Ken Hedlund guided participants through Retooling for the Recovery.

We discussed what can be done today to make your company stronger now and better positioned for the industry recovery. We provided operational and financial strategies for navigating an economic downturn, working with banks and sureties, improving your balance sheet, right sizing, maintaining profitability, maximizing cash flow and more. We presented ideas for consideration to maximize the potential for your organization to maintain financial stability now and be poised to thrive with the recovery.

In the March Webinar we covered 30-60-90-120 Day Cash Flow Risk Management in an Unstable Market

One of the primary reasons many businesses fail is their inability to meet financial obligations as they become due, caused by limited cash resources. No matter how sophisticated your business’s processes, if your business runs out of cash, it will cease to exist. Yet, surprisingly, many businesses do not have a cash flow plan. If they do, it’s often an annual projection done to accompany a bank loan renewal or application. This webinar incorporated the use of software to illustrate that a business with net profits can still suffer cash flow difficulties. It explored various methods for improving cash flow and looked at how cash flow can be managed by planning and monitoring on an ongoing basis. The presenters Ken Hedlund and Howard Cox shared methods to increase cash flow and anticipate cash needs and provided participants with the tools needed to minimize risk and maximize cash flow.

The final webinar in this series will include Economic, Banking and Surety Update and will be held on Tuesday, June 1, 2010 11:30 a.m. to 1:00 p.m. (Eastern) – Presentation / 1:00 p.m. to 1:30 p.m. – Open Q&A At the time of this presentation, we will be well into the second quarter. 2010 real time data on industry performance and outlook will be presented by Somerset and other industry experts. We will review current economic data and indicators, provide an update on the surety and banking industries outlook and practices, plus assess the ever-changing landscape of the political environment and any significant tax updates.