Co-Authored with Nishen Radia, Co-founder and Managing Partner, FocalPoint
A longstanding feature of many private-equity business sales is called, “rollover equity.” Many financial buyers want some equity to remain in the hands of the sellers as partial consideration for a buyout for several reasons. With financial buyers making up a significant portion of the buyer market, potential sellers should understand what rollover equity is, why it is important and pitfalls (and opportunities) to take note.
WHAT IS ROLLOVER EQUITY?
Rollover equity is when a seller reinvests a portion of the proceeds from a sale into equity of the acquisition company that is formed to buy the business. This portion can be as small as 5 percent to as much as just less than control at 49 percent.
Historically, buyers wanted sellers to retain equity in the newly formed company as another assurance that the sellers also believes in the future prospects of the company. With the optics of many transactions characterized as being about more than just money – finding a partner to fund growth, selling 100 percent of a company will potentially give a buyer cause for concern, particularly if the management team that remains is not A-team quality.
Structure can also play a role in considering rollover equity, as there can be tax consequences to get advice on, as sellers study an offer.
BENEFITS AND DOWNSIDES TO ROLLOVER EQUITY
What benefits should a seller consider as part of a proposal when deciding to accept rollover equity? There are two key benefits seen most often. First, accepting such consideration will help get the transaction closed and allow the seller to diversify its wealth planning activities as compared to not transacting.
Second, it allows the seller to participate partially in the future growth and value of the business at the time the financial buyer exits its investment. While not the norm, there are cases where a client was able to reap more cash value at the time of the second bite than in the first transaction.
There are downsides as well to sellers that accept equity as part of a transaction. Importantly, through no fault of their own, the business may falter under the buyer’s ownership. The risks inherent in the operations of any company are well known to every seller; operations managed by a new owner with different ideas of how best to execute add more uncertainty. The economic environment in which the company operates also presents risk, as seen this past year during the lockdowns promulgated by government officials as a response to the COVID-19 virus.
If the business does not perform to plan or loses value from market conditions, the value of the rollover equity piece may collapse all the way to nothing, leaving that piece of consideration as a drag to sellers’ plans or needs for that liquidity. Sellers should consult with personal wealth advisors to determine the necessity of this second bite of unknown future value as they analyze their individual financial goals.
There may also be benefits and costs from a tax perspective, depending on belief of the direction tax rates might be going.
IN AN UNCERTAIN ENVIRONMENT: RECENT DEVELOPMENTS AND TRENDS
Five years ago, private equity groups were adamant in wanting material-seller equity rollover in a transaction, often starting at no less than 30 percent of the go-forward ownership. As the M&A market has become more competitive, private equity groups have shown increasing amounts of flexibility with regard to how much equity sellers want to roll over post-transaction. Typical rolled equity amounts today range from 20 percent to 35 percent in most transactions. In some cases, sellers have been able to roll even less equity and still be able to reassure their incoming investors they will be as hungry as before. Working with advisors to properly message this is of paramount importance.
There have also been positive developments that are seller-friendly in the way rollover equity is being structured. Historically, private equity groups would request a preference on their investment ahead of a selling shareholder – in other words, they would get their money out first in a sale. However, in the new era of “founder-friendly” transactions, sellers have been able to ensure that their equity is “pari-passu” (the same instrument) as the private equity group. Private equity groups increasingly claim that doing so will allow an alignment of incentives going forward and optimize the likelihood of a strong outcome.
EXPECTATIONS FOR 2021
Much of 2020 M&A activity post-pandemic was driven by sellers wanting to transact and recognize gains ahead of a potentially strong showing by now President Joe Biden and the Democratic Party in the general election. Much of Biden’s tax plan has hinted at an increase in capital gains rates, and sellers have been eager to transact before any tax increases materialize. Now in 2021, it is predicted that sellers will continue to keep a keen eye on the tax agenda when deciding whether to lean towards increasing equity rollover amounts. If they believe Biden’s tax plans will not impact capital gains, no material change to seller behavior is expected in terms of rollover equity, the opposite being true if a capital gains rate hike seems imminent.
Another factor to consider is business performance through the pandemic. While multiples on sale transactions stayed strong in 2020, many companies experienced some level of business disruption. While private equity groups are willing to give some credit for that disruption, some sellers may feel that rolling over more equity prevents them from feeling like they sold too early. A higher percentage of go-forward equity ownership will allow a seller to feel like they are de-risking by taking money off the table today while preserving upside.
If you have any questions about rollover equity or other advisory services please reach out to GHJ’s Advisory Team or FocalPoint.