Why M&As can outdo ESOPs for specialty trade contractors
Owners of specialty trade contractor businesses ready to begin succession planning or prepare for an exit may have more options than they think. Too often, many overlook attractive opportunities to entertain a sale of their business in the M&A market by defaulting to exit strategies built around employee stock ownership plans (ESOPs).
However, changing market conditions have made a potential exit via an M&A an increasingly attractive alternative to consider instead. Selling all or part of your business in an M&A can lead to maximizing valuation, maximizing liquidity and minimizing post-transaction risk while creating exciting opportunities for employees.
Let’s explore some of the key factors you should know when weighing your options.
M&A transactions for specialty trade contractor businesses are increasing
Over the past decade, M&A activity for specialty subcontractors has increased substantially and become a viable option that owners should be sure to understand. 2024 M&A activity for businesses in this industry was more than five times the level the industry experienced in 2016.
Source: Pitchbook
This increase in market activity is driven largely by financial sponsors (private equity buyers and family offices) who are increasingly looking to acquire construction services businesses. This means if you’re preparing for succession or an exit, you have more options than you did in the past.
However, those options have very different deal characteristics that should be carefully evaluated when determining the optimal path forward for owners, employees, customers and other stakeholders.
Why ESOPs can be risky
ESOPs can be a genuinely good solution in some situations. But they come with risks too. For example, let’s imagine you own a roofing company where you’re also the key generator of new business opportunities.
If you decide to exit via an ESOP, your remaining employees may not be able to maintain the business’s existing level of performance. As a result, the company could begin to falter as it struggles to bring in new clients, which creates risks for both you and employees:
- As the departing owner, you’re likely exiting the company with cash worth only about 30% of the overall value of your equity. This means you’re sitting on a seller note post-ESOP transaction for the remaining 70%. You are effectively personally underwriting the company (now without your leadership in many cases) from a credit standpoint, which can become a major risk if the business later struggles.
- The business, now owned by your former employees, needs to maintain a strong balance sheet in order to meet bonding requirements necessary to stay in business.
- From a big picture perspective, subcontracting is becoming a grow or die arms race. A smaller business that’s already leveraged to buy out a departing owner may find it tough to invest in the tools and resources needed to stay competitive.
- Finally, with interest rates unlikely to drop significantly anytime soon, businesses transitioning to an ESOP model may struggle to pay the higher interest on the seller note held by the departing owner.
Why an M&A can be a better fit for specialty trade contractors
For owners looking to do right by their companies, there’s no one-size-fits-all solution. But here are three reasons why pursuing an M&A might be a better solution for your business:
1. Better financial outcomes for the seller
With an ESOP, owners will typically receive a lower valuation for their equity. This is because there’s no competitive bidding process, and the value of the business is typically driven by what a bank is able to underwrite. This valuation is based on historical financials and does not take synergies into consideration.
By pursuing an external sale with the right M&A team, however, you can confidently be sure you are vetting the M&A market to understand the fair market value of your business. With the influx of private equity buyers and large strategic acquirers pursuing opportunities in the specialty subcontractor space, business owners can gain confidence that they are maximizing valuations and also help ensure they are partnering with a buyer who is a strategic and cultural fit.
Owners pursuing an M&A event typically end up with significantly less financial risk post-transaction. M&A deals frequently see the seller walk away with 70%-80% of the purchase price in cash, which can be more than double what a seller gets upfront in an ESOP transition.
2. Protect a business’s long-term viability
As noted above, the specialty trade contractor space is increasingly competitive. This means many businesses require scale to afford investments in technology and other resources needed to remain competitive in an evolving market. Large strategic acquirers and financial sponsors can be strong resources with the expertise, experience and financial muscle needed to effectively make and leverage these investments.
ESOP-owned businesses can be at a disadvantage in this environment. They often simply lack the financial resources to invest in automation, AI and other enterprise-level tech that better capitalized competitors are leveraging to create competitive advantages and grow.
For the right buyer, this sort of investment will often be easier to make. Acquirors in the M&A market often plan to upgrade your business’s processes and systems post-transaction to keep up with the changing marketplace and thrive into tomorrow.
3. Creates opportunities for employees
It may sound counterintuitive, but an M&A exit can deliver better outcomes for employees than an ESOP. Frequently, the assumption is that ESOPs can increase employee loyalty, performance and investment in a company’s work. In some situations, however, a given employee’s shares in an ESOP business can be below a threshold that would truly inspire the type of motivation and ownership mentality that might be expected.
Meanwhile, going to market to find a buyer can create opportunities for employees that wouldn’t otherwise exist. If the new buyer helps improve a business’s growth trajectory, that can create better financial rewards for employees than they’d see through an ESOP that’s struggling to perform.
And while maintaining culture is often a primary driver for considering an ESOP, a professionally led M&A process likely leads you to finding a buyer with cultural alignment who shares your mission and values.
How to decide if an M&A is right for your business
Should you pursue an external sale over an ESOP for your business? The answer may depend heavily on your circumstances. Take the time to get clear on your goals. What do you want to achieve from a potential transfer of ownership?
Consider the financial implications of different exit strategies for yourself and your employees, along with any long-term repercussions for your business. This is a good time to bring in an M&A advisor to help you understand your options and the implications of selling to a buyer versus transferring ownership internally.
The M&A market for specialty trade subcontractors remains strong, and the buyer universe is diverse. This often presents business owners with a multitude of exciting opportunities to maximize value for selling shareholders while strengthening a company and creating meaningful opportunities for the business and its employees post-transaction.
As a business owner, you get to do this once. Thoroughly vetting what exit strategies exist and how they align your goals is paramount.
How Wipfli can help
Wipfli helps specialty trade contractors find M&A opportunities. Our team of sell-side advisors will help you define why your business is valuable, meet with potential buyers and navigate every stage of a deal. Learn more here.
Is an M&A right for your business?
