A well-crafted shareholders agreement is the foundation of any professional service firm’s ownership transition plan. In privately held firms (which make up the vast majority of firms in the A/E industry) this is the document that governs how ownership is transacted by and between the company and its shareholders. A good agreement will speak to virtually any circumstance that may arise, and specify the obligations of the company and shareholders in each circumstance with respect to ownership.
With over 20 years of ownership planning consulting work we’ve seen great examples of shareholders agreements, and some poor ones. The best examples have been thoughtfully crafted by an experienced attorney from the start, and regularly revisited and amended to remain relevant in the ever-changing tax and legal environment.
Based on that experience, below are some core elements that all agreements should include, or at least consider.
Events triggering stock redemption: One of the primary goals of a shareholders agreement in a professional service firm is to ensure that the company’s stock remains in the hands of employees. Therefore a good shareholder’s agreement will mandate the redemption of stock from a shareholder (or his or her estate) in the case of death, disability, marital dissolution, bankruptcy, termination of employment and other events that might otherwise cause shares to fall outside of the control of the company and its active employees. It might also cover events such as a shareholder’s loss of professional license, or other events that might limit the contributions of a shareholder to the company.
Stock valuation: A privately held firm must have some method of establishing its value for transactional purposes. This method should be clearly defined in the shareholders agreement. Some firms will simply mandate that a valuation analysis be conducted annually or as needed by an independent professional appraiser. Other firms employ a stock valuation formula, which is carefully defined in the agreement, often with a sample illustrating the application of the formula.
For companies that have a policy of carrying life insurance on key employees, the stock valuation language should be very specific as to how the cash proceeds from such policies will be accounted for in the valuation, and how the proceeds will be applied in the repurchase of the deceased shareholder’s stock.
Financing provisions: In order to protect the cash flow and solvency of the company, a good shareholders agreement will contain provisions that allow stock redemptions to be financed with notes payable to the selling shareholders. Financing terms are often as long as eight years, with the company having the discretion to decide whether or not to use financing, and if so, how long the term should be.
Non-solicitation and/or non-compete covenants: Non-compete agreements can be controversial, and their enforceability depends greatly on how restrictive they are and the governing jurisdiction. That said, the departure of a major shareholder (pre-retirement) has the potential to be very damaging to the company and its remaining shareholders, particularly when the company has a major financial obligation to the separated shareholder. It is therefore reasonable to include language in your shareholders agreement that restricts a separated shareholder from actively soliciting clients and employees.
Tag-along / drag-along rights: The rights of minority interest shareholders in a merger or acquisition scenario is an important one to address in your shareholders agreement. In the event that a majority of the shareholders decide to sell or merge the company with an outside entity, tag-along / drag-along rights give minority shareholders the right to require that their shares be treated in the same way as those of the controlling interest shareholders (i.e. they may “tag-along”). Conversely, this provision allows controlling interest shareholders to require the minority interest shareholders to participate in the transaction (i.e. they may be “dragged along”).
Mandatory redemption provisions: This is another sensitive topic, but a trending one. More and more companies are choosing to include language in their agreements requiring shareholders to begin to divest of their shares as they near retirement. Such provisions should not be confused with mandatory retirements. The goal of the provision is to allow companies to project and plan for future stock redemption liabilities by removing the uncertainty surrounding when a shareholder may choose to retire. As an example, an agreement might mandate that a shareholder begin divesting of their stock at the rate of 1/5th each year beginning at age 60, causing the shareholder to be fully divested by age 65.
Once again, the above topics are not meant to be a comprehensive list of every provision to include in your shareholders agreement, but they should provide some food for thought. If you’ve not reviewed your own shareholders agreement in some time, you might be overdue or a tune-up.
I remember when the US economy declined and M&A activity slowed in December 2007. It was easy to conclude, after years of robust design and construction activity, that we were no longer in a sellers’ market as the buyers of A/E firms were dictating transaction terms and considerations. What stood out to me during that time was that the acquiring firms spent more time and due diligence on revenue visibility because a payback on their investment became less certain. A lot has changed since then. As we start our annual valuation updates with our A/E clients, I see more firms with increasing confidence in the future outlook for their services, but there is also a talent war that is making it difficult for firms to meet future growth plans. As a result, ROG is engaging with more firms interested in acquiring A/E firms to fill that talent gap. Is this the sign for a seller’s market?
Setting aside politics, 2017 began with promise as the Trump administration focused its attention on the US economy by reducing the regulatory environment and promising a corporate tax cut with the latter becoming a reality on December 22, 2017. Key economic statistics are leading us to believe that 2018 could be another year of growth. The Architecture Billings Index for January 2018 came in at 54.7, which is the highest level at the start of a year in more than a decade; the Dow Jones Industrial Average increased 24.3% in 2017; the S&P 500 increased 18.4% and; confidence from consumers and small business owners are at highs that we have not seen since the early 2000s.
Timing the market to maximize the value of the sale of your A/E firm can be risky. The best time to sell is when your near-term growth is strong, and any indication of slowing growth in the long-term is not clearly visible. We are at a stage in which companies are seeing great growth opportunities, but the access to talent is limited as the good ones are already working. Does this mean that the cost of acquiring talented employees is about to get too expensive? Would it be more economical to acquire a firm full of talented employees? As firms look to fill areas of voids within disciplines, market sectors, or geographic regions it may just be a better opportunity to move quicker by acquiring a firm.
The tax cut is on your side. The Tax Cut and Jobs Acts lowered corporate tax rates from 35% to 21%, or as I would put it, reduced the tariff of producing goods and services in the US – regardless of where it is consumed. This means that not only US-based companies would be interested in investing in the US, but also foreign companies because the tariff has been reduced for hiring US-based employees. The pent-up demand for infrastructure spending, increasing manufacturing investment, and the residential housing shortage are all leading to more upside potential than downside risk in revenue visibility. With valuations being very strong, using your company stock as currency is more attractive because the dilution to your ownership is smaller and the lower tax rate has effectively reduced the cost of using equity securities by 40% (21%/35%).
There are some potential headwinds. Just as I am writing this article, Jerome Powell, the new chairman of the Federal Reserve, indicated that rate hikes will be needed to keep inflation at a 2% target. Currently, inflation is at 1.8%. As interest rates climb, your valuation is likely to decrease. On average, the S&P 500 price to earnings ratio (“P/E”) is around 14 to 16 times. Today the P/E ratio is 25.7x, which is being driven by growth potential and a low-interest rate environment. It is not unusual for P/E multiples to fall to single digits when inflation takes hold. With a talent war for qualified design professionals, companies increasing wages and paying out bonuses, the signs of inflationary pressures are a reality.
Even if you’re not ready to sell, taking some chips off the table and taking some of your transaction consideration in stock of the acquiring firm may allow you to enjoy the benefits of today’s higher valuation and still capture the upside potential with your new firm.
“Too often, people have pre-conceived notions about ESOPs that are based on one or two anecdotal experiences, but ESOPs come in all shapes and sizes.”
As business owners in the A/E and environmental consulting industries examine their ownership transition options, we’re finding more and more are considering employee stock ownership plans (“ESOPs”). But too often, people have pre-conceived notions about ESOPs that are based on one or two anecdotal experiences. Perhaps they worked at a firm in the past that had an ESOP. Or maybe they have a professional colleague that instituted an ESOP in his or her firm. The problem is that ESOPs come in all shapes and sizes. An ESOP strategy that might have been successful for one company, may not be appropriate for another. Conversely, because a particular company had a disastrous experience with an ESOP, doesn’t mean that an ESOP couldn’t work for your firm.
General ESOP statistics
Here are some ESOP statistics that many readers may find surprising. The National Center for Employee Ownership (NCEO.org) reports that there are approximately 7,000 ESOP companies in the U.S., with the most common industries being manufacturing, banking, construction and, you guessed it, engineering. In fact, NCEO’s 2016 list of the top 100 ESOP companies include some of the country’s most prominent A/E firms, such as Gensler, HDR, Black & Veatch, Burns & McDonnell, HNTB, Terracon, Kleinfelder, and STV Group, among others.
However, ESOPs are not solely the province of large firms—on the contrary. NCEO’s latest study reports that 41% of ESOP-sponsoring companies have 50 or fewer employee-participants, and 60% have 100 or fewer employee-participants. So if you had dismissed an ESOP as an ownership transition alternative for your firm because you thought you were too small, you may want to reconsider.
Various Shapes and Sizes
One of the most common misconceptions is that all ESOPs must take the form of a leveraged transaction (i.e. the Company takes on debt to fund the ESOP’s purchase of stock from a retiring shareholder), or that the ESOP will end up as the controlling shareholder. In fact, ESOPs may be funded and accumulate stock in a number of ways, and the plan may hold ownership stakes ranging from a small minority interest up to 100%.
Many of the horror stories about failed ESOP companies involved highly leveraged transactions, where companies took on more debt than they could afford, or conducted a leveraged ESOP transaction and then experienced an unexpected downturn in their business. This is a legitimate concern in cyclical industries, or for businesses that have volatile earnings histories, but there are ways to address this.
An increasingly popular ESOP structure in the A/E industry is the non-leveraged or “pre-funded” plan. As an example, let’s say a firm is planning for the retirement of a group of shareholders anticipated to take place three years from now. The firm could establish an ESOP, and begin making cash contributions to the plan, effectively building a fund using pre-tax profits (contributions to an ESOP are a tax-deductible expense) that may be used at a future date to purchase stock from the retirees.
The advantage to the pre-funded plan is its flexibility. If the sponsoring company has a particularly strong year, it could increase its contribution to the plan (within statutory limitations), thereby sheltering more profit from taxation and potentially accelerating the timeline of the transition. And if the company had a weak year, it could reduce or postpone its contribution to the plan.
Controlling the process
The tax benefits that ESOPs provide to the sponsoring company, and in some cases to the sellers, are often what accounting and financial advisors focus on. However, while the tax savings of the ESOP structure can be significant, another advantage is often overlooked. Unlike orchestrating a sale to a select group of employee-managers, or seeking to sell to or merge with another firm, transitioning ownership to an ESOP is a process that can be planned and executed with a much higher degree of predictability.
With a sale to an ESOP, the company’s directors decide when and how to structure the transaction, and the share price is informed by an independent appraiser engaged by the ESOP’s appointed trustee to ensure that the ESOP does not pay more than fair market value for the stock in order to comply with the Employee Retirement Income Security Act (ERISA).
Once an ESOP has been established, its ownership level can be actively managed in accordance with the culture and strategic objectives of the Company. Our own A/E Ownership Transition Study, conducted in partnership with Practice Lab, indicates that the average ESOP ownership interest in the industry is 51%, and ranges from a low of 8% to a high of 100%. Many firms in the A/E industry maintain their ESOPs at a level that provides a meaningful employee account balance, while also allowing direct ownership opportunities for the management team.
The ESOP’s ownership level can be managed by controlling how repurchases of ESOP shares are handled (are the shares redeemed and cancelled, or recirculated to remaining plan participants), what is contributed to the plan, and the ESOP’s purchases of stock from retiring shareholders and the treasury.
The bottom line
When it comes to ownership transition planning, ESOPs are not the panacea. But if such an ownership model is in keeping with the culture and strategic direction of your firm, they may very well be an option worth considering.
Ian Rusk will be co-presenting an informative session on ESOPs together with Attorney David Solomon of Levenfeld Pearlstein, and Pete Prodoehl of Principal Financial Group on November 4th at the Growth & Ownership Strategies Conference in Naples, Florida. Registration for this popular educational and networking event is still open. Visit http://conference.rog-partners.com/ to register.
Employee Stock Ownership Plans, or ESOPs, are increasing in popularity as a vehicle for ownership transition, but in spite of this, they are frequently misunderstood. In this article, we examine the recent trends in ESOP ownership and address some of the misconceptions.
Recent ESOP Trends
According to the National Center for Employee Ownership—a private non-profit research organization, since the recession, both the number of plans, and the number of employee-participants have increased steadily.
Source: National Center for Employee Ownership (www.nceo.org)
This trend is even more pronounced within the architecture, engineering and environmental consulting industry. Firms in these industries already make up a disproportionate percentage of ESOP-sponsoring companies. Among the 100 largest employee-owned firms in the U.S. as reported by NCEO (defined as a company that is at least 50% owned by an ESOP or other type of qualified plan) approximately 20% are in the design and construction industries.
Our anecdotal experience working with industry firms on ownership transition planning efforts also suggests that more and more firms are implementing or considering implementing ESOPs. Furthermore, in our annual A/E Business Valuation and M&A Transactions Study, 20% of participating firms reported that they sponsored an ESOP.
Why the trend toward ESOPs?
The simplest answer to the question above is “supply and demand.” In the U.S. we are in the midst of a demographic shift, with the “baby-boomer” generation moving into retirement, and the younger generations “X and Y” moving into larger leadership roles. With the baby-boomers representing sellers (or the supply side of the equation), and generations X and Y representing buyers (or the demand side of the equation), we have the classic Economics 101 supply & demand curve shift.
If the demand (D) for stock is less than the supply (S), all other things being equal, the price (P) and quantity (Q) will fall, as the supply and demand chart below illustrates. In an ownership transition scenario this will result in lower value for the sellers and a longer or delayed transition.
In many cases, an ESOP can help “pick up the slack” by serving as an additional buyer, and helping the sponsoring company maintain supply and demand equilibrium.
“But we don’t want to be an ESOP company”
This is a common refrain, and often originates from a lack of understanding of the many shapes and sizes an ESOP can take. It’s a mistake to characterize a firm that sponsors an ESOP as simply “an ESOP Company.” An ESOP is simply a qualified plan (like a 401(k) plan) that is designed to invest primarily in its sponsoring company’s stock. The ESOP is considered to be a single owner, and the employees of the firm are its beneficiaries. Just like any individual owner, the ESOP’s ownership could range from a very small minority interest in the Company, all the way up to a 100% interest. An ESOP may also be leveraged, having borrowed money from a third party to fund its acquisition of stock, or unleveraged / pre-funded, using annual profit contributions from the company to acquire shares over time.
Unfortunately, many peoples’ perceptions of ESOPs are informed by a single personal experience, or that of a friend or colleague. If that experience involved a leveraged ESOP that owned a majority of the sponsoring company’s stock, their assumption might be that all ESOPs take this form, which of course is incorrect.
In fact, the most common form of ESOP we encounter in the A/E industry is one that holds a minority interest (often between 20% and 40%) and is not leveraged. This form of ESOP allows the company to be majority owned by its senior management, while providing a stock-based benefit to its entire workforce, and taking advantage of the tax benefits the ESOP affords.
Tax benefits can be substantial
The primary tax benefits that an ESOP provides relate to the tax-deductibility of the company’s contributions to the plan. Because contributions to the plan are a deductible compensation expense, the company can effectively use pre-tax dollars to fund the redemption of shares from a retiring owner. Thus a $1 million block of stock, if purchased by the ESOP using contributions from the company, would result in a tax savings of approximately $350 thousand (assuming a 35% corporate tax rate).
ESOPs bring additional tax benefits to S-corporations. Because S-corporations are pass-through tax entities (the income tax obligation associated with corporate profits flows through on a pro-rata basis to the owners), and because the ESOP is not a taxable entity, the ESOP’s share of the sponsoring company’s taxable income is effectively sheltered from taxation.
Finally, in certain circumstances, an individual who sells his or her shares to an ESOP may be able to defer the capital gain associated with the sale. This benefit applies only to the sale of stock in a C-corporation, and only if the ESOP holds a 30% interest after the transaction. The seller must also roll over the proceeds into investments that meet the IRS definition of “qualified replacement property” in order to defer the gain.
There are other considerations as well. Company culture, management structure, and corporate governance structure are all factors to consider. Generally speaking, firms that already have widely distributed ownership, practice open book management, and promote employee participation in management are better suited for ESOP ownership than those that do not.
From a financial point of view, a feasibility analysis prepared by a qualified financial advisor can illustrate how an ESOP might work in your firm, taking into consideration factors such as: 1.) The company’s stock value; 2.) Future stock redemption liabilities; 3.) Projected direct stock investment by individual owners; 4.) The projected growth and earnings of the company; 5.) The ages and compensation of your workforce.
If you’re interested in learning more about how an ESOP might fit with your firm’s ownership strategy, feel free to contact us. And please plan on joining us at the annual A/E Growth & Ownership Strategies Conference taking place from November 12th – 14th in Naples, Florida. A pre-conference workshop will cover ESOPs in the context of other ownership transition strategies, and a special break-out session will cover the legal and financial mechanics of establishing an ESOP.
For more information and to register, please visit the event website at:
If you were interested in buying a house, and the seller told you it was worth $1 million, would you take their word for it and write them a check. I certainly hope not. Ideally, you’d want to see an appraisal. At the very least you’d want to do some research to see what similar homes had actually sold for—what appraisers refer to as “comparable sales.”
Transacting stock in a privately held A/E or environmental consulting firm should be no different. As business appraisers and financial advisers, we make our living helping owners establish the value of their businesses, and transact stock either internally (to other employee-managers) or externally (through a strategic merger or acquisition). But we also realize that not every situation requires a full independent business appraisal. Sometimes all a business owner or a potential investor needs is some independent data on “comparable sales.”
While there are surveys of how firms in the industry value themselves and the formulas they use to do so, there has never been an in-depth study of actual transactions of stock between willing buyers and willing sellers in the A/E industry, UNTIL NOW.
Over the last six months we have been conducting a confidential survey of firms in the architecture, engineering and environmental consulting industry, as well as researching stock transactions in the public realm. The result is the 2014 A/E Business Valuation and M&A Transactions Study.
What makes this study unique is that we have incorporated ONLY data from actual transactions where consideration (cash, notes, earn-outs, etc.) has changed hands between willing buyers and willing sellers. The study examined data from over 200 distinct stock transactions collected via a confidential online survey. We have supplemented this with data collected from publicly available sources. All data was analyzed and compiled by accredited business appraisers with decades of experience valuing privately held A/E firms. The result is the most comprehensive and reliable study on business valuation ever published for the A/E and environmental consulting industries.
Among other information, the study provides statistical data on the following valuation ratios or “multiples.”
Unlike any other surveys on the subject, this study examines the differences in valuation multiples between controlling and minority interest transactions, the difference in value between marketable stock (stock of publicly traded firms) and non-marketable stock (stock in privately held firms), and the valuation of stock in ESOP (employee stock ownership plan) transactions. Also provided is a statistical analysis of merger and acquisition deals—including how the transactions were structured, and the forms of consideration paid.
Data from this study begins to quantify concepts like the premium paid for controlling interests in A/E firms. For example, the survey, which includes statistics on 40 controlling interest M&A transactions revealed that earnings multiples in controlling interest transactions were 48% to 80% higher than corresponding earnings multiples in minority interest transactions.
As a bonus, the collection of detailed income statement and balance sheet data from survey participants afforded the opportunity to calculate a wide variety of key financial performance metrics—19 in all. These financial metrics are also detailed in the study and include: net service revenue growth rates, various measures of profitability, staff utilization rates, labor multiplier rates, overhead rates, return on assets and return on equity, various balance sheet and leverage ratios, and more.
This study is available for a limited time for only $349. Click here to purchase.