Protecting Bonding Capacity During an ESOP Transition

For a bonded contractor, an ESOP is more than an ownership decision. The transaction can materially change what a surety sees on the balance sheet, making early planning essential. Chuck Mazzanti sits down with Alan Starks, Senior Vice President – Surety at Christensen Group, to discuss working capital, equity, debt-to-worth, seller financing, management continuity and long-term cash planning. Alan explains how contractors can give their surety team a well-supported case instead of a last-minute surprise. Every company, transaction and surety decision is different. No ownership structure guarantees bonding capacity or approval.

About Alan Starks and Christensen Group

Alan Starks is Senior Vice President – Surety at Christensen Group, where he leads the surety practice. He has worked in surety since 2003 and joined Christensen Group in 2021. His team serves construction companies ranging from first-bond startups to large heavy-highway, vertical and specialty-trade contractors. Christensen Group has been 100% ESOP-owned since 2006. That gives Alan the perspective of both a surety professional and an employee owner who has seen how a well-run ESOP can support stability, shared ownership and continuity. Meet Alan: https://www.christensengroup.com/team/alan-starks

What We Covered

How an owner’s goals around liquidity, legacy, community and employees shape the succession conversation
Why a heavily bonded contractor should treat its surety program as part of both transaction planning and company value
How ESOP financing can change reported equity and leverage, and why working capital, equity and debt-to-worth remain central underwriting considerations
How bank financing, seller notes, possible subordination and, in some transactions, limited personal indemnity may affect the surety structure
Why management depth, leadership runway and retention of key employees matter to an underwriter
How post-close balance sheets, cash-flow forecasts, debt-service schedules and downside stress tests help answer the surety’s “what if” questions
How mature ESOPs can prepare for repurchase obligations without allowing growth to consume liquidity needed for future commitments
Why an ESOP-owned contractor should deleverage, model an acquisition and discuss surety capacity before closing an M&A transaction
When a contractor may need to pause or reconsider an ESOP because of management gaps, inconsistent cash flow or insufficient financial capacity
What advisers can accomplish with 10 to 15 years of planning compared with a 90-day fire drill
Why the surety agent, banker, tax adviser, ESOP team and lawyers should communicate before the transaction documents are written

Key Takeaways

Bring the surety team in before the deal is documented. A longstanding carrier that understands the contractor, its leadership and its history has more context for evaluating the proposed transition.
Protect liquidity and support the request with numbers. Working capital, debt-to-worth, post-close cash flow, debt service and downside scenarios all help the underwriter understand how the business can perform after the transaction.
Financing structure affects the underwriting view. Seller-note subordination or limited personal indemnity may be considered in some transactions, but those tools can leave the seller with continuing risk and do not assure bonding approval or capacity.
Management continuity can strengthen the case. Sureties want to see experienced financial and operational leaders with enough runway to carry the company forward.
Cash discipline matters long after closing. Mature ESOPs need to model repurchase obligations, maintain liquidity for uncertain timing and balance growth opportunities against future commitments.
An ESOP is not automatically the right fit. Consistent cash generation, management depth, sufficient scale and an aligned advisory team should support the ownership strategy.

Full Transcript

Alan Starks: I’ll remember this forever, that I’d go to their office and they had, whatever at the time, 300, 350 employees in a small town. And when I’d ask how the year went—maybe it was a tougher year—he wouldn’t tell me; he’d tell me what the P&L said. But he says, “You know what’s more important, Alan? I put food on 300 families’ tables every day for the last year. And that’s more important to me than what you’re going to tell me, you know, I did or didn’t do right on my P&L.” And again, those are the type of people that, you know, tend to own construction companies and build them, is have that type of mindset. And then the ESOP, like, you know, that’s the type of guy that ESOP works perfect for, where he’s just proud that he’s providing a living for all these people in town.

Chuck Mazzanti: Welcome to the Construction ESOP Collective. I’m Chuck Mazzanti, Senior Vice President at Christensen Group Insurance, and this is the show where we explore the wins, challenges, and real-world lessons of employee ownership in construction. Each episode brings insights from CFOs, former owners, and employee owners who are building something bigger together.

Chuck Mazzanti: Today I’m joined by someone I have the pleasure of working alongside every day at Christensen Group: Alan Starks, our Senior Vice President of Surety. Alan brings a unique perspective to this conversation. He works alongside ESOP-owned contractors in his day-to-day, along with being an employee owner himself. We break down how surety companies view an ESOP transaction, why early communication and planning matter, and what contractors can do to make sure their bonding program doesn’t skip a beat as ownership changes. Here’s my conversation with Alan Starks.

Chuck Mazzanti: Alan, great to have you on the Construction ESOP Collective. Alan Starks: Thanks for having me, Chuck. I appreciate you having me on here.

Chuck Mazzanti: Yeah, no, it's great. A little bit of background for our audience: It's Alan Starks. He's our head of surety and bonding at Christensen Group Insurance, so he's a teammate of mine. I'm a little biased, but I think you're the best in the business. I'd like to give the audience a 10,000-foot overview of who you are, why you're at Christensen Group, and why you're passionate about surety and bonding for our ESOP contractors. Alan Starks: Absolutely. Like Chuck said, I'm Alan Starks, Senior Vice President and Surety Practice Leader here at Christensen Group in our Eden Prairie office. I joined Christensen Group about five years ago, in the spring of 2021, after the agency I was at had some transitions and we all became free agents. By a lot of dumb luck in my life, I happened to own my own book at that time and connected with Charlie. Charlie was looking to start a surety practice, and I happened to have a bolt-on surety practice that was able to come in. That's why I'm at Christensen Group. The value of the ESOP that Charlie presented to me was one of the big factors in doing that.

Alan Starks: I've been in the business since 2003. My father got me into it at that time. I didn't know what I was doing, but back in those days surety was pretty easy, and there was a lot of golf and beer drinking going on in the surety business. As a 27-year-old kid, I said, “This seems like a great, great job.” Then 2008 came, and I learned that we actually had to roll up our sleeves and do a lot of work in the business. I've been doing it for 23-ish years now. Alan Starks: Since we've been at Christensen Group, we've built out the team. I brought my team from my prior agency with me. There were three of us in the department then besides me. In the last year, we've added two more. With the growth at CG and our handling all the different offices and markets we're in, we've been able to put on a couple more employees and allow me to spend more time with clients and with the other producers here who bring us into deals.

Alan Starks: That's the big overview, I guess. Depending on the day, we have 18 to 20 different surety markets we're working with here, so we get a broad view of the surety-underwriter marketplace from the construction side that contractors work with. We've got a little bit of everything. Because we're based here in Eden Prairie, I brought a large book over with us. Most of our clients are in the Minnesota, North Dakota, and South Dakota area. We have done surety work in the Kansas City, Texas, and Chicago offices as well, but a large part of our book is still fairly Upper Midwest-based.

Alan Starks: We're pretty evenly split between heavy-highway and vertical contractors, with trades on each side. It's a pretty spread-out book, from some pretty large contractors in all the spaces doing $300 million to $400 million, down to a mom-and-pop starting a shop on day one who knew us through their prior employer. We helped them with the first couple-hundred-thousand-dollar bond they'll ever need. We get a good view of the market. I guess we don't handle some of the jumbo-jumbos, but other than that, we see a little bit of everything here.

Chuck Mazzanti: Yeah, no, that's awesome. I can vouch for the team. It's one of the best in the business. I've been at some of the biggest brokers in the world, and the white-glove service you and your team give every client—not just the jumbos, but down to the startups—makes a big difference. Chuck Mazzanti: Before we get into the specifics of surety, ESOPs, and all that, we're unique in the sense that we've been 100% ESOP-owned since 2006. If you wouldn't mind, tell me what ESOP means to you, what it's done for you and your team, and maybe the difference it's made in servicing your clients.

Alan Starks: Yeah, and I'm going to go back a little bit to the prior agency I was at. They were a partial ESOP, so I had what I thought was knowledge of an agency ESOP then. When I came over here and Charlie presented the ESOP to me, it was part of our decision to come here, but some other things really drove the bus. I said, “Yeah, the ESOP is great,” but I'm coming here because of the value we put on our clients at Christensen Group. We have our three Cs, and our clients are one of the main things we focus on here.

Alan Starks: But now, after being here for five years and seeing how a well-run ESOP works, it's amazing what that provides to the team and to all of us who work at Christensen Group. Having somebody like Charlie Christensen who runs that—and that's his passion—provides value to all of us: stability in our retirement and stability in the company, knowing that we won't have something come from left field one day and all become members of a different organization we didn't know was coming.

Alan Starks: The stability and financial security are great, and I don't want to make light of the financial security it provides us. But it's more stability across the board. Knowing that we don't have one group of owners here that can make a decision, that you and I, Chuck, are equals, and that our support staff are equals in decision-making in this agency is huge. I think we feel that in the culture: We're all bought in. The bad example is that the receptionist has just as much power as you and I do, Chuck, and I love that. Once they're given their ESOP shares—they've been here a year and are getting ESOP shares—we're all the same here. We're all pulling in the same direction.

Alan Starks: I don't know if you've talked about it on your other podcasts, but our ESOP party is just an absolute blast. You get to see everybody we work with every day. Again, this goes more to the financial side and the financial lift. Some people, if they've been here a long time, are getting a lot more money than they ever thought they'd have in life in just one year of that lift. That's really cool to see across the agency. Chuck Mazzanti: Yeah, it's hard to believe, but we're, what, two weeks out from our annual ESOP gala? I'm pumped for that. Well, thanks, Alan. The next thing is I'd like to put the audience in your shoes. You're talking to a client or prospective client, and they say, “Hey, Alan, we're looking to have an exit in the next five years or 10 years.” Or maybe they're saying, “Hey, we want out in the next year, and we're thinking about going ESOP.” What are the first few thoughts you have when you hear that?

Alan Starks: I'm going to change the question a little bit there, Chuck. Usually, I get brought into an exit strategy way before there are any firm plans. It's, “Hey, five years from now, I want to exit. What's the story? What's the best way to do that?” Then it gets to their goals. If they're just looking for a financial transaction, to get all the chips off the table, get the max, and get some big dump truck full of cash coming in the door, most likely they're going to go the PE route.

Alan Starks: We've had very few of my close clients go the PE route because most of the entrepreneurs in my book—and, I think, in most of CG's book on the P&C side as well—either took over a company from a family member and grew it or founded it themselves. When you talk to those business owners, they don't want the dump truck full of cash and to disappear into the sunset, move to Florida, and never think about their company again. In construction especially, these entrepreneurs have put their blood, sweat, and tears into it. When we start having these exit discussions, we're talking about legacy and all the different things they want before we get to the financial piece.

Alan Starks: When we sit down with somebody and they say, “In retirement, I want to drive my grandkid over to the shop, kick some tires, have coffee with the guys, still be able to show up, and have everybody know who we are,” that's the legacy they want. They want to see the name of their company driving down the road and point out to the grandkids, “That's us. That's what I did.” Alan Starks: When you have that mindset, we start talking about whether we're transitioning to family members, managers, the next generation in one way, shape, or form, an ESOP, or whatever the next way to do it is. Especially if you don't have close family members involved, you don't want it to look like you're giving one or two people a handout. That's where the ESOP conversation starts to make a ton of sense: “These X number of employees got me to where I am today. I want to transition to all of them. Let's look at the ESOP route.”

Alan Starks: Again, it's about the values, and there needs to be a desire for a legacy transaction because you're going to have a little bit different transaction than you would with a PE firm that just backs up the dump truck and dumps the money. They're going to change the name a year later, and you're not welcome to come sit in the shop with the mechanics, drink coffee, and tell the stories you like to tell. That's a big piece of it to me. The first step is creating that mindset of what you want the future to look like.

Alan Starks: A lot of my clients think they want the big PE transaction. They're sitting and drinking coffee with their other construction-owner friends, and probably one of them had a PE transaction. They want to be able to brag that they got X amount of dollars. When you sit down and break down with them what they're going to do with X amount of dollars, that's where they start to struggle. It usually turns into a legacy-type transaction. These are guys who didn't live big lifestyles and have put every dollar back into the business. Even if they had all the money in the world, they're probably not going to change their lifestyle.

Alan Starks: So what means more to them: being able to say that they got X amount, or what they would do with the money? Do they want to start scholarship funds for their legacy? Do they want to give to the church? Do they want to give to an organization? The reality is they're going to have more money than they ever thought they needed. If we can go the ESOP route, give them a really big valuation that's close to that same valuation, and get the legacy piece to it, that's when we get the ball rolling on what makes sense to that entrepreneur looking at the exit. Chuck Mazzanti: Yeah, you bring up a really good point about being able to go back to the shop, share that with the grandkids, and go over with your dog. Even though you sold the company within an ESOP, you're still part of it. To your point, Alan, I think if you go PE, maybe you get a really hands-off buyer, but oftentimes it's their company. After a year, two years, or three years, when the earnout's done, you may not be welcomed back.

Chuck Mazzanti: It's funny—I was at the NCEO conference two weeks ago, and one of the panels was about M&A in the ESOP space. They said, “Listen, we can't sell to PE because we won't be able to go to the grocery store or the local diner,” because they were so prominent in their community. The legacy means so much more than just your own family to a lot of these contractors. The construction business is also so built around your employees. If you don't have good employees and a labor force, you don't have a company. Chuck Mazzanti: I'm never going to argue for a founder or a multigenerational construction firm to take a haircut. It's their business to do with as they please. But I think a lot of people are surprised that when you go ESOP, you can get damn near close to the money you would ever need or want. Then there are a lot of legacy things it solves that other exit strategies just can't.

Alan Starks: Yeah, that's a good point about the diner. One of my biggest clients with employees—I'll remember this forever—had, at the time, 300 or 350 employees in a small town. When I'd ask how the year went, maybe it was a tougher year. He wouldn't tell me what the P&L said. He'd say, “You know what's more important, Alan? I put food on 300 families' tables every day for the last year, and that's more important to me than what you're going to tell me I did or didn't do right on my P&L.” Those are the types of people who tend to own and build construction companies. They have that type of mindset. An ESOP works perfectly for that type of guy, who's just proud that he's providing a living for all these people in town.

Chuck Mazzanti: Yep. No, I couldn't agree more. What about from the surety underwriter's point of view? You're having this conversation with your clients or prospective clients, and you're part of the planning—you're integral to that process. But now we need to make sure it's served up to the surety market in a way that doesn't make them get skittish or scared. For a lot of our contractors, especially heavy civil, it's all surety-backed business. What are you doing from that standpoint to educate our clients, but also make sure our underwriters really understand ESOP so it doesn't become a deal breaker or a big bump in the road for contractors looking to go ESOP?

Alan Starks: There are two pieces of this. Surety 101, from a surety-underwriting standpoint, is that surety is an indemnification product. It's not insurance. If there's a loss, we look to have assets to indemnify the loss. That's been the basis of surety forever. When a surety is underwriting a balance sheet, we want equity and working capital there. By definition, when we do an ESOP transaction, that balance sheet is going to flip, and you're going to have negative equity because we're going to be using a multiple of book value. The sale price is going to be based on a multiple of something other than just pure book value, so we're going to create some negative equity in that transaction.

Alan Starks: We have to show the surety that there will probably be some support from the seller in this situation on the notes. We can subordinate that. There's probably some portion of the financing that's bank financing and some that's a seller note. If the seller is willing to leave some chips on the table in the form of that note—saying they're not going to take that money out unless the surety is okay with it—then the surety is going to add that back to the balance sheet and create positive equity again. Then the surety will have equity on which we can base a surety program.

Alan Starks: In our world, we're going to fight and say that working capital is more important than equity, but we still have to be in a position where the surety has some assets it can base its case on and go after. As we'll get into more throughout the discussion, one piece we want to educate sellers on if they want to go ESOP is that, just like in a legacy-type transaction to a next generation—family or non-family—there's going to have to be some help from the seller.

Alan Starks: They want to enter this transaction maybe a few years before they really want to have all their chips off the table, because they want to project when the chips will be off the table and when they'll get all their different risks off the table. If we want our risk off the table five or seven years from now, we should probably start that legacy or continuity down to the next generation—or into an ESOP—sooner rather than later. Then they can still hit their de-risking in that same time frame, or try to hit that goal in that same time frame. Chuck Mazzanti: Okay, yeah, that makes sense. Is there anything you're discussing with our clients or prospects in terms of different financial metrics or ratios and so forth that you want them to uphold, or to start getting all their ducks in a row, so to speak, before we start talking to the surety underwriter?

Alan Starks: The biggest piece, especially if we're looking at a transaction of any type here, is making sure working capital is going to be a strong case. Again, Surety 101: You want a 5% working-capital case—or, working backward, 20 times your working capital as your maximum aggregate program. That's the first number to start with. We've got some moving pieces around equity and subordination, or however we're going to work through it. Every ESOP transaction is different: what portion is a seller note, what portion is bank financing, and what we have to work with to create some equity through different metrics. Working capital is going to be a true number.

Alan Starks: We want to make sure we're maintaining that. We're going to want the ESOP advisors, the banks, and everybody giving us good pro forma numbers to say, “Hey, this working capital needs to be here.” The next big number we're going to look at is debt-to-worth, especially if we're talking about our civil contractors, where they most likely already have some leverage on their equipment. We want to make sure that debt-to-worth doesn't really go above four- to five-to-one. If we do go above that, we need a quick plan in place to bring it back down, and we don't want plans to go out and acquire a bunch more new equipment that's heavily leveraged, or whatever it may be that we can work through.

Alan Starks: The equity number is one we can manufacture a little differently through subordination and other ways. But we really want working capital and debt-to-worth to still fit within the Surety 101 metrics and probably be a little stronger than we'd normally want because our equity case might not be where we would have it. Then we put the game plan together for how we're going to get the equity to that normal standard metric, and we can start really ramping the surety program from there.

Chuck Mazzanti: Sure. No, that makes sense. Alan Starks: So I guess, to sum it up, Chuck, we're looking at working capital, equity, and your debt-to-worth. I could talk about a lot more surety metrics, but those are kind of the three big ones, I think, in any transaction we're going to do. We want to focus on making sure that, hopefully, two out of three of those are really healthy to overcome one that might be weakened by the transaction.

Chuck Mazzanti: Well, and one of the big C's that surety underwriters are looking at is character. Chuck Mazzanti: So I would argue that, for everything we've already discussed in this podcast, character is being highlighted by ownership choosing to go ESOP and caring about their employees, and by being able to stay around in some shape or fashion and have an ongoing connection to the business. Because in a PE deal, outside of an earnout, if they sell and they vanish, a lot of times those owners are integral to the future of the business, with relationships with customers and the community and so forth. For some of the perceived negatives of going ESOP as it pertains to surety—which I think are, in large part, going away with proper planning and communication—I would say one of the biggest obvious benefits would be that character piece of it in a sale.

Alan Starks: Yeah, I agree. You've got the character of the ownership, but you also have a better chance of keeping your top managers around, along with foremen, superintendents, and all the important pieces. It's much more likely in an ESOP transaction than in a PE transaction. Like you said earlier, at the conference you were at, the guy said, “You don't want to go to the supermarket anymore.” Yeah, because all those guys are looking for a new job when the PE transaction happens. They know there's a change in culture.

Alan Starks: The positive of the ESOP transaction is that the character and culture of the organization stay the same because we're not bringing in new blood. We're not bringing in new people. We're letting the people who are already there—the people who made the seller successful—run it. What more could we want as a surety underwriter than to know that the exact same people are running the ship? We don't have some PE firm that could come in and grab a bunch of cash one day, when the cash goes up, to use it somewhere else. It's all the top people who made it what it was for the last 20 or 30 years; they're taking over.

Alan Starks: In my mind, that's what I want in a transaction: to know that the people who made it successful are still there. Again, we can't promise anything in an ESOP transaction, but there's a heck of a lot better chance they're sticking around than in a PE transaction. Chuck Mazzanti: Yeah, I agree 100%.

Chuck Mazzanti: We've covered our internal discussions with customers and prospects pretty well—getting them ready and making sure that their metrics and all those sorts of things are in line. Now let's cross the barrier into your conversations with our actual surety underwriters. What are a couple of things you would like ESOP contractors, or prospective contractors looking to go ESOP, to know? What are we hearing from our underwriters in terms of the questions they're asking, the scrutiny they're putting on certain things, and so forth?

Alan Starks: It's going to come down to sophistication. If you're going to be doing an ESOP transaction, just to get to that point, you're going to have to be a fairly sophisticated contractor to deal with the valuations and all of that. Your accounting department needs to put together sophisticated pro formas for post-close, day one: what the balance sheet looks like after the ESOP transaction. It's also about forecasting cash flow, all the debt service you have to pay as you get down the road, and the future obligations for when people retire and you have to buy out their shares—the repurchase obligations.

Alan Starks: It's showing that sophistication: that you can look forward, prove this out, and do some stress testing to say, “Hey, if this happens and it's not the perfect year, we still have this covered.” It's showing the underwriter that you have plans A, B, C, D, E, F, and G for cash flow, because cash is king in any business. Alan Starks: So it's showing the underwriter, “Yes, we're going to do this. Yes, the balance sheet looks a little different, but here are all the steps we've taken to show that this isn't riskier than we were before.” I think the big keys are transparency, communication, and being sophisticated enough to put together all the projections they're going to want to see—and to show them you've already stress-tested those projections. Show them you already have backup plans in place.

Alan Starks: Whatever it is—for example, if you have a reduced bank line because of this—you can say, “We've already had conversations with the seller. If we need a backstop, are you willing to put a million back in for the short term to allow us some cash flow for startup costs? For a heavy civil contractor in the North here, we're seasonal. We have a lot of startup costs. Are you willing to give us a short-term, seller-financed line of credit to get us up and running and mobilized for the year?”

Alan Starks: It's getting way out in front of it. The surety is going to want to ask, “But what if this happens?” If you can immediately tell them what your plan for that already is, that's where you're going to get that conversation on a really good path, because it sounds like you've already thought through all the questions the underwriter throws at you. Chuck Mazzanti: One hundred percent. I call it the Eight Mile approach, right? If you can confront the objection before they even have it, it just goes so much more smoothly.

Chuck Mazzanti: And so that's more from the lens of going ESOP. You touched on the ROs, or repurchase obligations. You flip the balance sheet and you've got a bunch of debt, but now, in most cases—especially if you go 100% S corporation ESOP—you've got no federal income tax. In most cases, you don't have state income tax. So you have all this excess cash flow to pay down the note and start looking really profitable. Chuck Mazzanti: But then you become a mature ESOP. Fast-forward seven, eight, nine, 10, or 11 years down the road, and some of the people who have been with you and benefited from the ESOP growing may want to exit or retire, and you have these repurchase obligations. So there's potentially a new financial stressor, and you don't necessarily get to choose when people retire. If 2008 happens again, you've got the cyclical nature of the business, and that is a true peril. Could you talk us through how you get existing ESOP contractors ready so they don't have a bump in the road with their surety as they go through the ESOP life cycle?

Alan Starks: Yeah, great question. Moving to the mature phase, hopefully we've had good cash management through those good years, because the reality is that repurchase obligations, from a heavy cash standpoint, aren't going to happen for 10 or 15 years down the road. By then, the value of each individual's shares has really grown. So now it's about being a good steward of the ESOP. You and I are lucky enough to listen to Charlie talk around here, and I don't think we could ask for a better steward of our ESOP than Charlie.

Alan Starks: For a heavy civil contractor, it's making sure we don't get yellow iron fever three or five years into this when we pay off—actually, I guess we should talk a little bit about the cycle of the ESOP. You do it, you're debt-heavy, and you're leveraged. You're getting a lift because of the no taxes. In the first three to five years, you're really focused on paying down that debt to deleverage the ESOP. Then that five-to-10- or 12-year stretch is when the ESOP really starts kicking, and you're able to hold that free cash flow.

Alan Starks: It's making sure you use that extra cash in a good way and don't get yellow iron fever. We want growth because growth helps the ESOP, so take a conservative growth trajectory, but don't get too crazy and eat up all the free cash flow that comes after you've paid off the debt. Make smart growth decisions during that time and put cash away in the right spot. Use good analytics to model when the ROs are going to come up, while knowing that sometimes you can't predict it. Someone could get run over by a bus one day. Someone could have a health issue and retire early. You can't predict that. But make sure you've got rainy-day funds set aside for those ROs when necessary.

Alan Starks: Again, it's that sophistication. There's a sweet spot, I think, for contractors that go ESOP. You have to be at a size where you're going to create enough cash flow once the debt is paid off to start squirreling some away, be a steward of it, and make sure everyone knows that cash has a future need. We can't run to a new market and take on some risky work that might make us claw back that cash until we get the piggy bank set up for the repurchase obligations. Once that's healthy and we know we can cover our repurchase obligations in the future, we can get a little bit more risky.

Chuck Mazzanti: Yeah, I think that outlines it perfectly. Alan Starks: And again, be transparent with the surety. Show the surety what analytics you're using to project your ROs and all the different things that are there. It's having an open, transparent relationship with your agent and the surety. I view surety relationships as a marriage. Most of my clients have been with the same surety for 30 years. When you go through a transaction like this, you hopefully want to stay with the same surety—the surety that's seen you during the good years and knows why you're a great candidate for an ESOP.

Alan Starks: Hopefully that surety and the underwriting team can back you on this, because that's going to give you a lot more rope. That's where the marriage analogy comes in. I preach this all the time to our clients: like any 20- or 30-year marriage, there are some ups and downs. There are times when each one is mad at the other, and that's okay. This is one of those times when you can say, “We've shown you for 20 years how outstanding we are. We want to do this to make us even better for the future. Will you buy into it?” If you've got that good relationship with your surety, they should be really open to this—

Chuck Mazzanti: Yeah. Alan Starks: —conversation. Even if, as a whole, they're not a big fan of ESOPs, if you're open with them and have them involved in the process, you might be able to get them behind you and keep that same surety. It's going to give you a little bit more capacity when you need it during the beginning phases, because they've known all the key people and all the other things involved.

Alan Starks: I stick to my guns on this. A lot of my biggest clients have had the same surety for 30 or 40 years. We have our tough times. We talk about whether the grass next door looks a little bit greener, but is it worth giving up the positives we have with that long-term relationship with a surety? Chuck Mazzanti: Yeah, I think continuity in all business relationships is important. That's not to say you're not going to stress-test them. You want to make sure you're competitive in the marketplace and no one's getting fat and happy. But to your point, everyone has ups and downs, both on the surety-carrier side and the contractor side. I think the best business relationships are the ones where both sides have gone through bumps and they've stuck it out. Then, when the next bump happens—because it's going to happen at some point—they already know they can trust each other, and they're willing to go out on a limb rather than just being transactional. The ESOP sale is so nuanced that, if that's your approach, it'll be paid back in spades.

Alan Starks: Yeah. Again, it's everything we've discussed: transparency early in the process with your agent and your legacy surety—your current surety—is the big key, along with bringing everybody in early so they know what stress you might be looking at. If you're a heavily bonded contractor, part of the value of the company is in the surety program. If you sell it, whatever the transaction may be, and there's no surety program left, it's not worth as much as it is if you sell it and there's a massive surety program in existence.

Alan Starks: That's one of the things sellers have to get their heads around a little bit. They're probably going to be part of the surety process, whether that's subordinating the note or maybe personally indemnifying a limited part of it for a little while. But the risk they're still taking is getting them significant value in the sale price, because they're allowing that contractor to maintain essentially the existing surety program, creating the profits and cash flow needed to pay off the debt.

Chuck Mazzanti: Right. One hundred percent. We touched on the more mature ESOP, repurchase obligations, and some other stressors. A big topic in construction right now—I was just at a CFMA event yesterday on M&A in the construction industry—is, “If you're not growing, you're dying.” A big, powerful piece of a mature ESOP is all that free cash, and they may want to go on an M&A spree and use the story: “Hey, if we buy you, we're not going to strip everything out of the company. We want to keep your employees, and we want to give them the added benefit of being employee owners now,” while also helping grow the construction company.

Chuck Mazzanti: That's a huge recruiting tool. All things being equal, you're an owner now and we're going to pay you a similar wage. For your concrete guys and gals in the field, that could be a tiebreaker. So what are the surety implications for an ESOP-owned contractor that's now looking to make an acquisition? Is there anything you could impart to help empower them to get their surety house in order and then make the acquisition, versus making the acquisition and then realizing that could…

Alan Starks: Yeah. We’ve got to tell somebody about the acquisition we just made and build that in. Again, it’s the transparency piece, and it’s making sure you’re in the right spot—that you’ve gotten through deleveraging your ESOP transaction. That’s the first step. You probably don’t want to go on an M&A tear until you’ve really taken care of the first piece and gotten the debt paid down. Talk to your agent and the surety: “Hey, if I do this, do I have the capacity from a surety side to add this on in general?” Chuck Mazzanti: Correct.

Alan Starks: And then, again, make sure that your analytics are perfect, so you still have your cash to the side for the repurchase obligations. It’s making sure you’re sophisticated and you’ve got the right people in your accounting department who are really looking at all the different angles on this and showing your surety why this all makes sense—and that you’re not putting too much stress on that balance sheet while you do this. Try to build in a pro forma: “Okay, if we add this in, what does this provide in new cash flow for us from a profitability standpoint?” So again, I’m going to sound like a broken record here: transparency and openness, and getting ahead of it well before you make the transaction. It’s never good in the surety space when you call your agent, or your agent calls the surety, and says, “By the way, this just happened a week ago, and it’s a big deal.” If you’re leading up to it and everybody knows about it, it’s like, “Okay, they closed on that deal. We all know everything about it. We’ve already got a little performance.” It’s a non-event at closing. That’s the key. Sureties—we live in the surety world—we’re still about 20 years in the past. We just don’t like surprises. We still move pretty slowly, and we don’t like to get the phone call that something major happened to the balance sheet that nobody knew about leading up to it. So that’s the big key: just transparency and communication.

Chuck Mazzanti: Yeah. It’s not like a surprise birthday party that’s good. Surprises in the surety world—it’s a bad word. Alan Starks: Yeah. Birthday parties and surety underwriters don’t go well together. They’ve got their day all planned out. They don’t want anything throwing a loop into their day.

Chuck Mazzanti: Correct. So I don’t want it to sound like we’re trying to pitch that ESOPs are the be-all and end-all and the only way to go. ESOPs are intricate decisions, and there are a lot of pieces to the puzzle that have to be lined up. It’s just not right for every single contractor. So I’d like you to touch on when, in your professional opinion—as both part of an ESOP organization and from your seat in surety—a contractor should hit the brakes and say, “Hey, maybe we want to go ESOP, but we’re just not ready for it.” And also, when is it just not the right fit and maybe they shouldn’t go the ESOP route?

Alan Starks: Yeah. One of the things we touched on a little bit earlier, but the big key to getting a green light for an ESOP is that your management team is in place, is really strong, and has a long runway. They’re not all—hate to pick on ages—they’re not all 63 years old and looking to retire in two, three, or four years. We’ve got a runway of high-level people at staggered ages who are going to be able to run this for the next 20 years, and we’ve identified those people. If you don’t have great management—financial, operational, in every different sector—and maybe you’re missing one piece of that, that’s fine. Every business has its different pieces where maybe it’s not clicking as well as you want it to. Maybe you want to tap the brakes until you find the right person to sit in that seat on the operations side, the finance side, or whatever it may be. Then you can say, “Okay, maybe we get the right person in that seat, and then we can move forward with it a little bit more.” I think that would be making sure the pieces are in place from that side of it, because that’s the underwriting. Number one, as a seller, you need this to be successful on the back end because you are going to have some sort of seller’s note or options, or however you want to—whatever terms the lawyers put into it—you’re going to have some risk still there, and you want to make sure you get your full value out of the company. Secondly, that’s what we surety people are looking at: Do we have the people in place who have been there for a while, who know how to run this, to keep it going the way it is? If maybe you just had some key people retire and you’ve got some really green people there, maybe we tap the brakes and wait a couple of years. When those people have shown they really are the right people there, we can move forward with this conversation. To your no-go question: if you’re a little bit too cyclical in your P&L every year, and if you’re in a business with too many ups and downs—one year you hit two home runs and make just a pile of cash, and the next year you have a couple of clunkers and lose some money—you really want a level cash flow for the ESOP to work. And I think you have to have some mass from it. You and I have talked before. I think you want to be making a couple million dollars of free cash flow a year, whether we call it EBITDA or whatever term we want to use. We want a couple million dollars of free cash flow so we can really get that lift from, like you said earlier, Chuck, not having to pay the corporate taxes for the U.S. or possibly our state. On $2 million, we’re probably talking about roughly $800,000 that we’re creating in free cash flow. Now we’ve got enough mass from a cash standpoint to start paying the attorneys, all the TPA costs, all the valuation—all the stuff that comes with an ESOP, where you’re adding another line item on your P&L that you didn’t have before—and we can absorb that and still move forward. Or maybe you’re not quite there yet and you want to do the ESOP. Maybe your focus for the next two or three years is growing the business to get there. Or, if you have a cyclical business because of the economy in general and your top line goes like this, maybe you look at diversifying it and filling in this gap so you can be a little bit more consistent. If you’re just in a risky type of operation that has some home runs and some clunker jobs every once in a while, that one’s harder. Maybe you dive into your estimating to say, “How do we try to get rid of some of these clunker jobs and bring that up so we can try to level it out?” In some industries, it’s just not possible. You’re going to have the home runs and the clunkers. That’s the risk-reward basis, and that’s why there are home runs—because there are clunkers in there. Maybe they’re just not the perfect fit for an ESOP when they have years in which they tend to lose money and they’re not able to really take advantage of that free cash flow.

Chuck Mazzanti: Yeah, I think that’s a good point. It’s redundant, but I think it’s by design, and that’s okay: planning, preparation, and transparency help ease the transaction of an ESOP. To that point, you have the home runs out of the gate. There’s one—I won’t name-drop them yet; hopefully they’ll come on the podcast—but there’s one local to you, Alan, that’s a billion-dollar civil contractor that just went ESOP. That’s a home run: great namesake, great business, great reputation. Then there are the clunkers that don’t want to change the business model, and don’t force it. There’s another avenue to have a succession plan, and an ESOP probably isn’t part of that. Then there’s the stuff in the middle. If they can have the right advisory team, from a surety broker to an attorney to all the different advisors, the more time you have, the more benefit you can get—ESOP-ready and get your bond line ready to absorb an ESOP transaction. If you have five or 10 years and say, “Hey, we’re looking to make the transaction at that point,” then you can start steering the ship in the right direction and smooth out any bumps. If you’re doing a fire drill trying to sell—whether it’s ESOP or otherwise; I don’t care—in a year, you’re just going to cause yourself a lot of unnecessary heartburn.

Alan Starks: Yeah, I think succession planning in general needs to be thought of all the time. My dad, who was really brilliant, would always ask—we always knew what the next succession plan was—but he always asked, “Well, what’s the one after that?” He could have been 25 years old, but he wanted to get them thinking about it. Again, there are a lot of different ways to skin these cats, and decisions don’t have to be locked in stone. But the more you can have people advising you—“This is your goal”—we can help a lot in a 10- or 15-year process by steering you in little ways in that direction. If you’ve got 90 days to work on it, well, there’s not much steering we can do in 90 days. It is what it is. You either get it done or you don’t. That’s kind of where we’re at in a 90-day process. And that’s our job as your advisers on the surety side—talking to you. We shouldn’t be surprised when you are ready to exit. If we’re surprised when you’re ready to exit, then we haven’t done our job for you either, because that should be a constant communication with us for years and years leading up to it. Even before ESOPs were more popular, we had to worry about life insurance. Back when it was always just “pass it to the oldest son,” right, wrong, or indifferent, it was, “Okay, well, how does that look? Is the tax man going to come after him and take all the cash out of the business?” As a surety adviser, it’s no different now than it was when I started 23 years ago. We still need to know what the plan is to help you plan for it. It doesn’t need to be perfect, and it doesn’t mean it’s exactly how the plan happens, but we should have a plan in place so that we’re here to help you make sure there’s a surety program after whatever the plan is happens.

Chuck Mazzanti: One hundred percent. It’s the old adage: begin with the end in mind. It’s not perfectly linear, but the more you can think about that in every business decision you make and try to be intentional, the more your future self is going to thank your past self for that. Alan Starks: Yeah. It’s no different in any business, Chuck. Even you and I need to plan for it. Charlie’s talking to all the different guys here: “I’m in my late 40s. What’s your plan, and how do we put the next person in place for you? What if Al gets run over by a truck one day?” Every business should be thinking about this for its key people. What happens? There’s too much between all of our ears that is not in some system somewhere, and the businesses need to survive after that person goes away. Again, this is fun to talk about in construction because there is nuance to it, but a lot of this should be part of every single business, from top to bottom. They should be thinking about these things.

Chuck Mazzanti: One hundred percent. Before we start to wrap up, are there any parting thoughts from the surety underwriter’s perspective? Let’s single out a prospective ESOP transaction for a mid-sized contractor. Is there anything else you want to impart to them to get them ready to make a decision that’s going to benefit them in the long run? Alan Starks: Yeah. I think a big key is just getting everybody in the room. Get your surety agent, the lawyers, and your ESOP people who are talking about it. Once you’ve made that decision, get us all in a room. Your tax person, your banker, and your surety person are all going to have slightly different angles that are important to us. Let’s make sure everything is on the table up front so that all your advisers are pulling in the same direction for you. We all work for you. Put us all in a room, let us get everything on the table, and do it before anything is put in writing. Let the lawyer who is trying to put the documentation together listen to all the different pieces. Create open communication among all the different advisers you have in that process, so that if the banker needs to call me, he or she has the ability to call me without having you give approval each time. That makes any transaction much easier when we can have full transparency across all the different parties that have a stake in it. Again, just to repeat the broken record we keep saying: transparency and being open with us will really help that process all around.

Chuck Mazzanti: Yeah. Having all the boats pointed in the same direction, and having communication among the advisers, is paramount in this type of work. Well, to end on a lighter note, Alan, like you said—and I know for me specifically—I never planned on being in insurance as a young boy. So I’m curious: if you weren’t leading our surety practice for Christensen Group, what would you be doing? Alan Starks: God, who knows? Flipping hamburgers, I guess, is about the only skill. Doing this for 23 years, I think the only skill I have is talking about surety. Who knows where life would have sent me without this? Even when I was young, I worked for some of my contractors. I think somehow or another I would have been in the construction space. Who knows at what level, but I did like construction as a kid and as a laborer. I liked the numbers. Maybe I would have been in the accounting department at a construction company. Who knows? Again, I got into this pretty young and early in my working career, so I don’t know much else. Either that or flipping hamburgers somewhere, because I don’t have many other skills in life. I could handle it. Especially now that you say “on the beach”—that sounds pretty low-stress. I could sit there and flip hamburgers on the beach.

Chuck Mazzanti: Hey, flipping hamburgers on the beach is nothing to scoff at. Alan Starks: Exactly.

Chuck Mazzanti: There’s something to be said about calling it quits at the end of the day and not having to carry it home with you. So I’m not going to scoff at beachfront hamburger-flipping in our next life. Well, Alan, I really appreciate you coming on. I appreciate all the good work you do for our clients. How can people reach out to you if they want to pick your brain or just learn more? Alan Starks: I think the Christensen Group website is probably the best way to find me. You can get me there. Our email address is long and complicated here, so I’m not going to repeat that. You’ll find my profile on the Christensen Group website. All my contact information is there, and you can get ahold of Chuck and me on that website and ask us any questions. Again, we’re both here to help in any way we can.

Chuck Mazzanti: Yep. And I can always connect you. Alan and I are pretty close, so you can always come to me and I’ll connect the dots from there. Alan, thanks again. I’m looking forward to seeing you at our ESOP share-price reveal in a couple of— All right, we’ll see you. Alan Starks: Absolutely. Looking forward to seeing you there, Chuck.

Chuck Mazzanti: Thanks for listening to the Construction ESOP Collective. If this was useful, follow the show and share it with a colleague. Join the conversation with me, Chuck Mazzanti, on LinkedIn, and find all episodes at constructionesopcollective.com. Until next time, keep building ownership, one conversation at a time.

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