Succession Planning Increases Bonding Capacity

January 27, 2016

Performance bonds involve a three party arrangement: the Bond Company, the Contractor, and the Project Owner. Risk occurs for the bonging company ("the Surety") when the contractor is unable to complete a project. A replacement contractor must be brought in to complete the project within a specified period of time and the costs to compete the job will rise and be much higher than budgeted. So the surety has greater risk if something should go wrong and the contractor has not done adequate succession planning. 


Construction owners may understand that succession planning is necessary but they are hesitant to implement a plan. Since most contractor owners spend the majority of their lives working, there is the fear of the unknown in giving up what they have created. The Surety, is analyzing risk potential, would want, at a minimum, a continuity agreement in place for key personnel to remain with the company to complete any contracts in progress in case an unexpected hardship (death, disability, divorce, or personal financial hardship) occurs. If a contractor that has quick turning smaller projects has a management completion agreement in place with its key personnel, the surety will look upon this arrangement in a positive fashion. 


Other options that a contractor could implement are as follows:


Transfer or Sale to a Family Member


A common practice in the industry is to perpetuate the Company by the sale or transfer by the sale or transfer of the contracting business to the next generation of the family. If a sale takes place, the surety will need to feel comfortable that any related debt will not severely impact the cash flow of the business, as well as providing sufficient economic benefits to the new owner so that he/she isn't working to merely service the debt. In the eyes of the surety this can only work when the family member has already been actively engaged in the contracting business and that the new owner has been well received by the contracting business community, including other credit grantors. Statistics show that only about 30% of family businesses survive into the second generation. The current owner will need to convince the surety that the family can beat the odds. 


Buy-Sell Agreement


In a multi-owned contracting business, the most common way to transfer equity is through the use of a buy-sell agreement. The mechanism to transfer equity can be in the form of a cross-purchase plan, whereby surviving owners can purchase equity directly, or through the corporate stock redemption, whereby the Company re-aquires the shares. The purpose of the buy-sell agreement is to safeguard the assets against death (usually funded by life insurance), disability, retirement, or withdrawal. The agreed upon value of the business is defined in the buy-sell agreement and is updated by the owners periodically. The buy-sell agreement usually prohibits any sales of stocks to inactive shareholders or outsiders.


New Entity Formation


Under the alternative, a 2nd entity is formed and is owned, either in full or in part, by the next generation or a mix of the old and new owners. Basically, a strong existing company remains in place along the newly created company. The better capitalized older company enters into an agreement with the surety and agrees to maintain a certain level of agreed upon capital to support the bonding of the new entities. This allows the contractor to maintain significant capital in the business for bonding purposes.


The new company contracts all new work. Net earnings for the new company are retained and capital is built in the new company. After a period of time, the new company can stand on its own for banking and bonding purposes and the old company can make distributions of its capital to the old company and owner.


Sureties favor this method since it fosters communication, brings them into the succession planning issue and enables the surety to be a partner in the future plans of the business.


Summary


Failure to develop a succession plan can cost a construction company a contract if the bond for the prospective contract is denied. Begin the process, huddle with your advisors, develop a plan, and execute it. 

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