Nobody likes surprises!

Well, I take that back a bit. I know my kids like surprise birthday presents, a surprise ending in a movie is usually nice, and I’m pretty sure my mom likes when I give her a call to take her out to lunch as a surprise.

But I’m here to tell you that surety underwriters, who issue surety credit off of financial statements, definitely don’t like surprise transactions.

The Popularity of ESOPs

There has been a lot of talk about Employee Stock Ownership Plan (ESOP) transactions in the construction community over the last couple of years as contractors look for the best ways to perpetuate their companies. The ESOP transaction has a lot of different structures, with a lot of different scenarios that can play out over time.

ESOPs can be an exciting cultural change for employees knowing they are employee-owned and have some skin in the game. ESOPs are normally a long-term play to help the business push forward, and they give employees an opportunity to run a successful company. This helps with company culture as employees tend to bring an “all-hands-on deck” attitude to their work. So, it’s no wonder ESOPs are becoming a popular topic of conversation.

The Importance of Informing Stakeholders about Your Plan

If your company is planning to form an ESOP, we would advise you not to keep this a secret from the surety company issuing surety credit in the future.

Honestly, your surety company will probably like that you’re working on a perpetuation strategy and actually can be a lot of help to you by bringing a lot of different scenarios of buyouts to the table.

On top of that, your insurance agent can also help you manage the future risk an ESOP may bring to the new structure.

Why Surety Companies Need to Know about ESOP Plans

Sureties look at the three Cs when issuing surety credit to contractors:

• Capital, meaning the statement of financial positions
• Capacity, meaning available equipment and people to execute the work
• Character, meaning the ethical character of the management group making decisions and running the company

Sureties typically like to underwrite off of financial statements that are based on positive working capital and cash flow ratios, along with positive net worth and “in line debt-to-worth ratios.”

A leveraged ESOP transaction can throw off all of these stated ratios and can surprise an underwriter if they are not ready for it or if they are unfamiliar with the new structure.

On a leveraged ESOP buyout, the reduction to equity combined with new additional debt may be concerning to lenders and sureties who are not familiar with leveraged ESOPs. Financial ratios could be impacted influencing debt covenants, etc.

Make an ESOP Game Plan

The best thing to do is work with your insurance agent to lay out a couple of game plans to communicate the path going forward post-ESOP transaction and involve them on what surety capacity will be needed to keep the company running smoothly.

These scenarios may look different based on how leveraged the ESOP transaction is, but having different templates worked out with your CPA, bank, and surety company will help show all parties that the game plan is in place. Putting it down on paper also gives these parties a chance to see how things may look different, but also how all items are accounted for.

Holmes Murphy has been through many stock ownership changes with our customers (as well as with our own employee-owned perpetuation). Communication with the surety company is key to help you reach your long-term goal.

If you need help preparing a buyout template or transaction or if you just want to talk through different scenarios, please don’t hesitate to each out to us.