Rollover Equity — When to Do It and When Not to Do It

2023 was a down year for mergers and acquisitions, which plunged to their lowest level in a decade. Global M&A was down 20% in 2023 compared with 2022. The reason? With higher interest rates, buyers and sellers are having a tougher time coming together on price. One way to get a deal done is for business owners to roll over part of their equity into the new entity. 

Rollover equity is a transaction structure that allows sellers to reinvest a portion of their sale proceeds into the acquiring entity. This can be a double-edged sword as it presents an opportunity for continued growth and wealth creation, but it also carries inherent risks.  

Why would any business owner looking to sell also consider keeping some equity in the business after they lose control? Here's one reason: If the new buyer is a private equity firm, they will most likely be looking to sell the business in 3-5 years. This would give the business owner another bite at the apple. 

Why else? In this high-interest-rate environment, the interest rate on debt owed by the business may be at a significant discount to current rates. If a business owner sells more than a controlling stake, then that ability to keep that low-rate debt may be an attractive option for a buyer. 

Finally, the selling business owner may believe that the new owner(s) will be able to add value beyond their capability, increasing the intrinsic value of the business and allowing a buy-out at a higher price later. 

What Exactly Is Rollover Equity?

Rollover equity is when the seller of a business retains a stake in the newly combined entity by selling less than 100% of the business to a buyer. In essence, the seller "rolls over" a percentage of their equity into the acquirer's company, becoming a minority shareholder. This approach allows the seller to participate in future success, providing tax advantages by deferring capital gains taxes on the reinvested portion of the sale proceeds and potentially getting a higher buy-out price later.

When Does it Make Sense for a Business Owner to Rollover Equity?

When they have a belief in the acquirer's vision and growth potential. For business owners who firmly believe in the acquirer's strategic vision and future growth potential, rollover equity can be an attractive option. By maintaining a stake in the combined entity, they can benefit from the synergies and economies of scale that the acquisition brings. This alignment of interests can be particularly compelling when the acquirer has a proven track record of successfully integrating and growing acquired businesses.

You are not ready to retire or move on to your next chapter and want to stay involved in the business after the sale. Many business owners are deeply passionate about the businesses they have built, and the thought of completely severing ties can be emotionally challenging. Frequently, their friends, family, and support network are all part of the business, making business a frequent dinnertime topic. Rollover equity provides an avenue for these individuals to maintain a connection with the company. As part of the transaction, they could be offered leadership roles or advisory positions within the combined entity, allowing them to continue contributing their expertise and guiding the business's future trajectory.

In this world, nothing is certain except death and taxes and all things being equal, you would rather pay less taxes than more. In this case, rollover equity transactions can offer significant tax advantages by deferring capital gains taxes on the reinvested portion of the sale proceeds. This deferral can result in substantial tax savings, which the business owner can then reinvest in the combined entity or explore other investment opportunities. Always consult with tax professionals to fully understand the implications and ensure compliance with applicable regulations.

When Should a Business Owner Not Rollover Equity?

You like the color of the potential acquirer’s money, but you are not confident in their management ability. While rollover equity can be enticing, it also carries the risk of tying a significant portion of an individual’s personal wealth to the combined entities’ performance. If there are concerns about the acquirer's ability to effectively integrate and grow the acquired business, accepting rollover equity may not be a good idea. Remember that due diligence goes both ways, and thoroughly vetting your counterparty, including their education, work history, track record, management team, and operational capabilities, is essential before deciding to invest your hard-earned equity into the new enterprise.  

You are done. Whether it be stress, health, or other personal considerations, you just want a clean break from the business. For some business owners, the sale of their business represents an opportunity for a fresh start and a chance to pursue new ventures or interests. In such cases, accepting rollover equity may not align with your personal goals and aspirations. A clean break can provide the freedom and flexibility to explore alternative paths without the constraints or potential conflicts of interest associated with maintaining a stake in the former business.

Your business most likely represents a significant percentage of your net worth. Taking risk off the table means that you will need to diversify your portfolio to less volatile asset classes. Concentrating a significant portion of your personal wealth in a single entity can expose business owners to heightened risks. Rollover equity transactions inherently limit portfolio diversification, which is a fundamental principle of risk management. Business owners must carefully evaluate their overall financial situation, investment objectives, and risk tolerance before committing a substantial portion of their net worth to a single investment post transaction.  

What You Need to Think About

If you determine that rolling over some equity is the best personal and financial decision for you then what percentage should you roll over? The percentage of rollover equity negotiated in a transaction can significantly impact the overall deal structure and the entrepreneur's level of risk exposure. Typical rollover equity percentages range from 5% to 25%, but can vary depending on the specific circumstances. It's crucial to negotiate a fair and reasonable percentage that aligns with the business owner’s objectives and risk tolerance.

To protect the interests of both parties, rollover equity transactions often include vesting schedules and clearly defined exit mechanisms. Vesting schedules ensure that the business owner’s rollover equity stake is earned over time, typically through continued employment or advisory roles. Exit mechanisms, such as put options or redemption rights, provide a path for the business owner to eventually cash out their rollover equity stake, either through a future sale or a buyback by the acquirer.

Due diligence and legal considerations go both ways. As a business owner considering rollover equity you are taking on new investment risk. Engaging in a rollover equity transaction requires thorough due diligence on the acquirer's financial and operational performance, as well as a comprehensive understanding of the legal implications and due diligence on what the combined entity will look like. Seeking the guidance of experienced legal counsel is essential to navigate the complexities of these transactions, ensure proper structuring, and protect the business owner’s interests throughout the process.

Negotiating the Right Deal Terms

In addition to the key considerations discussed earlier, business owners must also be prepared to negotiate favorable deal terms when accepting rollover equity. These terms can have a significant impact on the potential upside and downside of the transaction.

Thoroughly understand the valuation and pricing. The valuation of the combined entity and the pricing of the rollover equity stake are critical factors that can significantly influence the potential returns for the business owner. It's essential to ensure that the valuation is fair and accurately reflects the true value of the business, as well as its growth prospects. Engaging experienced valuation experts and negotiating with the acquirer to arrive at a mutually agreed-upon valuation is crucial.

Agree on governance and control provisions before the deal closes. As a minority shareholder in the combined entity, business owners should negotiate governance and control provisions that protect their interests and provide a degree of influence over strategic decisions. These provisions may include board representation, voting rights, and veto power over certain actions that could significantly impact the value of their rollover equity stake.

Negotiate anti-dilution protections. Rollover equity transactions can involve future capital raises or equity issuances, which can dilute the business owner's ownership stake. Negotiating anti-dilution protections, such as weighted-average or full-ratchet provisions, can help mitigate the effects of such dilution and preserve the value of the rollover equity.

Will there be any non-compete and non-solicitation clauses? Acquirers may seek to include non-compete and non-solicitation clauses in the rollover equity agreement to prevent the business owner from engaging in activities that could compete with the combined entity or solicit its employees or customers. While these clauses are common, it's important to negotiate reasonable time and geographic limitations to protect your future business interests.

Conclusion

Rollover equity presents both opportunities and challenges for business owners selling their businesses. While it offers the potential for continued growth, wealth creation, and involvement, it also carries risks and requires careful consideration of individual circumstances. Business owners must weigh the advantages of participating in the future success of the combined entity against the potential drawbacks of tying a significant portion of their personal wealth to the acquirer's performance.

The decision to accept or reject rollover equity should be based on a thorough evaluation of factors such as the acquirer's vision and capabilities, personal goals and risk tolerance, tax implications, and diversification needs. By seeking professional advice and conducting rigorous due diligence, business owners can make informed decisions that align with their long-term objectives and financial well-being.