Master the ownership transition game
By Brian Moore
Who comes after you?
The ownership transition and succession of closely held businesses is one of the greatest challenges in the engineering and construction industry.
Leading industry consultants FMI recently surveyed contractors to gauge where they were in the process of company ownership transition and how they develop and carry out a plan to transition ownership to the next generation or sell. Nearly 20 percent of the respondents were heavy/highway/civil contractors. The average age of the owners was 54 with 33 percent older than 60. Eighty-one percent of the H/H/C companies report more than $20 million a year in annual revenues, and 36 percent more than $100 million. Seventy-six percent of H/H/C respondents say their business is a family business, and 72 percent of businesses have been in the family for two generations or more.
In most respects, heavy/highway contractors’ concerns were very similar to the overall response, and, not surprisingly, most of the owners were of the baby-boomer generation, the notable exceptions being those few respondents of the next generation who are just recently taking over management and ownership.
It is not surprising that family members are the recipients of stock either by gift or bequeath in the event of the owner’s death. However, many owners also expect select senior managers to become owners by buying shares over time. And only 52 percent say they prefer family members ultimately run the business.
It is still somewhat alarming that so many owners have not begun to make formal plans for management and ownership transition.
Only 37 percent have a formal plan in place to transition themselves out of managing the business, and 34 percent do not have a plan in place to ensure continuity of operations in the event of their death. One area that seems to be improving since earlier surveys is the number of owners (49 percent) that now say they have strong managers who could easily manage the business in the owner’s absence. However, 47 percent have managers that still need considerable training before taking over the helm. On the plus side, 84 percent report having a buy/sell agreement in place in the event of their death.
The long recession hasn’t made it any easier for owners to plan their transition to the next generation or sale of the company. But only 16 percent of respondents say the recession has caused them to put their plans on hold. Recession or not, 42 percent have yet to begin an ownership transfer plan. Notably, a portion of those are younger than age 55, so they have time. Others do not have as much time to plan and execute a transition plan, and it does take time.
We have also found that more of the baby-booomer genration owners are intentionally creating what we are calling a “lingering ownership transfer plan.”
Ownership transition planning for engineering and construction firms has historically focused on a transaction, with retiring owners selling to the next generation. The transaction typically took place over a period of years and had a defined end. FMI is seeing a shift in the way sellers think of “retiring.”
Sellers are taking a slower approach to the sale, and sometimes the process does not have a defined end date. Thus the “lingering ownership transition.” Several factors are driving this change in thinking:
1. People are living longer – the prospect of living to 90 or 100 means that retirements are longer, which, in turn, implies that retirement income may potentially be needed for decades.
2. Traditional retirement investments have been underperforming for more than a decade. Since 1999, the stock market has been essentially flat, interest rates are nominal and real estate has struggled. The strategy of living off the income from traditional retirement investments is not working very well. Trading stock in a profitable private business for traditional retirement investments is not very appealing economically.
3. Many business owners want to stay engaged in their businesses. Pure retirement does not appeal to all. The traditional model of working until the magic number of 65 is no longer desirable to many owners who still want to contribute while reducing their time obligations.
4. Government’s role in the economy undermines confidence in the future. In combination, budget deficits, trade deficits, the falling dollar, entitlement liabilities and expectations of rising taxes undermine the confidence of business owners. Will inflation and taxes eat away at personal net worth and the retirement nest eggs in coming decades?
The reaction of some business owners to this environment is to put off transition planning indefinitely. Others sincerely want to sell and move towards retirement, but are unsure how to proceed in the new environment. Some business owners feel the need to tie in the next generation with ownership, but are not sure they are ready to make the full transition.
For these owners we see what we call a “lingering ownership transition strategy.” It works like this:
1. The selling owner(s) begins a process of selling a portion of the business to the next generation with the intent of retaining 10 percent to 51 percent of the company indefinitely.
2. Selling owner(s) continues to work, drawing salary and benefits while transitioning responsibilities of lesser interest to himself to the next generation.
3. Put in place a buy/sell or stockholders agreement that protects the business and is in the best mutual interest of both selling shareholders and the next generation of shareholders.
4. Sellers maintain a flexible transaction structure that allows them to retain some ownership indefinitely, but also a structure that can be accelerated should full retirement be desired. The advantages of this structure for the seller are that it maintains income for the indefinite future, holds exit options open and, locks in the next generation. The owner’s slow exit also provides stability for the organization, less financial strain on the company and, hopefully, a positive mentor for the next generation’s leaders.The disadvantages of this structure include the retention of business risk and the possible under-motivation of the next generation.
This structure could be perceived positively or negatively by the next generation. A negative perception could result from the possible delay and uncertainty in gaining control of the business. The next generation also may not look favorably upon sharing income with a less active, or exiting, owner. If structured fairly, the positive should be in the opportunity for increased ownership and leadership.
The primary key to this strategy’s success is developing and motivating the next generation. Prior to our long national recession, finding top, next-generation talent was already one of the greatest challenges facing leaders. This situation was likened to a “perfect storm” for the construction industry because of three factors that would transform the competitive landscape:
• Industry image
• Changing workforce demographics
• Ineffective or nonexistent recruiting, development and succession planning
It is unlikely that the talent that left the industry during the recession will return. Demographics are still a critical issue as the baby-boomer generation transitions out of senior roles in droves, leaving gaps that cannot be filled by the next generation.
Finally, the recession has forced many companies to cut back on anything discretionary associated with talent development, which has had a major impact on recruiting, employee development and succession planning.
FMI expects more engineering and construction business owners to adopt the lingering transition strategy. Our advice for this strategy is as follows:
1. Objectively plan the financial side of your retirement.
a) Prepare a personal financial statement and make projections for your retirement income needs and desired personal balance sheet.
b) Evaluate the risk you retain in the business. How long will you sign bonds if you are required to do so? What limits can you put on your indemnities? Open-ended personal signatures should be avoided.
2. Take care of your next generation of leaders. Without them, this strategy may not work.
a) Make the deal good for the next generation.
b) Empower the next generation to do their jobs, while monitoring your risk.
c) Commit to leader development strategies including educational opportunities, peer/association affiliations, management planning and personal time with them in running the business.
3. Have a sustainable transaction strategy.
a) The structure for your sale should be a template for the next generation’s future sale.
b) Put in place a buyer/seller or stockholders agreement that is in the mutual best interest of selling and next-generation shareholders while being protective of the company as well.
4. Make your lingering a positive for the company.
a) Transition your responsibilities appropriately.
b) Be supportive of the development of the next generation.
c) Earn your returns on personal contributions and capital invested.
As economic and political volatility continues to impact construction markets, the “lingering ownership transfer” will be a common occurrence.
It takes a significant amount of time to plan and make decisions, but it takes longer to implement the plan for a smooth transition. If the transition is internal, the most likely choice for the majority of owners, you will need to select and prepare the future leaders. Bottom line: Start now.
Brian Moore is a principal with FMI Corp. focused on consulting with contractors and construction materials producers on strategic, organizational and operational issues. Contact at (919) 785-9269 or email@example.com.