Summary: An equity rollover happens when the seller of a company reinvests a portion of the proceeds into the newly formed acquiring entity. Typically referred to as "rollover equity," it is common in middle-market leveraged buyouts and serves multiple purposes.

This article explains how rollover equity works, its benefits, and potential areas of caution. We cover the following:

1. What is rollover equity?
2. What are the seller's benefits?
3. What are the buyer/sponsor benefits?
4. Common challenges
5. Conclusion

1. What is rollover equity?

Middle-market business acquisitions typically involve a sponsor, such as a private equity group or family office, who wants to purchase the company. Sponsors usually want to retain the target's management team after an acquisition since the team knows how to operate the business.

This situation creates a dilemma for the sponsor. How can the sponsor convince the owners or management to stay after the acquisition? It's not unusual for management to have an equity stake in middle-market companies. The sale of the business creates a liquidity event for them.

Why should the management team stay? They just cashed out of the business. And even if the managers decide to stay, what is their incentive to perform as buyers expect? This is where seller equity rollovers come in.

An equity rollover is a transaction where a seller reinvests some of the sale proceeds into the newly formed acquiring entity. It provides the seller's management team with partial ownership of the new entity, which helps align the interests of both parties. However, using rollover equity also helps with other buyer and seller objectives.

2. What are the seller's benefits?

An equity rollover can be beneficial for sellers in many cases. These benefits fall into three areas.

a) Take some money out of the business

The equity rollover allows sellers to take some equity out of the business without having to give up their entire ownership stake. It can be one of the few opportunities for a small to midsize business owner to sell equity.

b) Leverage future growth potential

An equally important benefit is that sellers keep an ownership stake in the post-acquisition entity. Consequently, they can benefit if the company is sold for a profit or taken public. From the seller's perspective, they can participate in two company sales. The first sale happens when they initially sell the company to the buyer/sponsor. The second sale occurs when the post-acquisition entity is eventually sold or taken public.

c) Reduce liabilities

The equity rollover can help reduce future seller liabilities since they may go from being majority owners to minority owners of the post-acquisition entity. Minority owners below a certain percentage typically don't have to guarantee company debts and may have other reduced liabilities.

3. What are the sponsor benefits?

Sponsors typically require equity rollovers, especially those who want to retain the ownership and management team in the post-acquisition entity. Benefits fall into the following three areas.

a) Aligns incentives

Having the seller invest in the post-acquisition entity ensures that they have the potential to gain in any future liquidity event. Consequently, they are likely to have the same incentives as the sponsor. Having the seller's management as a minority owner also helps ensure buy-in of the future strategy.

b) Reduces equity injection

Lenders typically require that sponsors contribute equity towards the transaction. The size of the equity injection contribution is often a subject of intense negotiation between both parties.

From a lender's perspective, a higher equity injection reduces their risk. This is why an equity injection is a requirement to finance most middle-market acquisitions. On the other hand, sponsors want the lowest possible equity injection they can negotiate. A smaller equity injection serves two objectives. It increases the sponsor's equity returns by allowing them to structure the acquisition as a leveraged buyout. Additionally, it reduces their need to raise equity.

Having rollover equity in the transaction helps reduce the size of the sponsor’s equity injection contribution. This is another reason sponsors typically ask sellers to invest in the post-acquisition entity.

c) Shows seller confidence in their business

A seller's willingness to invest part of their proceeds as an equity rollover shows they have confidence in their company and its prospects. Furthermore, it shows a commitment to invest in this potential upside. This show of confidence is important for both sponsors and potential lenders.

4. Common challenges

An equity rollover may initially look attractive to sellers. However, they also have potential challenges that must be considered. These challenges include the following.

a) Poor fit

This financial arrangement requires that sellers and sponsors work together productively for several years. However, the management teams will operate in a different business landscape at the post-acquisition entity. They will face ongoing requirements to grow, cut costs, and produce enough cash flow to cover lender payments. The management teams must be comfortable with these objectives while operating under the direction of their sponsors.

b) Shareholder stock class

Companies may have different classes of stocks, with the higher classes typically having the most voting rights. Sellers must consider the types of shares they will get in the post-acquisition entity. In general, sellers typically want the highest class of shares.

c) Dilution

Dilution happens when the percentage you hold of a company decreases when new shares are issued and sold to investors. The post-acquisition entity may eventually issue shares, affecting your ownership percentage. Dilution can be an issue if the buyer is engaged in roll-up acquisitions and needs to issue additional shares and new companies are added to the acquiring entity.

d) Ability to hold shares until the sale

The equity rollover may come with a clause that gives the sponsors the right to buy your shares at a specific price in the future. This clause gives the sponsor the ability to buy you out at a fixed price if they believe they can sell the company at a higher price in the future.

e) Come-along rights

Come-along rights give minority shareholders the right to sell their shares if a majority shareholder sells theirs. This right is important since it also enables the management to sell equity if the sponsor offers theirs.

f) Business may not succeed

There is a chance that the strategy and company will fail. Leveraged buyouts, by definition, use a high level of debt. This debt leaves the company vulnerable to problems and is a well-known risk of LBOs.

The company could sell for a value below what the buying group paid. Consequently, the equity rollover may bring less than what was initially rolled over or could lose all its value.

5. Conclusion

A well-executed seller rollover equity transaction in the right entity has the potential to benefit the original sellers. However, a poorly executed rollover could become a long-term financial nightmare.

These transactions are complex, and the only advice we can offer is for participants to get legal and financial counsel. Ideally, sellers should consider working with an attorney and a CPA who are familiar with middle-market company mergers and acquisitions and who have track records of successful transactions.

Want to finance a business acquisition?

We offer small business, lower-market, and middle-market acquisition financing. The first step to work with us is to submit this form. Once we review it, one of our associates will contact you to discuss the specific details of your acquisition.

Editor's note:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.