02 Sep Don’t Roll Over on Your Rollover; A Guide to Understanding Your Rollover Equity
One of the most critical details to understand when evaluating an offer to sell your company is the structure of the purchase price. It is easy to see the dollar sign and think “that’s what I’m getting for my company” but it’s important to pay attention to how the purchase price will be paid and specifically if a portion of it is rollover equity. The concept of rollover equity is generally straightforward, but understanding all of the terms and consequences of the rollover equity often requires a detailed analysis. This article seeks to provide a high-level overview of the topic to ensure that you don’t “roll over” when negotiating your rollover equity.
1. Why rollover equity?
While both buyers and sellers may have an interest in using rollover equity, it is generally the buyer that drives whether or not rollover equity will be part of the deal. This can cause you to feel like you have to “take it or leave it” without having done much research in to the new company. It is important to remember that you are indirectly investing your money in to another enterprise and you have a right to ask good questions and demand good answers before making this investment. The rollover equity is your ongoing investment and a significant part of the purchase price you are receiving for your company.
Your first question might be why rollover equity is being offered. Often, especially in deals with private equity groups, the rollover equity is used to bridge a gap in financing. Rather than raising or borrowing the funds to purchase 100% of a company, the buyer can allow the seller to roll over a portion of their ownership and therefore the buyer only needs to fund the remaining portion.
Rollover equity also aligns the interest of the parties; the seller and the buyer are both engaged in the business and have significant incentives to help the business continue to grow. A buyer wants to make sure the previous owners are using their knowledge and resources to help the business grow, and likewise, a seller wants to keep an eye on the business after closing for a variety of reasons including working towards any earn-out consideration offered and ensuring their customers and vendors continue to receive the same level of service.
Even if the buyer does not offer rollover equity, there may be reasons why you want to request rollover equity. One big reason is that if structured properly, the rollover equity will be tax deferred meaning you only pay tax on the percentage of the company sold in the contemplated transaction and not on the rollover equity. Rollover equity also allows you to cash out a controlling interest in their company while still maintaining a significant percentage ownership and having the potential for more upside as the company continues to grow.
2. How much rollover equity?
Once you have decided that rollover equity will be part of the transaction, it is critical to pay attention to the rollover equity valuation and resulting ownership. Without understanding this issue, it is impossible to determine if you are getting fair consideration for the rolled-over amount. Some structures are more simple and provide that the seller retains a percentage interest in the company they are selling. For example, say ABC Company, LLC sells household appliances. If a buyer that is a newly formed holding company proposes to buy 80% of ABC Company, the remaining 20% will be rollover equity (or a “retained interest”) and the owner will continue to own 20% of ABC Company. When determining the purchase price and rollover amount, the entire ABC Company will be valued and the buyer will pay 80% of such amount for the 80% interest. The owner has an understanding of their 20% interest, as they will have kept a 20% interest in the same company albeit there is now new ownership and the company has likely been recapitalized with more debt on the books than before. The math is relatively simple in that example but it is not always that straightforward.
Most private equity groups offer rollover equity at a holding company level, which complicates the issue in part because the holding company may have other assets besides the company they are purchasing from you. Rather than giving you a 20% interest in the company you are selling, private equity groups often issue the rollover equity further up the organizational structure so that all sellers that sell to the private equity group receive equity from the same entity. Continuing the example above, say this time you are selling ABC Company to PEG Company which has also purchased a few other regional household appliance companies in the past year. In that case PEG Company likely has a holding company, PEG Holdings, that owns all of the companies PEG purchased and they use that holding company for all rollover equity. So while the owner of ABC Company intends to rollover 20% of its value in ABC Company, the owner might only end up with a 2% interest in PEG Holdings because PEG Holdings owns a share in many other related companies so its value is much higher. To use real numbers, if ABC Company is valued at $1,000,000, the 20% rollover has a value of $200,000, but if PEG Holdings is worth $10,000,000 then the amount of ABC Company rolled-over only entitles you to 2% of PEG Holdings. In this example, the value of 20% of ABC Company equals to the value of 2% of PEG Holdings. To ensure that you are getting an appropriate interest in PEG Holdings, you must do diligence on the valuation and capitalization of PEG Holdings.
Reverse due diligence to understand the valuation can be difficult work. A lot of private equity groups are reluctant to share full capitalization tables or make any representations and warranties regarding their financial statements or structure, but most are open to some level of diligence on the valuation. Make sure you understand the value and proceed with caution if you are not getting the information you need to understand the value. It is a difficult position to take, but you need to prepare yourself to stand firm and maybe even walk from the deal if the buyer is not providing adequate information.
3. What are the perils of rollover equity?
Once you understand the value of your rollover equity, you should make sure you understand how your position has changed now that you have gone from a majority owner to a minority owner.
For starters, your liquidity has been significantly reduced. As a 100% owner (or majority owner), you had the option to sell all or a portion of your interest at any time, however the rollover equity will be subject to a new operating agreement, or other agreements, that contain significant restrictions on how and when the rollover equity can be sold. As a counter to these restrictions, the seller should negotiate “tag along” and “drag along” rights which ensure that if the buyer sells its interest in the future, the rollover equity will be sold with their interest. In other words, the buyer cannot sell their 80% interest without giving you the opportunity to sell your interest as well.
You will also lack any form of significant control over the company going forward. This can be partially addressed in the operating agreement by making sure that there are certain company actions that require the company to obtain unanimous consent or super-majority consent, effectively ensuring that you still have a say in those decisions. However, as a general principle you are now a minority owner in a more passive role and should not expect to control the day-to-day operations of the company.
Finally, you should make sure you understand the class of equity you are receiving as rollover equity. In many cases, it is the same class as owned by the other members at which point you can take comfort knowing their rights are the same as everyone else’s rights. However, there are times where the rollover equity will be a different class and therefore it is critical to pay attention to the rights and preferences associated with the different classes including the right to vote and the right to receive distributions.
4. Final Considerations
This is not a comprehensive list of all considerations of sellers contemplating rollover equity but it should serve as an introduction to the issues. Before moving forward with any rollover equity transaction, stop and ask yourself the following: Do I understand the value of the rollover equity? Do I understand the perils of the rollover equity and my rights and obligations under the new operating agreement? And, is my transaction structured properly to ensure the rollover equity is tax deferred?
We have assisted sellers in numerous transactions with rollover equity and seen that it can be a great benefit to buyers and sellers alike. In our experience, in order for both sides to receive the benefit of using rollover equity it is imperative that both sides understand the value of the rollover equity and the nature of the relationship moving forward. Rollover equity can give you great upside, a continuing interest in the business, and if done properly, tax deferred status. It may seem daunting but you’re not alone in the process. We are here to help.