Rollover Equity: Considerations for Sellers and Buyers

Rollover equity is a strategy frequently used by Private Equity (PE) firms when acquiring tech companies, and it has implications for both sellers and buyers. In a rollover equity transaction, the seller invests a portion of the sale proceeds back into the company being acquired. Specifically, in a PE transaction, the seller invests part of their proceeds into the PE firm's entity that is purchasing their company.

For example, if the owner of a profitable tech company sells their business to a PE firm for €30 million, the firm might allow the seller to roll over 15% of the sale proceeds—€4.5 million—into the acquiring company. Thus, the seller receives €30 million in cash while also gaining a 15% stake in the newly PE-owned company.

There are several advantages for the seller when investing in rollover equity. This approach can be beneficial, especially for sellers who wish to remain involved in the business. By rolling over equity, the seller becomes a minority owner, which allows them to maintain involvement while reducing personal risk, as their financial exposure is not entirely linked to a single entity. Additionally, rollover equity can offer tax advantages; it may be structured as a tax-free rollover, deferring taxes on the rolled-over amount until the acquired company is sold in the future.

One of the most appealing aspects of rollover equity is the opportunity it gives the seller for a "second bite at the apple." This means the seller can realize additional returns if the buyer later sells the acquired company at a higher valuation. For instance, if the PE firm sells the business after five years for €150 million, the seller's 15% stake would yield an additional €22.5 million.

For the buyer, rollover equity means they require less cash upfront to close the deal. However, both buyers and sellers must consider some potential issues related to rollover equity. Here are some key points to think about.

Who Will Run the Acquired Company?

In many cases, PE firms want the seller to continue leading the business post-acquisition, or at least to hold a significant leadership position. Often, they also prefer to retain the seller's management team. This is because the buyer sees the seller as a valuable talent who can help maximize the company's growth. Furthermore, having the seller maintain a personal stake in the company's future success is important to the buyer. For the seller, staying with the company allows them to collaborate with a knowledgeable partner who can help spur growth. If the seller chooses to remain, it indicates their belief in the future success of the new entity, creating a win-win situation for both parties.

However, not all sellers want to stay involved. Some may prefer to step away completely from the daily operations of the business, possibly due to personal reasons like health concerns. In such cases, a straightforward buyout or a single payment might be more appropriate.

Even for those sellers who want to stay involved or take on a leadership role, the differing philosophies and strategies of the buyer may complicate matters. While buyers conduct thorough due diligence before an acquisition, it is equally important for sellers to assess the buyer, especially if the buyer lacks a solid record of achieving returns that meet the seller's expectations. Part of this evaluation should include understanding whether the buyer's approach aligns with the seller's business philosophy. For buyers, ensuring that the seller invests in the acquired company through rollover equity helps align both parties' interests in pursuing the company's future success. Retaining the seller in a leadership position allows their experience and expertise to continue benefiting the company after the acquisition.

Who Is Eligible to Roll Equity?

In a typical rollover equity scenario, the CEO of the selling company is usually offered the option to roll over their equity into the new entity. However, if other members of the management team who are also shareholders will actively run the new business, the buyer may extend this opportunity to them as well. Generally, buyers are selective about who can roll equity into the new entity. This can sometimes lead to tension; for example, if the seller feels loyal to their management team but is restricted in sharing the opportunity.

How Much Equity Will Be Rolled Over?

One important consideration in any transaction is how much equity the seller will roll over. The amount that the buyer allows the seller to roll over is often a point of negotiation. For instance, a buyer might want the seller to roll over up to 20%, while the seller may prefer to roll over up to 30%, or vice versa. This depends on the seller’s plans for the proceeds from the sale. If the seller receives €10 million from the sale of their company, where do they intend to invest that money? This will impact their decision on the equity rollover. Additionally, private equity firms may prefer that the seller retains a larger stake in the business, sometimes encouraging them to roll over as much as 49%. Ultimately, it depends on the specific investor and the seller’s goals.

What Class of Stock is Offered?

Private equity firms may offer various classes of stock to their investors and employees of portfolio companies. Generally, sellers are on equal footing with other investors in the company being acquired. It is crucial for sellers to carefully review the Letter of Intent and the shareholder and operating agreements with the buyer to understand the type of shares they will receive if they roll over equity.

In certain situations, the capitalization table may include preferred stock. If this is the case, the buyer may utilize preferred shares to structure the deal. To ensure equal treatment, sellers should also be offered preferred stock, which may require negotiation. The seller's needs, the preferred approach of the investor regarding rolled equity, and the seller's specific goals will all play a role in these discussions.

It’s important to note that a seller’s equity can be diluted if the buyer conducts an additional stock offering or makes a capital call. To maintain their equity percentage, sellers should ensure they have the right to purchase a proportional amount of any new shares being offered, on the same terms and price as other investors. Sellers must also verify that they are treated equally with others on the capitalization table, which can be achieved through come-along rights (sometimes referred to as tag-along rights). These rights allow sellers to sell their shares on a pro-rated basis under the same conditions as the private equity firm if it decides to sell shares. Sellers should confirm that their come-along rights cover scenarios in which the PE firm sells part of the company's equity, as well as situations involving a complete exit.

Can the Seller's Shares Be Bought Before a Liquidity Event?

In certain cases, a private equity firm might include a call option in the rollover equity terms, allowing the firm the option to buy the seller's shares before a complete exit occurs. This could be disadvantageous for the seller, as the shares are likely to be purchased at a lower price than what the seller could receive if the company were sold outright. One of the primary reasons for rollover equity is to allow the seller a “second bite of the apple” when the buyer later sells the acquired company at a higher valuation. Sellers should approach the inclusion of call options in the rollover terms with caution, as they may reduce potential future gains.

Can the Seller Sell Shares Before a Liquidity Event?

Sometimes sellers negotiate the inclusion of a put option in the rollover equity terms, granting them the right to sell their shares. It’s also possible for both put and call options to be present in the rollover terms. However, the timing and valuation for both options need to be carefully negotiated. While these options can effectively align the buyer's and seller's interests, the negotiation process can be challenging.

Ultimately, successful negotiations hinge on mutual trust and flexibility.

Rollover equity is a negotiable component of an M&A agreement, and negotiations can often become complex. Discussions regarding rollover equity can continue right up to the deal's closing, as there are many considerations beyond just timing and price. For example, what happens if the seller becomes incapacitated or passes away? What if not all shareholders of the seller's company have the option to roll over their equity? These are just a couple of possible issues to consider.

In any case, it is in the interest of both the seller and the buyer to be flexible and find an arrangement that benefits both parties fairly and equitably. Being adaptable regarding rollover equity can also enhance reputational benefits. Provisions surrounding rollover equity are similar among various financial buyers. However, those who approach negotiations with a willingness to be flexible, rather than adhering to rigid mandates, are more likely to achieve significant benefits and establish a reputation for fairness within the M&A community.