Rollover equity can sometimes be the most important part for a business owner to consider when selling their business. This potentially lucrative element of an agreement can not only provide stronger assurance of future performance to a buyer but can also generate significant incentives to a seller looking to stay in place with a multi-year commitment.
What exactly is rollover equity?
Rollover equity is a financial arrangement in which a business seller retains an ownership stake in the business being sold, typically in the form of equity in the acquiring company. Rollover equity refers to the portion of sale proceeds that sellers reinvest in the acquiring company. This means that a portion of the proceeds from the sale is rolled over into an equity position in the new entity, and the seller becomes a shareholder in the acquiring company. This mechanism is often used in mergers and acquisitions (M&A) transactions.
How Rollover Equity Works
Rollover equity is a mechanism that allows business owners to generate liquidity while remaining engaged in the business and benefiting from future growth. When a private equity firm acquires a company, the seller may be required to reinvest a portion of the sale proceeds into the newly formed entity. This reinvestment is known as rollover equity. The seller’s commitment to rollover equity confirms their belief that there is more upside remaining in the value of the company’s future equity. By participating in the rollover transaction, the seller presents themselves with an opportunity to take some “chips off the table” and mitigate the downside risk of holding onto the full value of their equity.
The benefits of rollover equity for the business seller include:
1. Continued Ownership Interest
Rollover equity allows the seller to maintain an ongoing ownership interest in the business. This can be particularly appealing to sellers who want to continue benefiting from the company’s equity and its success, especially if they have a strong emotional or strategic attachment to the company.
2. Alignment of Interests
By retaining equity through equity rollovers, the seller’s interests are aligned with those of the acquiring company. Both parties have a shared interest in the continued growth and success of the business, fostering collaboration and a mutual focus on long-term value creation.
3. Potential for Additional Returns
If the business performs well post-acquisition, the seller stands to benefit from the appreciation in the equity value of their stake. This can provide an additional source of financial returns beyond the initial sale proceeds.
4. Support for Business Transition
The seller, by retaining an ownership stake, may be more motivated to assist in the transition process of the company post acquisition. This support can include providing guidance, sharing industry knowledge, or even staying involved in an advisory capacity to help ensure a smooth transition of leadership.
5. Mitigation of Buyer-Seller Asymmetry
Rollover equity can address the information asymmetry between the buyer and the seller of the target company. Since the seller retains an interest in the business, they are more likely to provide accurate and comprehensive information during the due diligence process, as they have a stake in the business’s ongoing success.
6. Tax Benefits
Depending on the structure of the deal and tax regulations, rollover equity may offer potential tax advantages for the seller. It could allow the deferral of capital gains taxes, providing the seller with more favorable tax treatment compared to an all-cash transaction.
7. Flexible Deal Structures
Rollover equity introduces flexibility into deal structures, allowing sellers to maintain a stake in the post acquisition company. It allows for creative negotiations where the seller and buyer can tailor the terms of the deal to meet their specific needs and objectives.
While rollover equity can offer various benefits to the business seller, it’s crucial for both parties to carefully negotiate and structure the deal to address potential risks and concerns. Detailed legal and financial agreements should be in place to define the terms
Rollover Equity in Private Equity Firms
Rollover equity is a common feature in private equity platform acquisitions and some add-on deals. Private equity firms often require the seller to rollover some equity as part of the transaction. This arrangement is attractive to private equity investors as it reduces their cash outlay and aligns investor and management team objectives. Rollover equity allows equity holders to receive partial liquidity for their investment and still participate in further upside. Rolling equity may be attractive to sellers from a tax perspective, as the portion of sales proceeds that is reinvested is not taxable at the time of the sale.
Risks and Considerations
While rollover equity can provide significant benefits to both private equity firms and sellers, there are potential risks and considerations to be aware of. One of the main risks is the potential for dilution of ownership stake. The seller should ensure that they are guaranteed the option to subscribe to any new issue on the same terms and at the same price being offered to others. Additionally, the seller should ensure that they will receive the highest class of shares to maintain their priority in case of liquidation. It is also essential to consider the tax implications of rollover equity, as the tax treatment can be either fully taxable or tax-deferred, contingent on various factors. Sellers should consult with a certified tax professional to ensure their decisions are made with all factors of relevance considered.
If you are looking to sell your business or not sure where to start, schedule a free consultation with one of our expert advisors to find out what your options are.
