When you sell your company, should you consider “rolling over equity” into the buyer’s company?
It depends. It is no secret that 2019 and 2020 next may be the best time to sell your company. A lot of money is on the sidelines looking for investment opportunities and buyers are paying premiums for well run, privately held companies. Often, buyers offer business owners an opportunity to roll over a part of the purchase price proceeds into the buyer’s company.
This is particularly true with many private equity (PE) firms who are searching for companies in the lower end of the middle market space. We see many private equity acquisitions and some add-on deals offering business owners what is referred to as rollover equity. Rollover equity arises when certain equity holders in the target company, including founders and key members of the management team roll a portion of their ownership stake over into the new equity capital structure put in place by the acquiring PE firm. In other words, they sell less than 100% of their interest with the balance becoming equity in the new capital structure.
Equity rollovers generally result in post-transaction ownership by the seller from 10% to 40%. In a 30% rollover, for example, the private equity firm would own 70% of the newly capitalized equity in the business with the seller “rolling” a proportionate amount of value to equate to 30% of the new equity.
Private Equity: Rollover Upsides
Most PE firms strongly prefer equity rollovers for seven reasons:
1. Asymmetric information benefits the seller. The seller has more knowledge than the buyer since the owner has operated in his/her industry over many years. Buyers believe that the acquisition will be more successful with the sellers at the helm.
2. Confidence is built with the buyer. When the seller accepts an equity rollover, it signals confidence to private equity buyers that continuity will be assured, and the interests of the seller and buyer will be aligned.
3. Rollover equity incentivizes sellers to continue to grow the business. With “skin in the game” sellers provide buyers with some comfort that those who built the business are incentivized to continue to grow it since they retain an economic interest in the business.
4. Less capital is needed in the acquisition from the buyers. Since the sellers are investing some of their profits from the sale into the buyer’s business, less capital is needed from the buyers to buy the seller’s business.
5. Alignment between the parties provides the buyer to grow the business in a shorter period of time. This arrangement helps align the seller’s management team to align with the buyer’s management team’s growth objectives since the seller will continue to have “skin in the game” post-acquisition.
6. Seller receives major liquidity from the initial sale of their company. At the same time rolling over a portion of their equity allows them to participate in further upside — a “second bite at the apple” in a second sale by the PE firm.
7. Sellers rolling over equity can defer taxes. From a tax perspective, taxes can be deferred by sellers on the portion of the purchase price that is rolled over into the new capital structure from the seller.
How does an equity rollover work?
Owners contemplating an equity rollover often find themselves facing a new world in terms of capital sources and leverage. Most of our clients have a modest amount of bank debt and a single class of stock (perhaps split among several shareholders/members). Private equity capital structures typically consist of multiple tranches of debt (mezzanine, junior, and senior debt), or one large piece of “unitranche” debt. Also, the structure can include differing levels of liquidation preferences in the equity structure of the capital stack. The increased complexity of the capital stack and the different debt structures are not business characteristics many owners are experienced or comfortable with.
Equity rollovers offer substantial upside, and downside. For example, consider the hypothetical transaction involving an equity rollover with a PE firm. Two brothers jointly own a distribution business. They are considering a transaction with a private equity firm. The enterprise value of their company is $12 million; the outstanding debt is $1 million, and a $2 million equity rollover has been requested from the PE firm. After paying off the debt and reinvesting the $2 million, the brothers pocket $9 million. The new capital structure, post transaction, is 50% equity and 50% debt (a mixture of senior and mezzanine debt), with the PE firm owning 80% and the brothers owning 20% of the recapitalized company. Leverage is implicitly touted as a benefit to sellers considering an equity rollover. The argument is that when the business grows, debt is paid down, and the business is eventually sold to a strategic buyer for a higher price. In this example, the second transaction will yield $50 million for the business. All equity owners earn a return on their investment. In this case, the brothers parlayed their $2 million equity rollover into nearly $10 million.
Equity rollovers can also bring risk. PE investors generally operate with a more leveraged capital structure than family-owned firms or entrepreneurial firms. While added leverage boosts equity returns, risk increases as well. For the PE firm considering this business as one in a portfolio, the risk/return ratio might be more suitable to the buyers than to the sellers with this being their only investment.
PE firms love to promote success stories, particularly the instances where an owner made more on the second sale than in the initial sale. A seller doesn’t typically hear about the disasters. A seller considering a rollover should ask for the capital structure pro-formas, and detailed financial pro-formas the PE firm has created to support such a capital structure and financial projections.
For those considering a rollover, the following four questions should be asked:
- Taxes — Will the transaction enable a tax-deferred rollover?
- Corporate governance — What say does the seller have in ongoing strategic, operating, and financial decisions?
- References — How has the PE group behaved in partnership with previous sellers?
- Debt — Does the higher leverage require personal guarantees of the debt in what will most likely be a more leveraged business?
To roll or not to roll
Our clients are generally entrepreneurs or families who have built successful businesses over many years or decades. When they finally reach the difficult decision to sell, most sellers do not contemplate retaining a piece of the business. It is not because they have a negative view of the business, but because they have poured so much of their lives into their businesses that retaining any involvement — financially, operationally, or emotionally — conflicts with their decision to sell. Those owners should seek a strategic buyer who wants to own a 100% of their businesses.
For those owners rolling over equity need to fully appreciate that while they are partnering with the PE group “buying” their company, the seller’s influence over important decisions may be minimal. Compatibility with the new owner with regard to strategy, expectations, culture and performance metrics are important to asses before becoming partners. It is important to be comfortable with the decision-making rules of the governance agreement. Some PE firms expect a hidden form of return (fees) that often doesn’t show up until the deal is being documented:
- Management fees
- Finders fees
- Administrative fees
- Breakup fees
- Transaction fees
- Origination fees
All the fees above contribute to a skewing of the returns among the parties. PE firms will argue these expenses are non-recurring and therefore shouldn’t affect value in a future sale, but they are real cash expenses that alter the return profile of the two parties. Asking for a complete schedule of proposed fees earlier in the process will reduce unpleasant surprises further down the road.
Getting professional advice in advance and during discussions with PE firms or other strategic buyers is a must if you want to avoid disappointments down the road. So, the answer to the question, “Should I roll over equity in the buyer’s company”?