All About Rollover Equity - Benefits, Challenges, and Best Practices

Rollover equity is a common component of mergers and acquisitions (M&A) deals, especially in private equity acquisitions of middle-market companies.

But what exactly is rollover equity, and why has it become such a defining feature of private equity buyouts? We’ll cover everything you need to know in this blog article.

Meanwhile, if you're considering selling your business, contact us at Exitwise. We streamline the business selling process by assisting you in hiring and managing your dream M&A team to create the exit you deserve!

What is Rollover Equity in M&A?

Rollover equity (equity rollover, rolling equity, or reinvestment equity) refers to the portion of sale proceeds that the seller reinvests back into the company post-acquisition.

Typically representing 10-40% of the total deal value, you can exchange cash proceeds for an equity stake in the new entity controlled by the buyer.

Instead of cashing out completely, you're investing in the business's future growth under new ownership.

You can capitalize on the power of rollover equity, maintaining the potential for future gains while also realizing immediate returns.

Here's a simple example to illustrate the concept:

Let's say you're selling your company for $100 million. Instead of taking all that money in cash, you might agree to a 20% rollover. This means you'd receive $80 million in cash at closing, and the remaining $20 million would be reinvested as equity in the new entity.

Rollover equity is particularly common in private equity transactions. Many PE firms require it as part of the deal structure.

Why? Because it aligns the interests of the seller with those of the buyer, ensuring both parties are invested in the company's future success. The buyer benefits from reduced upfront cash requirements and mitigated risk should the business underperform.

Note: Rollover equity isn't just about the numbers. It often comes with continued involvement (e.g., a seat on the board or a role as a consultant) in the business, though usually in a reduced capacity.

Benefits of Equity Rollover for Sellers

Opting for an equity rollover can offer several advantages. Let's see some of the key benefits:

Deferred Taxation: Rollover equity can often be structured as a tax-deferred transaction. This means you won't have to pay capital gains tax on the portion of the sale you roll over until you sell your stake in the new entity. This can be a useful tactic for tax planning and wealth management.
Upside Exposure: Retaining equity preserves upside exposure to business growth and eventual sale by the private equity buyer.
“Second Bite of the Apple”: This is perhaps the most compelling reason to consider rollover equity. You profit from sale proceeds twice by reinvesting back into your company — first when initially selling your majority stake and second upon the future exit.
Enhanced Valuations: Buyers may increase exit valuations for sellers demonstrating confidence via substantial rollover equity, as high as 30-40% of the sale value.
Active Involvement (Optional): For many entrepreneurs, their business is more than just a source of income - it's a passion. Rollover equity often comes with the opportunity to stay involved in the business. You can continue contributing to its success without the full responsibility of ownership.

In 2018, when Hellman & Friedman acquired Ultimate Software for $11 billion, the founder, Scott Scherr, and other key executives agreed to roll over a significant portion of their equity.

This decision paid off handsomely when the company was sold again in 2020 for $22 billion, nearly doubling the value of its rolled-over equity in just two years.

Challenges and Drawbacks of Rollover Equity

However, rolled equity also has several significant M&A risks:

Illiquidity: Rolled-over equity is usually illiquid, meaning you can't easily sell it or convert it to cash. You may be tied to the new owner's timeline for exit, which could be several years down the line.
Loss of Control: When you roll over equity, you typically become a minority shareholder in the new entity. This means you'll have less control over business decisions than you did as the owner, and you'll need to be comfortable with this shift.
Tax Uncertainty: While taxation on rolled proceeds is deferred initially, future rates are unpredictable. Higher future rates could diminish rolled equity returns.
Value Erosion: Should the business decline under new ownership, rolled equity can dramatically lose value. You may lose more than initially cashed out.
Conflicts of Interest: Buyers must balance focus between profit generation for investors and upholding the value of rolled equity for sellers. These motivations sometimes misalign.
Share Dilution: If not contractually protected against, additional acquisitions or capital infusions by the buyer may dilute your retained equity stake.
Complexity: Rollover equity agreements can often involve intricate legal and financial structures. You need experienced advisors to help you deal with these complexities.

At Exitwise, we help you connect with the top M&A team in your industry. Our advisors will guide you through the entire process, from initial evaluation to final negotiations, ensuring you have the right team to maximize your exit.

Key Considerations Before Opting for an Equity Rollover

Before deciding to roll over equity, here are some factors to consider:

Target Rollover Equity Range: You should determine what percentage range meets your objectives. Higher rolls enhance the upside but reduce liquidity. Conservative sellers may prefer 10-15%, while more opportunistic sellers might elect over 30%.
Buyer's Track Record: Research the buyer's history with similar acquisitions. Go through the process of qualifying a buyer. Have they successfully grown businesses and provided good returns to rollover equity holders in the past?
Growth Strategy: Understand the buyer's plans for growing the business. Do you believe in their vision and strategy?
Valuation: Ensure that the valuation of your rolled-over equity is fair and in line with what other investors are receiving.
Exit Timeline: Understand the buyer's expected timeline for exit. Does this align with your personal financial goals?
Governance Rights: Negotiate for appropriate governance rights, such as information rights or board representation, to protect your interests as a minority shareholder.
Tax Implications: Consult with tax advisors to understand the rollover's short and long-term tax consequences. As part of your evaluation, explore legal strategies on how to avoid paying taxes when you sell your business.
Personal Financial Situation: Consider your overall financial picture. Do you need all the proceeds from the sale now, or can you afford to reinvest a portion?
Future Role: Clarify your future role in the company. Will you have ongoing responsibilities? How will this impact your work-life balance?

Remember, every deal is unique, and what works for one seller might not work for another. Thoroughly evaluate your specific situation and seek professional advice before making a decision.

Best Practices for a Successful Equity Rollover Process

If you’re committed to equity rollover, consider these best practices:

Assemble a Strong Advisory Team: Work with experienced M&A advisors, lawyers, and accountants who understand the nuances of rollover equity transactions.
Conduct thorough Due Diligence: Don't just focus on the buyer's offer. Research their track record, financial stability, and plans for your business.
Negotiate Fair Terms: While you may not have the same rights as the majority shareholder, aim to secure the best possible terms for your minority stake. Negotiate for important protections such as tag-along rights, information rights, and anti-dilution provisions. Push for pro-rata rights to maintain your ownership percentage in future funding rounds.
Get It in Writing: All agreements should be documented. This includes formally outlining the rollover terms and any ongoing roles or responsibilities you'll have in the business within a proper asset purchase agreement checklist.
Plan for Various Scenarios: Work with your advisors to model different outcomes. What happens if the business grows faster than expected? What if it underperforms?
Understand the Capital Structure: Know where your rollover equity sits in the capital structure. Is it common equity, or does it have any preferred rights?
Negotiate Put and Call Rights: Consider negotiating rights to sell your equity (put rights) or rights for the company to buy you out (call rights) under certain conditions.
Stay Informed: Even as a minority shareholder, you should negotiate for regular updates on the company's performance and strategic direction.

Putting all these into practice isn't easy. For personalized guidance on navigating equity rollover and other strategic aspects of your business sale, contact us at Exitwise today. Our team can help you assemble and manage the ideal M&A team to maximize your exit value.

Investment Implications of Rollover Equity

From an investment perspective, rollover equity represents a unique opportunity. It lets you maintain exposure to a business you know well, potentially benefit from the new owners' resources and expertise, and participate in future value creation.

However, here are some implications to consider:

Concentration Risk: Rollover equity can result in a significant portion of your wealth being tied up in a single, illiquid investment. Consider how this fits into your overall asset allocation strategy.
Risk-Return Profile: Private equity firms often target high returns (typically aiming for 3-5x over 5-7 years), but there's no guarantee of success. Your rolled-over equity would be subject to this high-risk, high-reward scenario, potentially resulting in significant gains or losses.
Leverage: Many private equity deals involve significant leverage (debt). This can multiply returns in good times but also increase risk in downturns.
Post-Sale Strategy: Consider how rollover equity aligns with your post-sale goals. It might offer continued growth potential but could conflict with objectives like retirement or pursuing new ventures.
Liquidity Planning: Given the illiquid nature of rollover equity, you need to plan your finances accordingly. Ensure you have sufficient liquid assets to meet your needs until a future liquidity event.

Exitwise Helps You Find the Best M&A Expert

At Exitwise, we specialize in connecting business owners with top M&A advisors who can guide you through every step of the exit process.

Our network includes professionals with deep experience structuring M&A deals across various industries.

They can help you:

Negotiate favorable terms with potential buyers.
Structure the deal to optimize tax efficiency.
Plan for various scenarios and potential outcomes.
Protect your interests overall.

Don't leave the future of your business and your wealth to chance. Connect with us to create an expert M&A team that can help ensure you get the best possible outcome from your business sale.

Frequently Asked Questions (FAQs)

Let's answer some common questions you may have about equity rollover:

Is Rollover Equity Taxable?

Typically, rollover equity is structured as a tax-deferred exchange, meaning capital gains taxes on rolled-over proceeds are only owed once you sell the equity.

This tax deferral, which can benefit the seller, is a crucial reason rollover equity is popular in private equity deals.

What is an Equity Roll Forward?

An equity roll-forward occurs when you transfer some ownership in the original company to a new company that the buyer creates. As a seller, this allows you to roll over your equity tax-free.

It also allows you to stay involved in the company under the new buyer and allows the buyer to record a higher value for the assets purchased.

What is a Recapitalization Exit Strategy?

Recapitalization happens when the buyer takes out debt using the company as collateral. This debt pays back some ownership to the private equity owners or sellers who rolled over equity.

This lets private equity owners cash out part of their stake without selling the whole company. Sellers who rolled equity can also get some money back before the entire company is eventually sold.

Conclusion

Rollover equity can be a game-changer in your M&A journey, but it's not a decision to be taken lightly. Remember that expert guidance can make all the difference as you weigh your options.

That's where Exitwise comes in. We specialize in connecting you with top M&A experts tailored to your industry and needs.

Our advisors will be by your side throughout the process, from initial valuation to final negotiations. We'll help you interview, select, and hire the best investment bankers, M&A attorneys, and tax accountants to maximize your exit.

Reach out to us today and take the first step towards a successful business sale.