Finance

PPI Jumps 24% in 12 Months, Preventing Contractors from Passing Along Cost Increases

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By KERRY SMITH, EDITOR, ST. LOUIS CONSTRUCTION NEWS AND REVIEW MAGAZINE

Increases in prices for wood, metals, plastics and gypsum continue to narrow the margin between what contractors pay to acquire raw materials and what they’re able to charge the project owner.

Ken Simonson, chief economist for the Associated General Contractors of America, said the construction industry Producer Price Index – which measures the average change over time in the selling prices received by domestic producers for their output – has climbed 24.3 percent over the past 12 months, increasing 4.3 percent in May 2021 alone. The 12-month climb, he says, is nearly double that of any previous year in history.

“This increase far outstrips contractors’ ability to charge more for projects,” said Simonson. “This gap means contractors are being hit with huge costs that they did not anticipate and cannot pass on.”

Meanwhile, the PPI for new nonresidential construction – a measure of what contractors say they’d charge to build five types of commercial structures – increased only 2.8 percent over the past 12 months. AGC’s recent analysis included narrative from contractors across the nation who said they’d held their profit expectations down to compete for a limited number of new projects.

According to the AGC, the PPI for lumber and plywood more than doubled, increasing 111 percent from May 2020 to May 2021. The index for steel mill products increased 75.6 percent over the same period. The copper and brass mill shapes PPI rose 60.4 percent since May 2020, and the aluminum PPI rose 28.6 percent. The PPI for plastic construction products increased 17.5 percent, while the index for gypsum products such as wallboard climbed 14.1 percent.

Fuel costs, Simonson says, along with surcharges on freight deliveries, have also jumped.

AGC officials including CEO Stephen Sandherr, are urging the Biden administration to end tariffs and quotas on steel, aluminum and lumber as the first step toward easing pressure on construction costs and supply chain bottlenecks.

“Ending tariffs on Canadian lumber, along with tariffs and quotas on steel and aluminum from numerous allied countries, is good policy,” Sandherr said.

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Copper Prices Soar to 10-Year High, Metal Heads toward Deficit in 2021

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By KERRY SMITH, EDITOR, ST. LOUIS CONSTRUCTION NEWS AND REVIEW MAGAZINE

Copper prices have climbed to their highest level in a decade.

According to global metals analyst StoneX, copper was already trading at a nearly eight-year high in January when prices surged again in mid-February. In mid-February, copper contracts topped $4.25 per pound, approaching an all-time high of $4.58 per pound that the metal reached in 2011.

Investors are predicting that the supply chain will continue to tighten for this metal as the global market gradually recovers in the pandemic aftermath.

“We forecast that copper demand will rise in 2021 by approximately 5 percent year over year,” said Natalie Scott-Gray, a senior metals analyst at StoneX. “Demand is projected to outstrip supply, which we expect to grow by 2.3 percent year over year.”

StoneX analysts aren’t alone in predicting the looming copper supply deficit worldwide. Predictions are than the global copper supply is moving from a surplus in 2020 to a deficit of as much as 200,000 tons this year.

In January, the Copper Monthly Metals Index increased for the fourth month in a row. Analysts point to China’s manufacturing halts and slowdowns during 2020 as a key factor in the supply chokehold. CitiBank analysts say they expect copper prices to continue increasing, both in the US metals market and abroad, as key industries such as construction gain momentum. They project the copper market to shift into a deficit during the second half of 2021 and forecast deficits in the metal during 2022 and 2023, too.

From January through November of last year, the U.S. sold more copper scrap to China than during the same period in 2019. The U.S. exported 102,145 metric tons of copper scrap to China last year, an increase of 20 percent over the same 11 months in 2019. Analysts say China is an important ingredient in the overall recipe for copper demand, as the country is a significant consumer of the metal. Commodity analysts at the Bank of America Merrill Lynch say demand from China was the main driver of copper prices in 2020, but that as consumption from Asia has slowed in recent months, the recovery has broadened.

Pyramid Electrical Contractors, Inc. President Bob Snell knows well the volatility of the metals market. Snell says the firm began seeing increases in the price of not only copper but PVC resins and steel, too, as far back as August 2020.

“In 2021, the price increases have definitely accelerated,” said Snell. “It does affect projects that we had under contract pre-COVID. Some of those projects got put on hold and are now coming back around and we’re needing to adjust the estimate to reflect the metals market volatility. The volatility must also be taken into consideration when estimating our current projects.

We receive weekly conduit and wire pricing updates from our vendors and are continuously adjusting our estimating software to reflect what is occurring. It has been difficult for anyone in the industry to determine what’s going to happen next, even in the near future.”

Murphy Company VP of Estimating Kevin Suiter agrees.

“We’ve received notice from several of our material suppliers that pricing is going up,” Suiter said. “As far as estimating is concerned, we are constantly updating our prices to make sure our estimates include the latest prices. We are also including verbiage in our scope letters to notify our clients that our pricing is only good for a limited time due to the volatility in the market.”

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Building Materials Supplier, AGC Economist Attest to COVID Lumber Price Spikes

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By KERRY SMITH, Editor, St. Louis Construction News and Review Magazine

A Metro East building materials supplier with 72 locations across four states says the latest analysis by the Associated General Contractors of America is accurate: Builders and consumers are hurting from un precedented increases in the cost of lumber.

Robert Plummer, chairman and CEO of R.P. Lumber Company, Inc., says record price increases of more than 200 percent in lumber and panel products are not only choking the supply chain but also affecting commercial and residential contractors as well as consumers.

The life-long industry veteran’s observations track with AGC Chief Economist Ken Simonson’s latest analysis – released Feb. 17 – that prices for materials and services used in construction and contractors’ bid prices have diverged sharply since April 2020. A government index measuring the selling price for materials and services used in nonresidential construction increased 2.5 percent from December to January and a whopping 10.7 percent since the extreme price increases.

“Current conditions are harming contractors on existing projects and making it difficult to bid new work at a profitable level,” Simonson said, noting that the PPI for new nonresidential construction is a measure of what contractors say they would charge to erect five types of nonresidential buildings. The PPI increased only .2 percent since April. “While contractors have kept bids nearly flat until now, project owners and budget officials should anticipate the prospect that contractors will have to pass along their higher costs in upcoming bids,” he added. “Since this government data was collected more than a month ago, numerous sources indicate price increases have continued or even accelerated since then.”

Plummer attests that this is indeed the scenario. In addition to its 44-year history of serving as a building materials supplier, R.P. Lumber operates a truss plant and has retail home centers across Illinois, Missouri, Iowa and Wyoming.

“In all these years, I’ve never seen anything like this,” said Plummer. “We buy and sell a tremendous amount of lumber, drywall and roofing product – thousands of semitrailers’ worth – every year. It’s shocking where the price of lumber has gone since the (COVID) pandemic began, particularly on lumber and panels products such as OSBs (oriented strand board), ZipWalls and plywood. One year ago, we were paying somewhere in the $300 range per thousand board feet for 7/16ths (7/16-inch by 4 feet by 8 feet). Today we’re paying slightly more than $900 for the identical material.”

Even precut lumber is not immune from mills’ drastic price increases since COVID hit. Plummer says a 2×4-foot precut that cost in the $3 range in February 2020 now costs in the $6.50 to $7 range.

No doubt supply chains were impacted by the West Coast wildfires of 2020 that consumed huge forests of cedar, spruce and fir, and tariffs for product entering the U.S. from Canada has also played a role, Plummer says. But beyond these conditions, the severity of material increases continue to stymie lumberyards and contractors while hitting owners and homeowners’ bottom lines.

“This week we’ve heard of another 20 percent price increase in drywall, the second such increase this year, and it will take effect in March/April,” said Plummer. “In addition to lumber price increases, we’ve experienced three increases in the cost of metals, from steel studs to soffits, metal panels and I-beams. And we’re anticipating a second increase this year on wiring and on roofing materials. Builders will forward these increases through the pipeline. They may be protected on one job if they have locked-in pricing, but they may feel it on the next job.”

The entire industry is buying more building materials from Europe, according to Plummer. “Euro-Premium, a spruce product, is shipped into the U.S. more cheaply than we can many times buy a comparable product domestically right now,” he said. “That’s a reflection of how volatile the domestic supply chain is right now.”

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Struggling Firms Get a Second Chance

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FacebooktwitterlinkedinmailSubmitted by: Schmersahl Treloar & Co.

For many business owners and executives, filing for Chapter 11 bankruptcy proceedings seems like admitting defeat, but it shouldn’t be that way. 

The bankruptcy code exists to provide second chances. Chapter 11, which covers business reorganizations, allows struggling companies to right themselves so that they may once again be profitable engines of the nation’s economy.

No provision in the Bankruptcy Code is more important to achieving this goal than the automatic stay provision of Section 362.

Current Bankruptcy Law

A wide-ranging law that makes major changes to the country’s bankruptcy laws was signed by President W. Bush on April 20, 2005 and went into effect on October 17, 2005.

Under the Bankruptcy Abuse Prevention and Consumer Protection Act, it is more difficult for individuals to file for Chapter 7 bankruptcy, which wipes out most unsecured debts — including credit card debt. Lawmakers say the changes, which prohibit some individuals from filing for bankruptcy altogether, are necessary because at the time this law was passed, filings had reached historic highs.

In addition to the major changes in consumer bankruptcy, the Bankruptcy Act also contains numerous changes for business bankruptcy cases, including rules for reorganizing under Chapter 11. It also created a new chapter of the Bankruptcy Code, Chapter 15, which addresses cross-border insolvency.

Time-Out

The automatic stay provides a time-out — a window of opportunity to fix problems. In some cases, time is all that’s needed.

Whenever a company — or an individual — files for bankruptcy, the automatic stay kicks in. Like a temporary injunction, the automatic stay prohibits any action by a creditor against the debtor or its property.

Actions prohibited to a creditor under an automatic stay include repossession, foreclosure and lawsuits. The automatic stay even affects the IRS. While the stay is in place, the IRS is prohibited from issuing tax liens or seizing property.

There is one major difference between the automatic stay in bankruptcy and a typical temporary injunction: No hearing is needed for the automatic stay to take effect. It occurs as soon as a petition to file for bankruptcy proceedings is stamped at the court.

Power to Punish

A company can then move forward without fear. The bankruptcy court has the power to punish creditors that knowingly violate a stay by filing a contempt charge against them. Harassing letters and phone calls should stop. If they don’t, notifying the court of a creditor’s transgression generally ends the problem.

While the automatic stay is in place, the debtor company is prohibited from paying most of its pre-petition debts. This provides a chance for the company to rebuild itself as a going concern.

However, recent changes in the bankruptcy law impose limits on the duration of the stay for certain repeat filers (see box). These debtors must seek a stay from the court in order to have the protection of the automatic stay.

You might think that filing for bankruptcy to get an automatic stay sounds all well and good, but filing will surely dry up the pool of available credit for things such as operating expenses. Won’t bankruptcy tie the company’s hands and kill any hope of future success? This is generally not the case. Sometimes, a struggling company has an easier time obtaining credit once bankruptcy has been filed and the automatic stay is in place.

Credit availability tends to increase because of the prohibition against paying pre-existing debts. All debts incurred after bankruptcy has been filed (post-petition debts) must be paid first, before any pre-petition debts. As long as the company shows that it can operate profitably if it doesn’t have to immediately pay its pre-petition debts, credit is likely to be available.

Fruitful Negotiations Count

Consult with your accountant about the best way to proceed. And keep in mind that corporations that successfully come out of bankruptcy almost always do so because of fruitful negotiations with creditors. The automatic stay is not a cure-all. For some businesses, no amount of time can fix things. But for a company that is fundamentally strong, with credit in hand, the automatic stay provides an important opportunity to talk to creditors and get back on track.Facebooktwitterlinkedinmail

New Tax Law Largely Brings Good for Construction Companies

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FacebooktwitterlinkedinmailBy Kerry Smith, Editor – St. Louis Construction News & Review Magazine

Tax attorneys and CPAs across the St. Louis region are continuing to study the details of the nation’s new tax law, the Tax Cuts and Jobs Act, enacted nearly four months ago.

For contractors and other construction industry players, the news is overwhelmingly favorable – especially for S-Corps, LLCs, LLPs and other corporate entities whose income flows directly through to their balance sheets. But for developers seeking to rehab historic buildings, implications of the new tax law are arguably more restrictive.

Construction companies who purchase qualifying assets such as equipment are no longer limited to a maximum amount of $500,000 in terms of the cost of qualifying assets placed in service during that tax year. The new tax law does include a higher expensing limit of $1 million. Also part of the new law is the ability for contractors to write off the entire cost of the qualifying assets – new and used – that they purchase through what is known as bonus depreciation, according to Steven Dumstorff, senior tax partner at Kerber, Eck & Braeckel LLP. This part of the new law is slated to last until 2022 and then phase out 20 percent for each year following.

“Essentially any hard asset that a construction company buys can basically be written off now, where previously there had been limits,” Dumstorff said. “For example, a contractor that is building an expansion or putting in a new plant is now able to write off every hard asset it buys for that project. The new tax law has really opened up the spigot of what’s eligible to be written off,” he added. “We’re still poring over it and talking with our clients, but overall it’s very good news for contractors and others.”

The first major overhaul of the tax code in more than 30 years, TCJA offers a significant tax savings in the form of a qualified business income deduction or QBI, according to Philip Speicher, attorney/shareholder and federal tax law expert at Mathis, Marifian & Richter, Ltd. in Belleville. “On a broader scale, there are significant tax reductions for owners of construction businesses,” he said. “For owners of construction companies operating their businesses as pass-through entities, the top corporate tax rate has been reduced from in the 35 percent range to a flat 21 percent rate.”

Additionally, the rates for most brackets have been lowered and the income range for the bracket has been increased, said Speicher. “While pass-through income will continue to be taxed at ordinary income tax rates, many small business owners will be eligible to deduct 20 percent of their qualified business income or QBI starting in tax year 2018. In other words, some pass-through entities will only be taxed on 80 percent of their pass-through income. This is a real advantage in the new tax law for companies operating as an S-Corp, LLC or another structure wherein the business’s income flows directly to its balance sheet.”

The QBI takes into account real estate and equipment ownership for purposes of determining the amount of the deduction that is available, according to Speicher.

Another one of the major changes inherent in the new tax law is the availability and tax treatment of certain governmental incentives tied to economic development. Speicher said if there’s an amount that a governmental entity contributes to a particular project and agrees to refund a portion of the cost of that project within the parameter of an incentive such as tax increment financing (TIF), the new tax law likely won’t impact such an agreement. “But if there’s an economic development incentive that is actually paid by the governmental entity – such as a city or county – directly to the construction company, it used to be that income wasn’t considered to be taxable income for the contractor…now it will be under the new tax law,” he said.

Robert Berger, CPA, tax partner and director of real estate and construction services at Anders CPAs + Advisors in St. Louis, says another notable tax law change involves federal tax credits such as those being accessed by a number of developers seeking to rehabilitate classic downtown St. Louis buildings into lofts, boutique hotels and more. The rules on how the federal historic tax credit is paid to developers have changed, arguably not to the developers’ advantage.

“Under the new tax law, the federal historic tax credit reimbursement must now be spread over five years rather than accessed during the first year,” Berger said, adding that the change might deter this sector of development in and around St. Louis. “This is a pretty big deal to those operating in this market,” he said.

Another drawback of the new tax law, as it pertains to construction firms in St. Louis and across the U.S., has to do with the income tax deduction often used by contractors that had been known as the domestic production activities deduction. That deduction, which allowed nearly all construction companies to deduct an amount equal to 9 percent of their net income on work performed in the U.S., disappeared with the new tax law in 2018, Speicher said.

Berger urges contractors and others to seek out their tax accountant and attorney to talk through the nuances of TCJA in order to take full advantage of the opportunities it offers, and to understand all of the impacts of the new law on their business.

“I would caution business owners to pause before they make any quick judgments on the new tax law according to their business entity choice,” Berger said. “This is still a pretty brand-new law. We’re all still getting our arms around it. If companies make a decision to change (corporate structure) too rapidly, it’s not easy to rewind.”Facebooktwitterlinkedinmail

Job Costing: Seven Tips to Make it Easier

FacebooktwitterlinkedinmailSubmitted by Schmershal Treloar & Co.

Job costs are the lifeblood of your construction business and accurately estimating them will determine if a project will make money. Managing job costs across the life of the project will ensure that your firm makes money on every job. Moreover, those job-by-job profits make the office and your executive salary possible.

Despite this, some CFOs don’t take job costs seriously. Some see tracking those costs as more trouble than it is worth, while others think that the costs are so obvious that tracking them seems like extra, unnecessary work. Neither is true and both can limit your firm’s profitability. Here are seven tips that can make job cost tracking easier than you might think:

Tip #1: Set Priorities at the Top

Tracking job costs is a process that involves every level of your organization. All of your valued employees intuitively know the value of tracking costs by job. If you begin to place an emphasis on the accurate identification of every cost by job for every purchase, they will gladly join in and help identify jobs with enthusiasm.

Tip #2: Set up Solid Communication Between the Field and the Office

Cost tracking starts in the field, where the materials are delivered and the purchase decisions are made. Field people are well-placed to know which costs go with the jobs. The trick is making it easy for them to flag the job name or number so that the person entering the invoice, credit card or debit card charge into the computerized accounting system can follow the process of assigning the proper cost code.

Tip #3: Provide Information to Bookkeeping Staff Readily

Bookkeepers may be tempted to let it go when the job information isn’t available, promising to assign the proper job number later. This is the single most common source of errors. Making job information readily available to the bookkeeping staff is the best way to counteract this tendency for misinformation to cloud your reports.

Tip #4: Require Purchase Orders

Purchase orders are a good way to ensure the success of your job cost system, so have your accounting, finance or tax professional help you develop a good system. Purchase order systems work when the office must issue a unique order and all supplies must get purchase order numbers from field staff before providing materials to any job. An effective system helps ensure that no invoice will come to your office without a job identified on it.

Tip #5: Use Caution Handing Out Company Credit Cards

With credit and debit cards, there is usually no way to include a job name or number on the receipt. Provide cards only to responsible crew leaders. They should be required to send receipts right away to the office that identify the jobs. This can be done either by texting receipts as images, e-mailing scanned copies of receipts to the bookkeeping department, or dropping paper receipts off with the job name or number marked on them.

Tip #6: Clearly Separate Costs

Job costs differ from office and overhead costs by getting a job number that is distinct from the general ledger account number. The chart of accounts or general ledger can be a help or a hindrance depending on the skill of the accounting, finance or tax professional who develops your job cost system.

For example, general ledger expense codes typically start with the 5,000 series of account numbers. Job cost tracking then becomes easier for everyone if they are coded with 5,000 series numbers, while allocated costs are coded with 6,000 series numbers and office and overhead costs get 7,000 series account numbers.

If the chart of accounts and job cost ledger are set up professionally, cost allocations will become easier and more accurate and job cost reports will be more accurate and useful.

Tip #7: Follow Best Practices

The actual job number you assign should be carefully chosen following best practices. For example, a good job number is not just the next number in a haphazard sequence that starts with some arbitrary number and has three or four digits. A good job number always conveys information such as the year the project started, the specialty trade involved, and whether the expenditure was a material cost, equipment rental cost, labor cost, or subcontractor cost.

Consult with your accounting, finance, and tax professionals who are familiar with construction best practices. This will make your life easier down the road as well as more profitable.Facebooktwitterlinkedinmail

Preventing Fraud In Your Organization

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FacebooktwitterlinkedinmailIt seems that every day we hear a new story of significant monetary loss due to embezzlement or other crimes perpetrated from within a company by a trusted insider. We hope this column from an earlier edition of St. Louis Construction News & Review Magazine will help protect your business.

By Ken Van Bree

Here’s a statistic that will keep you up at night: according to the Association of Certified Fraud Examiners (ACFE), fraud within the construction industry is now costing an average median loss of $245,000 for organizations. Further, ACFE report that the construction industry’s median loss is approximately $90,000 higher than the average fraud losses across all industries.

Type of Fraud Schemes

The threat of fraud can never be wholly removed, but leadership should take steps to identify schemes their organization might face. Below are a number of schemes frequently used to defraud construction companies.

Billing Schemes

The ACFE indicates that billing schemes account for 35 percent of the fraudulent activity within construction companies. Such schemes can be payments to fictitious vendors, overpayment to vendors (often through collusion with an internal employee), and purchase of personal items with company funds.

Bid Rigging & Corruption

The ACFE reports that nearly 47 percent of the fraud cases examined in the construction industry had an element of corruption, whether it is bribery, kickbacks or quid pro quo situations The bid process can be riddled with opportunity for this type of fraud.

Theft

The construction industry is particularly susceptible to theft of materials due to the location of jobs and the difficulty of tracking construction materials. Job sites can be in remote areas or some distance from the corporate headquarters and subject to less supervision.

Additionally, materials on job sites are hard to track and measure during the construction process. Items lying around a job site such as lumber, concrete, copper pipe, wire and cable can create an opportunity for thieves if proper controls are not in place.

Misuse of Company Equipment

Similar to theft of materials, misuse of company equipment can also become an issue if there is a lack of controls present. For instance, an employee could operate a side business using a company’s idle equipment.

Other Fraud

The construction industry is subject to the same fraudulent activities faced by every other industry. These include payroll fraud through fictitious employees, check tampering, and fraudulent expense reports.

The Importance of Internal Controls

After identifying common fraud activities, an organization should design a control structure that will reduce the opportunity for fraud and increase the chances fraud will be detected. Although there are no guarantees, the foundation to a strong internal control environment is proper segregation of duties.

For example, the person in charge of setting up vendors should not be the same person who approves vendor payments or reconciles bank statements. Proper segregation of duties applies to all areas of business and can be employed effectively at little or no cost.

Here are some other simple yet effective internal controls organizational leadership should consider implementing:

  • Check all estimates for accuracy of calculations, labor rates and correspondence with drawings.
  • Compare job cost estimates with actual costs. Require approvals for cost adjustments or transfers of costs between jobs.
  • Require that estimates for materials above a specified amount include quotes from two or more vendors.
  • Make purchases only with pre-numbered purchase orders, and match them to both receiving reports and invoices before payment is made.
  • Check vendor invoices against estimates to ensure proper discounts and pricing.
  • Always refer to specific job numbers, phase codes or work order numbers in onsite communications.
  • Obtain ink or electronic signatures on change orders before work begins and revise contract values accordingly.
  • Allocate equipment usage to contracts weekly and record equipment maintenance expense in the ledger as they occur.
  • Review all billings for timeliness, accuracy, conformity with contract terms, and correct customer information.
  • Reconcile contract billings with general ledgers monthly, and calculate under-billings and over-billings.
  • Prepare and review monthly financial statements and reconcile them to supporting ledgers, bank statements, and loan schedules

Not all controls are created equal when trying to detect and prevent fraud.  For instance, according to the ACFE, an external audit was performed in 80 percent of the fraud cases reported, but detected the fraud in only three percent of those cases. The majority of fraud was uncovered through tips to a fraud hotline or management, and employees or customers were the leading sources of those tips. A fraud hotline was in place for 54 percent of the fraud cases examined.

Based on this information, it is important not to put too much reliance on a single control, but rather have a series of processes that will prevent and detect fraud.

Know The Signs

The profile of a fraudster can be as important to know as understanding the typical fraud schemes employed themselves. Per the ACFE, fraud typically is not perpetrated by a repeat offender. In fact, only 5 percent of fraudsters had been previously convicted of a fraud-related offense prior to committing fraud crimes.

Additionally, 82 percent of fraudsters had never been punished or terminated by an employer for fraud-related conduct, which shows that while background checks are useful in screening out some bad applicants, they might not be effective in predicting fraudulent behavior.

Most fraudsters were employed for more than one year before committing fraud, but most displayed some, such as living beyond their means, financial difficulties, or having unusually close associations with vendors or customers, that could have served as warning signs. Training management to recognize these warning signs for employees, vendors and auditors is important to help detect fraudulent behavior.

Protect Your Company’s Reputation

Ultimately, knowing the types of fraud, what controls to implement and the profile of a fraudster can help mitigate the chances of a significant fraud loss, but maintaining your reputation is another critical factor.

Reputation is a construction company’s most important asset since the construction industry is small enough for word of mouth to carry great weight in the decision process of sureties, bankers, suppliers or customers. Across all parts of the organization, companies should operate under a code of ethics that builds their reputation in the community.

Ken Van Bree, CPA, is a partner of St. Louis-based accounting firm RubinBrown and serves as the partner-in-charge of the firm’s Construction Services Group. For information, visitFacebooktwitterlinkedinmail

Planning ESOPS for Construction and Real Estate Firms

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FacebooktwitterlinkedinmailBy Thomas H. Mug

Maybe it’s the preservation of a legacy, perhaps it’s the conclusion of thoughtful succession planning, or it might be a desire to motivate employees and enhance corporate performance … for whatever reason, the construction and real estate industry is increasingly embracing employee stock ownership plans (ESOP).

Indeed, this publication documented the trend three years ago, noting transfers to some form of employee ownership at Brinkmann Constructors, McCarthy Building Companies, CH2M Hill, Parsons, Black & Veatch, HDR, HNTB, Burns & McDonnell and Terracon. Last year, Lawrence Fabric & Metal Structures Inc. and Balke Brown Transwestern, Inc. joined the ranks of employee-owned companies with the help of our law firm, Greensfelder, Hemker & Gale. However, ESOPs are not for every situation and require considerable forethought and planning.

Many businesses begin considering ESOPs as they approach a transition in leadership and want to preserve the distinctive qualities that define the company and its culture and ensure the company’s long-term success. That has been accelerating with a wave of baby boomers entering retirement.

An ESOP is an intense planning process. Business owners should consider the following:

  • Is the firm suited for an ESOP? Business owners should conduct a feasibility study as a first step to determine whether the company is a suitable candidate for an ESOP. This will consider the motivating factors for establishing an ESOP, the financial capability of the company to finance ESOP debt and suitability of the company as an ESOP candidate. The feasibility study will also identify any issues or obstacles in the establishment of an ESOP.
  • Before entering into an ESOP, a business owner needs to know the value of the company. It is likely that the owner will have an expectation of the amount that will be paid for his or her stock. One of the first steps in examining the ESOP as an exit strategy is for the owner to obtain an independent valuation of the company stock. If the result is not to the owner’s satisfaction, the owner may elect to forgo the ESOP and consider other alternatives. Valuation typically involves projecting the future earnings of the company and will rely on those projections of company income. Industry outlook is also a major consideration, as well as the general economic forecast. If appropriate, the valuation may also consider book value and sales of comparable businesses.
  • Federal regulations. ESOPs are heavily regulated by both the U.S. Department of Labor and the Internal Revenue Service. As an ESOP is a retirement plan designed to invest in company stock, the interest of the Department of Labor is to see that plan participants and their retirement savings are adequately protected. Consequently, the Department of Labor will scrutinize an ESOP transaction to assure that the terms of the transaction, including the price paid for company stock, are fair. One way to assure compliance in this regard is to engage a well-qualified independent trustee to represent the interests of ESOP in the transaction.
  • Repurchase obligations. One major consideration for any ESOP, new or mature, is an understanding of the company’s repurchase obligation with respect to its ESOP shares. As employees approach retirement, they will seek to cash out the company stock in their ESOP accounts. In addition to retirement, a repurchase obligation can also occur due to termination of employment, death of an employee or a participant’s exercise of diversification rights. In order to prepare for this eventuality, a company will want to have a repurchase liability study performed and develop a plan to have adequate resources available when the need arises. Failure to plan for this eventuality can result in a crisis in future years.
  • Creating a culture of employee ownership. Critical to the success of any ESOP is the presence of an ownership culture. Some companies have a workplace culture that will give them a head start on this. Others will need to work harder at the developing the ownership mentality. What is important is to have a culture in which employees are engaged as owners and are aware of the responsibilities that come with ownership. This is enhanced through the sharing of information on the financial health and outlook of the company and by developing a team approach to achieve success. An old saying is that there is no “I” in ESOP.

In a sense, a transition to an ESOP takes on the same attributes of a personal family decision. Business owners need to work with financial, legal, and accounting advisors who are familiar with the culture of the firm and its mission. It is a significant advantage when the team has an understanding of the challenges unique to the construction and real estate industry.

It can be more remunerative and sometimes easier to sell to an outside buyer than to embark on an ESOP. The decision depends on the motivation and goals of the owner, the desire for the future of the business, and the feasibility of an ESOP as a succession alternative. Many St. Louis construction and real estate firms have found that properly planned ESOPs are an effective way to develop the next generation of leadership who will continue to advance the legacy of excellence that has defined the company since its inception.

Thomas H. Mug is an attorney in the employee benefits and trust and estates practice groups at the St. Louis law firm Greensfelder, Hemker & Gale, P.C.Facebooktwitterlinkedinmail