Equity Rollovers 101
The Anatomy of a Deal Newsletter January 22, 2021
- In many cases, sellers aren’t able to simply walk away entirely from a sale and will be expected to remain involved in the business through an equity rollover.
- These rollovers come in many forms and the terms can differ greatly depending on the long-term strategic intentions of the buyer.
- If structured and managed correctly, and if the buyer has great success in implementing its post-transaction plans for the business, a rollover investment could, in some cases, be worth more than the value of the initial cash purchase price.
For many sellers, one of the primary reasons for selling is a desire to exit the business. Either it’s time to retire, to do something different or to diversify and de-risk your investment. You simply sign some documents, shake hands (if that’s still allowed in a post-COVID world) and walk away.
Not so fast- in many cases you may not be able to walk away entirely from your investment in the business. That’s because the “equity rollover” is a pretty common feature in many M+A deals.
1. What’s a rollover?
While the term rollover has a more specific meaning, it’s often used as shorthand to refer to a situation in which a seller reinvests some of his or her equity into the buyer, or simply retains some portion of the equity he or she currently owns in the company. As you can probably imagine, this can take any number of forms, but the basic idea is generally the same—the seller keeps some form of equity as part of the purchase price, rather than cashing out completely.
2. How much do I have to rollover?
You know never to ask a question like that to a lawyer, don’t you? The answer, of course, is that it depends!
In some cases, the rollover may just be a small percentage of the total enterprise value of the selling company—just enough so that the seller keeps some skin in the game. In other cases, rollovers can be a major portion of the seller’s total consideration—almost 50%.
The amount of the rollover in a particular deal depends on a number of factors, including the identity of the buyer, the plans for the seller’s continued involvement in the business, and negotiating leverage.
3. Why does the buyer care?
First off, let’s be clear that some buyers not only don’t care about rollovers, they won’t let you do a rollover even if you want to. Many strategic acquirers ( remember when we talked about those?) don’t have any interest in keeping the seller involved in ownership.
On the other hand, most financial buyers ( we talked about them, too!) consider rollover a necessity. And there are a few key reasons why they insist on rollovers:
- It forces the seller to give a vote of confidence in the business. If the seller is resisting the rollover, the buyer starts to get nervous that the seller doesn’t really believe that the business can achieve the rosy projections the seller has been trying to push on the buyer.
- It aligns the seller’s continued interest in the business’ success. Unless the rollover is very small, the seller can’t simply cash out and then stop caring about the business’ performance. So the seller has to cooperate in positioning the business for post-closing success and/or remain involved post-closing.
- It fills a gap in the buyer’s financing. Most financial buyers rely on “leverage” (fancy word for debt) to finance a large portion of the deal. However, just like when buying a house, the lender isn’t going to loan 100% of the purchase price. So the buyer has to fill that gap with a combination of (1) equity coming out of its own pocket, and (2) rollover coming from the seller.
4. What if I don’t want to do a rollover?
Then you probably shouldn’t sell to a financial buyer. OK, maybe that’s a little too flippant; not every financial buyer requires a rollover in every deal. And in other cases, some financial buyers may require only a small rollover.
But at a fundamental level, if you’re talking to a financial buyer and have an aversion to a big rollover, make sure you determine what the buyer’s expectations are early in the process to make sure there’s no misunderstanding before going too far down the road.
5. Does the rollover complicate my deal?
I bet you can guess the answer to this one. Yes!
How much more complicated? It depends!
If you’re getting all cash, the deal is pretty simple. You take the money, pay the taxes, and move away to paradise…somewhere like Hawaii, Italy, or Cleveland. If you’re getting any portion of the purchase price in rollover equity, there are a whole host of other issues to consider.
First, we have to determine what your equity is going to “roll” into. In some cases, the “rollover” is actually just retaining some portion of ownership in the seller company. In other cases, the seller is exchanging its equity for equity in the buyer company.
Then, we have to make certain that the rollover can be accomplished on a tax-free (or, more accurately, a tax-deferred) basis. No one likes getting something that’s not cash but still getting taxed on it. The IRS doesn’t accept tax payments in the form of private company stock.
The good news is that most of these rollovers can be accomplished in a tax-deferred manner. It just takes some careful planning and structuring on the front-end to make sure it works.
And then, once we have all of that figured out, we still have to figure out what rights, obligations, and terms come along with the rollover. Business owners who are used to being in a control position will find that minority ownership in a private company brings a whole host of new and sometimes uncomfortable issues. As a result, sellers who are taking a meaningful rollover interest will insist on certain minority protections designed to protect their investment. Minority protections take any number of forms—and will vary wildly depending on a number of factors—but it’s very important to think through the potential issues and risks associated with minority ownership and attempt to find a happy medium between the buyer’s desire to freely run the business it just bought and the seller’s desire to protect its rollover investment.
6. How do I liquidate my rollover investment?
Say it with me this time: “It depends!”
This is obviously a key question for most sellers who are rolling over any meaningful equity in a transaction. Most of them prefer not to have their purchase price tied up in an illiquid, unmarketable asset for long periods.
In most cases, the rollover investors are simply going along for the ride with the buyer. When the buyer exits, so, too, will the rollover investors. In some cases, that’s an easier pill to swallow because many buyers will have a clear plan to build and then exit in a relatively short time horizon, such as 3-5 years.
However, not all financial buyers subscribe to the buy-and-flip mentality. Specifically, family offices may prefer more of a buy-and-hold philosophy. So how does a rollover investor get liquidity in that case? It will require an understanding of the buyer’s proposed plans for the business and its current arrangements (if any) for existing minority owners, as well as some good old-fashioned negotiation. Put rights, call rights, rights of first refusal, and other similar concepts may help provide a solution, but each of those adds complexity and some degree of risk.
In any event, rollover investors will need to get comfortable with the idea that they can’t quickly and easily exit the rollover investment post-closing. So they’ll want to approach the investment with a clear understanding of what they’re getting into.
While rollover investments do add complexity and delay the seller’s ultimate exit, there are many situations where the rollover is wildly successful. We’ve seen situations where a relatively small rollover investment actually ends up being worth more than the cash purchase price from the initial sale. Of course, we’ve also seen situations where the rollover investment goes badly.
Many sellers like the idea of just cashing out and going home. But many others like the idea of the proverbial “second bite at the apple” which the rollover offers. Gaining a clear understanding of the buyer’s expectations around rollovers at the outset—and what those expectations mean for your ultimate ability to exit—should be high on your list of discussion items with a potential buyer so that you know what you’re signing up for…before you sign up for it.
Read last month’s piece: Anatomy of a Deal’s 2021 New Year’s Resolutions