Every business must have an ownership structure, whether it is a sole proprietorship, partnership, corporation or a limited liability company (LLC). According to Forbes, the type of ownership form depends on the type of business, how many owners it has and its financial situation. Several of the most important factors to consider include the potential risks and liabilities of the business, the formalities and expenses involved in establishing and maintaining various business structures, the income tax situation and investment needs.
Most smaller companies today, including electrical contractors, become S-type corporations, which do not directly pay federal income tax on their earnings.
“The company is incorporated and has all the liability protection offered by that ownership structure, but the income made is taxed at the shareholder level and is exempt from federal corporate income tax,” said Landon Funsten, principal, Investment Banking Group for FMI Corp., Raleigh, N.C.
Medium-sized and large companies, which are more attractive investments than small electrical contracting firms, share many of the same ownership issues, such as the ability to develop management succession or sell to a third party, and are more able to justify adoption of an employee stock ownership plan (ESOP). There also has been an increase in the LLC form of ownership structure among medium and larger firms recently, according to Funsten.
“With an S corporation, profits and sales can only be distributed in proportion to ownership. LLCs allow the company’s owners the ultimate flexibility to allocate profit and sales proceeds,” Funsten said.
There is a misperception that LLCs do not offer liability protection for the owners. “LLCs have the flexibility of a partnership and the full liability protection of a corporation,” he said.
ESOPs have gained popularity as an ownership structure over the past decade. According to the National Center for Employee Ownership, an ESOP is a type of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, the company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Shares in the trust, which are made on the basis of relative pay or some more equal formula, are allocated to individual employee accounts. If and when employees leave the company, they receive their stock, which the company must buy back at its fair market value. ESOPs are most commonly used to buy the shares of a departing owner, to borrow money at lower after-tax costs or to create an additional employee benefit.
“As an ownership structure, ESOPs create liquidity for the current owners, give everyone in the company an interest in its success and improve the long-term retention of talent,” said Lorne Rundquist, vice president of finance for ESOP electrical contractor Rosendin Electric Inc., San Jose, Calif. Even smaller, more mature firms are examining the advantages of an ESOP structure to provide the second generation of owners the ability to retrieve their investment upon retirement.
According to Francois M. de Visscher, president of the investment banking and private equity services firm of de Visscher & Co. LLC, Greenwich, Conn., tax incentives of ESOPs provide significant advantages for the company and its employees. The annual contributions made by the company into the ESOP are deductible from the company’s yearly taxable income. Annual dividends paid to the ESOP may also be deductible, as long as they are of a reasonable amount. Under ESOP legislation, according to de Visscher, earnings relating to the percentage of stock dedicated to the ESOP are excluded from taxable income, creating additional cash flow savings.
ESOP’s tax benefits, however, have limits and drawbacks. The law does not allow ESOPs to be used in partnerships and in most professional corporations. And, according to de Visscher, private companies must repurchase the shares of departing employees, which can be a major future obligation.
The ESOP program at Lemberg Electric Co. Inc., Brookfield, Wis., was launched in 1992 and has been a tremendous success, according to Dave Washebek, president and CEO.
“If employees have a vested interest in the company, they can see their own economic future secured with the success of the company,” he said.
A normally capitalized electrical contractor with industry standard profits of 3 to 5 percent requires eight to 12 years to fully sell 100 percent interest in the firm, if done internally.
“The vehicle for the sale can be direct to others in the company, through an ESOP or through some other type of transaction,” Funsten said. Therefore, electrical contractors need to think of ways to give young potential future successors the opportunity to bring work into the company, manage it profitability, and be responsible for rehiring and retaining groups of employees. “Basically, carve off a piece of the business, and see if the chosen potential successor can run it,” he said.
Another strategy for developing successors is to mentor them and have them “shadow” the owner.
“Most people underestimate how long this process actually takes. Developing a successor with the raw talent can take up to a decade,” Funsten said. What usually does not work as a strategy for succession is hiring someone from the outside. The market is saturated with talented people already, and since a successor from the inside is already familiar, and comfortable with the company’s culture, operations and strategies, it is more likely that the person will be successful as a leader in the long-term. Plus, hiring someone from the outside might create resentment that grows into an unhealthy dynamic for the company.
Scott Braley, president of Braley Consulting & Training, Atlanta, recommends a five-step approach to succession and ownership transition. The first is to develop an ownership transition plan that addresses how many owners the company will have, how long it will take for the transition to the next generation of leadership, and what the process will be.
“Current leaders also need to ask themselves some core questions, such as, ‘Do we want to be an enduring firm?’, ‘What direction should the firm take?’, and ‘What values will guide the business into the future?’” he said.
The other steps include defining the desired qualities and characteristics of future owners, publication of the transition plan and the extension of an invitation to people to consider being candidates for future ownership, and having an in-house leadership-development program.
“Such a program should include mentoring, introducing potential future leaders to the technical, professional and business aspects of the operation; strategic thinking and consensus building development; and the development of industry-wide relationships,” Braley said.
In family-owned businesses, which many electrical contracting firms are considered, succession is best ensured by focusing on who is most qualified to lead the company into the future, according to Washebek.
“ESOPs are an excellent option to ensure succession because employees will be more attracted to invest in the firm than an outsider might be,” he said. In addition, on paper, electrical contracting firms are not necessarily attractive investments; there are accounts receivable and payable and cash in the bank. However, equipment is depreciated, and employees aren’t obligated to remain if the company is sold.
“And in such a relationship-based business such as ours, key employees can leave with key accounts, leaving an electrical contracting firm purchased by an outsider starting at a disadvantage,” Washebek said.
Although the modern-day complexity of the electrical construction industry does not have an affect on ownership structure decisions, it is having an influence on merger and acquisition activity, according to Braley.
“The complexity of today’s construction industry is changing the characteristics being looked for in the next generation of ownership,” he said.
It is more necessary today for future leaders to be well-rounded generalists with more entrepreneurial drive and a focus on growth, rather than for them to have a deep technical knowledge.
“There’s a significant increase on nontechnical owners being sought because of the diverse market segments electrical contractors today are working in and the diverse types of projects they perform,” Braley added.
Electrical contractors, according to Rundquist, should understand the pros and cons of each corporate structure option as they prepare for their futures and any industry consolidation.
“Ownership structure could affect tax advantages or liabilities when selling the company. Electrical contractors must ensure that their assets and the company’s value to the selling shareholders are protected by structuring any consolidation deal properly,” he said.
BREMER, a freelance writer based in Solomons, Md., contributes frequently to ELECTRICAL CONTRACTOR. She can be reached at 410.394.6966 or email@example.com.