EP5 - Titanic vs. The Love Boat - ESOPs for contractors

Welcome to the ESOP Guy podcast. We are on a journey to an ESOP. I'm so thankful that you could join us today. And I want to start off with this. And this. This is a bit of a groovy sound. We expect What are you doing, ESOP guy? So, the Titanic, if you recognized that um clip from the Titanic movie versus the love boat. The title of this podcast today is which boat are you getting on? ESOPs for contractors. So this is going to be a continuation we've gone through some, um, we're looking at specific industries and really evaluating the applicability of an ESOP for industries and, and so as we go into this, I just wanted to kind of start off with, Um, the, you know, ESOPs do apply themselves differently, you know, in certain industries and sometimes they're more applicable than others. Contra a contractor's business is very interesting. I think there, it's a very viable, um, very applicable place to take and use the ESOP for. The exit and the succession plan and other and other ways to actually use the app to actually help and grow the company. So it's, I think it's very interesting, it's very compelling. I'm excited to go into the this episode. So if you're not a contractor, I wanted to say, you know, definitely this is, is for more of a construction type of business. But there's still going to be areas that you're going to be able to utilize or, or learn. So, you know, it, it, it is geared towards that type of business, but, but just keep that in mind if you're gonna continue to listen for this one. And um if you like what you hear, please share it with a friend, um subscribe to the podcast. And as we um start off, I wanted to just make a quick plug for something that's Coming up, and I think it's going to be very interesting for for we're starting our 2nd season as the ESOP guy and, and last year was really fun and and got to meet a lot of people with a lot of interesting uh topics. This year, as we go into the podcast, as I said, we're in our 2nd season, but I'm going to launch a monthly ESOP guy live webinar. So be looking for that on our website at journey to an ESOP.com. The first one should be in about 30 days. So please look at that and I think the nice thing about having a webinar is that people can come and they can ask some questions and it's one thing to get some information and you start taking notes, but the more you, you know, learn about ESOPs, the more questions you start to have. So we want to make that available to you guys as well. All right, so let's, let's just start off. What love boat versus the Titanic. What are we doing? Why are we even talking about these cruise boats? So, In real life, we start thinking about the Titanic, it set sail out of Southampton, England, and, and it was heading out to New York on April 10th of 2012. And very, very tragically, it sank on April 15th in the North Atlantic Ocean. And we all know the tragedy because we've seen the movie, but um one of the things I I picked up in terms of some, some real small amount of research is some of the facts that were, I think compelling to me, like what was going on, is that it underwent only 6 to 7 hours of testing. Now this is the largest ship ever built at that time in 2012. And it only underwent 6 to 7 hours of testing. In fact, they actually never tested its maximum speed. And when they were doing the evacuation test, they only lowered 2 of the 16 boats or lifeboats from the ship. And so they didn't really ever even have an idea of how long it would take to actually evacuate the boat or the ship. So, one of the things about that I thought was just interesting, interesting on a side note, and I've talked about this before, but, you know, the idea that you, you definitely have to plan and planning is really kind of some of the essence, and I would say the continuity of everything we've talked about in, in these podcasts, really it's what the whole podcast is about, it's about planning. So, without a good plan, I mean, you're, you're gonna have a, you, you're gonna have a problem and finding, you know, obviously good advisors and people to help you and your plan is, is going to be really important. So we move into the movie and we say, hey, what, what is going on with this movie? I'll tell you right now, I, this is not my favorite movie, but it's one of those movies where I just would never forget it, right? And it's, it's because it's so impactful. They take a tragedy and they kind of mix in some love and intrigue and, and the whole thing starts off with a high stakes game of poker and Leonardo DiCaprio wins this ticket to get on the ship and he's super like excited and, um, so he's a risk taker and you know, the reward is, hey, he gets to go on this great cruise. Uh oh, you know, it's not as great as it might have seemed. Um, and so the whole sound bite when I first started was like, hey, I'm so excited. I'm the king of the world. And he's starting off now ends tragically and everything else kind of, you know, it kind of speaks for itself. Now, contrast that with the Love Boat. Now, if you've never seen The Love Boat, it's a TV show that was, that was basically started in the 1970s. So it's super old. That's why the music's a little more discoy and You know, as embarrassing as it is, I watched the Love Boat when I was a kid. I actually spent, I think, a whole summer when I was 13 watching the Love Boat on reruns, and it was just a very difficult time, like a dark period in my life, but I, when, when you watch the show, OK, so here you have the contrast of get on the ship and you know, who knows what's gonna happen, get on the ship and love boat every time. You know, they have issues and stuff, and then they get off the boat, by the time the whole thing's over in 30 minutes, everybody's happy. Everybody's falling in love, and they're going to go live happily ever after. So, kind of tying that back together to the ESOPs for contractors is like when you go into your plan, which ship do you want to get on, what we all want is advisors is to make sure that you have a happy ending. And I think If you have to choose, obviously, you can kind of think for yourself, but you want something that you know is gonna work out well, and that's why you plan really well. We know the love boat's gonna work out well. Uh, we're not taking a huge risk when we start going through the process. When you get into the planning for an ESOP, you should know very early on in the process that this is something that really will work out and you'll find your happy ending. So, as we move into the contractor side, I want to talk a little bit about like this, the industry specific stuff as we start thinking about The, the who we're talking about. And one of the first things I think is important to nail down is the type of businesses that we're, we're talking about have what we would call a very cyclical nature to the way their businesses work. They're very much tied to the economy. And if the economy is growing, And there's capital flowing and there's productivity, there's usually building happening. And so when that's happening, then the contractors cycles of businesses are, are typically doing well. If they're in a location that, you know, for states and counties and localities, if they're in a geographic footprint that's growing as a, as a geographic place like Florida, for instance, Um, they're going to generally be doing well. So there's very, very much a a cyclical part of a contractor's business that has to be thought about. And, and one of the things I wanted to say about that, and this is You know, going interestingly back in the past, but I think you have to, when you talk about a contractor's business, you always have to kind of say, hey, you know what, when was the last major cycle? And we all know that it was in the Great Recession back in 2008, 2009, and those in those periods of time, we did have contractors that were going through something like the Titanic and their boats were their ships were sinking and some of those businesses, unfortunately didn't survive. Some of them, did and they became much stronger when the economy came back. But I think we, we, we know that the aspect of of a contractor's business is cyclical. And eventually we all will cycle back and the whole point of a cycle is we're going to come back again. Um, and, and repeat some of the things we've seen in the past. When is that going to happen? I don't know. Nobody knows. And as crazy as last year was with COVID, um, it just didn't, it did not create the type of cyclical problems, you know, not, and I'm just saying this in general, I'm not saying for like I know every single market and how it worked. But in general, I think it, it did not leave a lot of companies out of business. It did not do what what happened in 0809. And I think, I think in some cases, some companies had even better years than ever. So, Because of that, and I think one of the things is timing. When you think about uh when do you time out a succession and exit plan for a contractor? When is the perfect time? And I'm going to tell you just right off the bat, like, hey, how, how many, how many up years can we have? When do you want to actually be doing your planning for your, your exit plan? When you're having a good economic period? Because there's, there's ways to structure it, and I don't mean to push it up to the highest value multiple, but what I'm saying is, is that there's cash flow to be utilized in planning right now, that's very significant. What'll happen if we do have a correction in the market for contractors is people are going to come back and say, You know, oh, I need to start working on my exit plan. Well, we're, we've lost value, we don't have as much cash flow, it's not as easy. So I'm just going to encourage everybody to be thinking specifically about this to be a, hopefully a catalyst to think, I don't, even if you don't do any ESOP, maybe you want to do a management buyout, but get your plan started at least and know where you're going to go. That's my, that's my strong encouragement for you who are listening. So who are contractors, so we, when we think about contractors, I think that the easiest way to start this is to say, I know when I hire somebody. And I'm not employing them with a W-2, but I've contracted them to do a job when the contract is complete, then the job's over. And so that's what a contractor is and it works um very specifically when we think about contractors, we really more think typically about the, the construction type of businesses where they're going to build a building or, or build a project and, and, you know, they're going to do certain things in that contract. So the first real contractor we talk about is the general contractor, the, the contractor that is really acting as the project manager for multi-specialty jobs and this general contractor is really responsible for hiring specialized subcontractors for sourcing and buying materials for dealing with permitting and inspections and they're really there to communicate, hopefully with the customer and make sure everybody knows what's happening. So they they start with some, some construction plans, they work through what the timing and they get it all done by, by Managing all of the parts of the specialties of the composition of what's going to take to get that project built and um and up and running and, and, and have the CEO and all the different things that that happened. So that's what a general contractor is. Now, when you start thinking about that, that naturally segues us into who are these specialty subcontractors and these are contractors that what we call trade contractors that work specifically in the trades and do, do. Um, normally do one major thing. So we have, for instance, electrical contractors and plumbing contractors and heating and air conditioning, plastering concrete, painting, roofing, carpentry, masonry, and so kind of the list goes on, but those, those are specialty trades and they work as subs to the general in most of those situations where they're on a team and they're hired to do the job and then sometimes they're hired to do another job for the same contractor. And so, when we start thinking about The um the way that they all work together, it's, it's that, but they're all kind of in the same area of what I want to talk about in terms of each one of those types of companies, whether they be a general contractor or a specialty contractor are all um viable for a potential ESOP strategy. Now, when we start thinking about contractors, I want to get into the financial structure of a contractor's business because it's important and to really identify the aspects of this because planning um your succession and exit plan do have something to do with how that, how the business is actually putting together what they actually report in the financial information. So the first thing is, is that a contractor's business is usually under generally accepted accounting principles, going to account for their revenue and their expenses based on a percentage of completion. All that means is that whatever they build to this, whatever they've completed in terms of the work, they build that. Sometimes you have an overbill, sometimes you have an underbill, which just means they, they sometimes bill more than where they are really in the in the in the contract progress or they sometimes they build a little less than where they are. So, so they always have some of that going on within the, the way that they account for the revenue and the way they they start to, to work through the cash flow that's coming into their business. So that's gonna be, that's important because in that percentage of completion, As you start thinking about a contractor's financial structure, it's really just a, you know, when you start thinking about the revenue, it's just a, the revenue is a composition of or created by a composition of of multiple contracts. Some contractors have very large contracts that make up all the revenue, some of them have a lot of small contracts that make up the revenue. Some of them have a lot of various, various different types of sizes of, of contracts. So in that, we're going to be looking at contract schedules, which are basically going to tell us, hey, here's all of your contracts, and we're going to try to tie those contract schedules back to an overall revenue and make sure that we understand how that the backlog or the Completed work or the new work that's coming on, will affect future revenue. And so you have basically a financial structure that's kind of always, it's always flowing, it's kind of you close the year fiscally, like a 123 1/20. But you're always, you always have things going on. So we're gonna see in that contract schedule, completed contracts, the ones that they finished that last year, and they're gonna, we're gonna also see uh contracts that are in process. And so what, when we look at those contracts in process, we're gonna have what we call a whip report that ties itself to the financial statements, both on the income statement and the balance sheet. And I'm not trying to get too heavy into the accounting vernacular with this, but I think it's important to understand that's very different than a lot of their companies. They don't have to do that if they're just maybe selling a product or they're selling a service. So there's a little more financial information that you have to really kind of work through to understand where and and how strong the company is. Um, which, you know, then we start looking at the strength of the company. We're going to evaluate the contract schedules to determine and on on the completed side and say, you know, we estimated the contract at this, and when we finished the job, we actually made this much in profit or we actually lost money on it. So we have this gain fade analysis within that contracting schedule that we're going to evaluate as well. And why are we doing that? Well, one of the things that we're doing is we're trying to assess the ability of the contractor as the business itself, to properly estimate the amount of cost it's going to take to do the project and be able to to generate some some routine predictable profitability within those contracts. So, Obviously, if you have a company that has a, a bunch of contracts they're losing money on, we know the whole thing's gonna lose money. It's probably not a good time for that company to try to transition anything because there's, there's too much issue, there's too many issues which is profitability. But if you have a company that's been doing it, you know, on the other side that, that pretty much makes money everything they do, they know their world, they know their, their, the contracts that they do really well, they apply, you know, the right, the right formulas, and they make sure they do a good job, quality control is good, you know, that's the other side, right? That's the kind of company that when we start thinking about the predictability of cash flow, it's much easier to plan for. So then we take that and we so we go over to the balance sheet and we say, right, what is the balance sheet look like for a contractor and why is that important? Because it's, it's going to show the capital requirements that that that contractor has to complete the terms of those contracts, specifically when it comes to working capital. So, with a company that has uh not, you know, an under capital. balance sheet and they're growing and they're getting new contracts. That's kind of scary. And one of the things that's, you know, the bonding guys, the surety companies are going to be scared because they're going to start seeing that, hey, there's definitely a, uh, you know, a difficulty in this company being able to internally. That just means in the own, with their own companies retained earnings to have enough cash to make sure that they can pay the expenses to get the contracts completed on time. So that's something that is, is going to be evaluated. Now, when we go to planning an ESOP. We're gonna talk a little bit about that idea behind how do we make sure that we have enough working capital in the company, so that when we actually add more cash flow requirement of a debt payment for the company, which the debt payment is going to, in this case, be, I'm buying out the owner. And the bank may be loaning money to the company in order to pay for the buyout. So that's where a source of debt will come from, or the selling shareholder will take back a seller note, and then they are now the lender. And so either way, what we have is a real cash flow burden on the company. Now, this cash flow burden. Obviously, is going to be going to affect the company whether they do an ESOP or a management buyout. And so, We need to make sure that you, you have adequately planned enough cash flow to manage the, uh, the burden of that. And now, this is where ESOPs are so valuable because, hey, when we go back to the the ESOP 101 stuff, it's S corporations that are ESOPs are tax exempt. So, for a contractor, whatever I have sold my business for, Um, maybe it's a 30% ESOP or maybe it's a 50% ESOP, or maybe it's something more than that. That percentage of the company now is tax exempt. I get to pick up that additional cash flow that was, was going out to the IRS to pay taxes. is coming back into the company to subsidize the payment. So that's one of the strongest elements when you start thinking about uh ESOP for contractors versus a management buyout for contractors. As a management buyout, the fact the the financial statement, really, the balance sheet in itself is, is not going to be hit as hard. It is the cash flow strain as we distribute money to the owners to buy out those shares. It's going to be more of a strain because they're using after tax dollars to do that. So, all of that's very important because every single thing I just mentioned as far as the components of the financial structure have to be really put together and thought through in terms of the modeling that you're going to want to look at for proper planning. So, as we go through this, I want to kind of just talk through some of the advantages and some of the disadvantages of, of looking at it. So the the first part of this is really just to think about the um unless, I guess I would just say that for a contractor business, there's, there's a there's multiple reasons that there's less buyers in the marketplace looking to buy a contracting company. And so, when we start looking at this, there's definitely the one of the issues that you have is that you have a, uh, you have a cultural mismatch. So the owner of the company has created their own culture, this construction company is working and doing different things. Suddenly, a buyer comes along and they come in, maybe they're larger, maybe they're the same size. Now they have to kind of connect both cultures and try to kind of put this whole thing together. That's hard to do on the buyer side, right? That's really gonna give the buyer a little more of a um a squirmy feeling and think, I don't know if I want to do this. Secondly, the buyer, you know, whether it's a construction company buying or it's just an investor, you know, it's not as appealing to buy a company that has, um, when we start going back up to the financial statement discussion, your revenue is created by what we call non-recurring revenue, which is going to always have to be created every time when you buy it when you bid on a new contract. So when you buy something that's non-recurring cash flows, Then it's difficult to put a higher multiple on that. So, so looking on the marketplace and trying to get a higher premium is going to be somewhat less um available to a contractor. The one of the concerns the buyer might have is, hey, how do I keep, you know, with the contractor's business, one of the major assets that they have. And I think this is true for a lot of other companies too, but not necessarily specific to industry, but specific to contractor business is their key people. And as the business has grown, they, they really do rely heavily upon really good project managers. They rely heavily on the leadership and the structure they've had. So if the buyer feels like, hey, I'm not going to be really able to keep these key employees, then they're gonna feel a little less comfortable with the, the proposition. How do you tie up all those people? One thing that's true about a contracting business is, and this is part of the risk factors when you start start doing evaluation. there is a lower barrier to entry, that means from an economic standpoint, that anybody can really with a contractor license can start, you know, to do contracting and there's, there's not an intense amount of capital, you know, certainly with some contractors, they have to buy some heavy equipment. But a lot of them can rent stuff as they, as they get started. So there really isn't a lot of barrier to entry, which means like key people could jump out and start their own companies. One of the things I, you know, I, I love about an ESOP is it gives people a a strong reason to stay at that company and Um, and, and I'd say that with an MBO too, because you're able to tie people back in the management buyout. Um, but my whole rank and file for an ESOP are part are participating as beneficial owners in an ESOP. So I think that's a, a strength that you get. And now the buyer is going to have to think about how do I keep the key the key people. In addition to that, the buyer has to think, how do I keep, if, if the sales process, if the business development process is tied to the owner, the buyer has to figure out how do I, how do I transition that relationship. The goodwill relationship that that owner has created over all these years with these customers into their bucket, that's called transaction risk and that's very difficult sometimes to, to um smooth out and it's not impossible, but it's difficult. All of that being That means that there really is lack, a lack of a buyer group in within a uh contractors in the contractor industry, which means the ESOP and NMBO are going to be much more viable options when you start thinking about your options and looking forward. So, going into the uh advantages of an ESOP for a contracting business, one of the things I, I see all the time is that uh when we're looking at um the flexibility that an ESOP creates in terms of structure, the um transitioning like this happens on a couple of levels, we got transitioning of the ownership, but we have to transition. The responsibility of the bond in the, in the, in the possibility of an indemnity on the bond, we have to transition the, the banking relationship, um, we have to transition some of these key relationships. So one of the advantages of an ESOP is that There's a lot of flexibility in doing that in specifically for a contractor in doing it in smaller percentages. So if you take a 30% ESOP and you can start the process, you're getting the benefits of being an ESOP, and you're starting the process of actually taking some chips off the table, um. So that that process can happen and you don't have to immediately tell, you know, all these different people, hey, we've, we've sold to the ESOP. So flexibility is very, is a very good advantage for the ESOP. And I mentioned this in the very like up above this when we start, we were talking a little bit about the financial structure. And the cash flow. So being able to not only do that, but if, if I take the tax benefit of an S corporation ESOP, and I apply that, that is like the fundamentally the strongest aspect of this. So now I can do a partial ESOP for a contractor. I can fund part of it with the tax dollars that were going to the IRS. And I can start transitioning. This is gonna take us some time, so it's nice to have a little bit of, of, um, you know, room to do a partially up and help every everybody kind of get what they really need going forward. Um, when an ESOP is um going in, they're borrowing money and, and they're doing that, um, really with the pre-tax dollars, it's, they're going to have some advantages in terms of, of lower after tax costs when it comes to um financing the ESOP as opposed to other options to get some cash for the purchase. Um, So going into a construction company and the controlling shareholder of a construction firm, they have, they really have built their business over a lifetime. And I would say that the major thing that I'd say is the major advantage of an ESOP is that um looking at what this does to reward the employees is is so significant. I, and I think that would be other than the tax benefit, that would be the major advantage for construction company is to benefit the employees for the long term accumulation of, of, of future wealth and reward them for what they've done for all those years, leaving a very strong legacy for the business going forward. Now, some of the concerns, some of the things that I think are important to pick out as we start thinking about it is, um, as I mentioned at the very beginning of this, is this, this cyclicality of the business, and I wanted to really kind of pick, you know, pin that down. Um, the more cyclical, the more difficult it is to plan and the more cyclical of um in terms of volatility and the cash flow, the more difficult. So that's definitely a concern. When you're doing a 100% ESOP for a contractor. Um, it's, it's obviously possible and you can do it. It's just a little more difficult because we have to really work with the bonding people and make sure everybody understands, um, what's happening and, and make sure everybody's on board with that and really doing that early on is, is my advice to everybody. The employee, uh, demographics, I think is very important and I mentioned this briefly, but on a smaller contracting company, if they have a lot of turnover and they have um fewer employees, so I, I'd say at that 20 person firm level, if there's a lot of turnover, that could be a real difficulty. In terms of working through section 409P um on the disqualified person. So that's definitely a potential disadvantages, disadvantage to putting together an ESOP. But, you know, if the, if the company has, you know, more than that, and, and they have some turnover, maybe they're 40 or 50, that's probably not going to be an issue at all. The um bonding requirements, um, and like I said, get the bonding companies involved early on. My experience is some bonding companies have a very good overview and understanding of how ESOPs work. I think there are many that don't. And so having those conversations early on, they're going to be very concerned about The working capital and the net worth. And so being able to model out those financials into some pro forma financials are going to be very helpful to present well to the bonding companies and make sure that they feel um satisfied with what the plan is. Now, on a side note, One of my, my, my greatest fundamental beliefs with, with ESOPs and any kind of succession exit planning is, is the bonding companies and the banks and everybody else has a, a risk of the issue of what happens if the owner ages out and there's, there's not a plan in place. And that would be something that I think is something that needs to be measured and discussed with the bonding company because They need to know that there's new leadership and they need to know that there's a plan in place that makes it more uh a solid company where they mitigated the risk. Um, and so I just kind of throw that out as a conversation when you do talk to the bonding company and the bank. Um, this is very good that you're planning and it's not, and it's not like you've surprised them, so never surprised the bonding company, but letting them know this is what's coming is going to be helpful. Um, I mentioned that. You know, going into the idea of a, uh, you know, an ESOP for a contractor, um, it's, it's sometimes difficult, you know, when you start thinking about the people that are under you, um, it has to, you have to be building a succession plan as you go. So whether you do an ESOP or an MBO or whatever you're going to do with your business. An internal sale, always be thinking about that. So ESOPs that don't have a strong management succession plan for contractors specifically, um, are difficult because when the owner wants to exit and they don't have the right people in place, that can be definitely a disadvantage and a difficulty in the process. So with all that, I wanted just to say thank you so much for joining. Look for more on the on contractors as we go forward. Um, I hope this was very helpful for you as you start thinking about your business, potentially becoming an ESOP. So check us out at journey to an ESOP.com for all of our podcasts and as I said before, look for ESOP Guy Live coming up in 30 days on our website as well. And also just, you know, as we look forward to the next, um, you know, episode that we have, we look forward to our next step on this journey.