Over the past few years the HVAC industry, like other construction trades, has experienced much consolidation. I know, it’s a “b*tch” to get old. It even happens to the owners of companies!
After analyzing hundreds of acquisitions in the HVAC and electrical distribution industries, my conclusion is that 90-95% of the acquisitions over the past four years have been driven by aging. The fact is that current ownership in many distributors does not have familial next generation working in the business.
It is the fiduciary responsibility of the owner of a family-run business to monetize the business for the family. That’s the hard fact. Their options are sell to a strategic buyer. Sell to management. Sell to a third party who wants to enter the business. Sell to private equity. Another option is to convert a business, and hence “sell” it, to an ESOP and let the company become “employee owned” and hence have the opportunity to leave a legacy, empower the employee (associate) base, while still enabling the owner to financially benefit.
Late last year I saw this LinkedIn posting from 20/20 Plumbing & Heating, which is an ESOP. While they are a contractor, the posting shares their rationale for becoming an ESOP. Coincidentally, at about the same time, Andrew Nikolai, vice president of CSG Partners, an investment banking firm that specializes in ESOPs, reached out and we talked about ESOPs.
One of the takeaways is that forming an ESOP is a strategic decision. You cannot wake up and say, “I want to sell, let me start a process and I can be out of the business in 3-6-9 months.”
As part of a strategic planning process, distributors should consider an ESOP as a viable alternative. It can provide a company a competitive advantage.
Here’s my interview with Andrew.
Is an ESOP Right for You?
Q: There’s been increasing talk about employee stock ownership plans (ESOPs) in the HVACR industry. What’s driving the chatter?
A: There’s been substantial M&A activity in recent years, and lots of companies feel pressure to pursue some sort of exit transaction. Suppliers, manufacturers reps, and contractors are getting calls every day from potential acquirers and private equity outfits. That doesn’t mean owners should feel compelled to act – especially if they have no desire to sell – but it’s hard to block out the noise.
In the meantime, good talent is getting harder to find, teach, and retain. So, you have industry consolidation, rising competition from investor-backed players, and a war for human capital. Companies that value their autonomy and are prepared to bet on themselves for future growth could benefit from new competitive advantages. Those same companies also need to create liquidity opportunities for shareholders looking to retire or take chips off the table.
That’s where employee stock ownership plans come into play. An ESOP sale is an M&A and private equity alternative. Business owners sell at least a portion of outstanding equity to an employee trust, with third-party lenders and/or selling shareholders providing financing. These strategies offer liquidity events for shareholders, retirement benefits for workers, and tax benefits for all parties. Employee-owned companies stay independent and are often well-positioned for the long-haul.
Q: Why should HVACR owners consider an ESOP strategy versus a strategic or private equity sale?
A: Two of the most common considerations are tax-efficiency and legacy. An ESOP can pay fair market value for an owner’s equity. That’s generally the same price a private equity or other financial buyer will pay. However, with an ESOP, an owner can defer and potentially eliminate capital gains taxes on those sale proceeds. That strategy is known as a 1042 rollover, and it can help an owner secure 30-40% more in post-tax proceeds than a private equity sale.
Employee-owned businesses also remain independent – no outside investors, no corporate takeovers, no concerns over employee layoffs. Owners can continue to guide their companies or turn day-to-day leadership over to their management teams. Meanwhile, the ESOP rewards loyal staff. Eligible employees earn stock periodically, and the price of those shares is tied to the business’s value. When employee owners move-on or retire, their shares are repurchased by the company at a current valuation. Those employees can build a meaningful retirement nest egg.
Q: So, does the ESOP benefit help with talent attraction and retention?
A: Absolutely. Employees earn ESOP stock at no cost. On average, ESOP accounts hold balances that are two-times greater than 401(k) balances at non-employee-owned firms. That’s a significant, tangible benefit for both current workers and prospective hires. In competitive labor markets, the ESOP can be a major differentiator.
Because company performance drives share price, employee owners often demonstrate an emotional investment in their companies that matches their direct financial investment. This shift in attitude creates stronger company cultures, fosters job satisfaction, and encourages retention.
Q: Succession planning shortcomings force a lot of HVCAR sales. Many family-run businesses don’t have a next generation waiting in the wings. How can an ESOP help in these situations?
A: ESOPs can facilitate structured exits, management buyouts, and continuous, sustainable operations. An owner who plans to stay with their business for at least three years can sell a minority stake to an employee trust, continue to lead their company, and use the ESOP benefit to attract or solidify a management team.
Once that transition-ready team is in place, the employee stock ownership trust can purchase the owner’s remaining equity. At that point, the owner can retire at their leisure having fully liquidated the business, but with the firm’s legacy intact and loyal employees in charge.
When companies start an employee ownership process with a great group of managers already in place, owners have more latitude to consider a complete sale. In those instances, additional incentives can be built alongside the ESOP to provide a business’s incoming leaders with additional skin in the game.
Employee stock ownership plans can also be used to buy out individual members of an ownership team, such as retiring members of a partnership group or family members who are ready to step away. The tax advantages of an ESOP sale are generally more efficient than traditional buy-sell agreements.
Q: Does an ESOP impact future transactions?
A: All ESOP shares are held in a trust, with a trustee serving as a fiduciary. Trustees aren’t involved in operational decisions and don’t sit on a company’s board of directors, but they do have a say in major strategic events, like an acquisition or a divestiture.
If a competitor makes a compelling offer to buy your employee-owned business, you don’t need to convince each individual plan participant to sell their shares. The trustee acts on the ESOP’s behalf. They have a fiduciary obligation to consider and accept offers that are in the employee owners’ best interest. If an acquisition offer is accepted, ESOP participants become financial beneficiaries of the deal.
Employee-owned companies can also become acquirers – especially once their ESOP sale debt has been paid off. The corporate income tax deductions and exemptions afforded to these companies can help generate significant excess cash flow that can be used for acquisitions. This enables employee-owned companies to grow through inorganic means and create ESOP conglomerates or holding companies.
Q: What is the minimum criteria for a business to become an ESOP?
A: Companies earning at least $3 million in adjusted EBITDA, with 20 or more full-time employees, are generally better suited for an ESOP sale. Companies of that size are more likely to secure favorable transaction financing, maximize the associated tax benefits, and support the costs of building and maintaining an employee stock ownership plan.
Aside from that, think about HVACR companies that are attractive acquisition targets. Recurring revenue related to maintenance contracts or repeat orders helps drive higher valuations. Companies that have demonstrated resiliency in economic downturns are also better positioned.
So obviously, it depends where companies in the industry sit, who they’re servicing, and who they’re selling into from the distributor perspective. But a lot of the underlying factors that draw interest from private equity and strategic buyers also align with good ESOP candidates.
Beyond that, an owner’s motivation and their company’s long-term goals are critical elements to any transaction decision. If there’s no desire to perpetuate a business, shareholders should consider traditional M&A. But if legacy, autonomy, and employee well-being are motivating factors, an ESOP can be a powerful business succession and liquidity tool.”
A little about Andrew Nikolai. He is a vice president of CSG Partners, a leading ESOP investment banking practice. In this role, Andrew builds employee ownership-led succession and exit strategies for middle market companies nationwide. He can be reached at anikolai@csgpartners.com.
Take Away
In speaking with many distribution owners, the philosophy is appealing. The challenge, inevitably, is that most do not consider the concept until they are getting ready to sell … and by then it can be too late.
At the same time, there are others who, in all honesty, do not manage their business with mentoring their team and are hesitant to entrust their business, and their ability to optimize their financial benefits, to others. They have a good, maybe great, management team, but they do not have an empowering and participatory leadership style.
Hopefully the interview dispels some of the myths regarding ESOPs. Andrew is a great resource for learning more.
But for those with the right philosophy, an ESOP can be a great investment for yourself, your team, and your family.
As always we appreciate your insight, comments, and support. Please feel free to contact our Channel Marketing Team with any insight you may wish to share.
