Rollover equity, something that Private Equity firms often utilize when they buy tech companies, has implications for both sellers and buyers. In rollover equity, the seller invests part of the proceeds of the sale of his or her company with the buyer. In a Private Equity transaction, it means the seller invests part of the proceeds from the sale into the PE firm's entity that is acquiring the company. For example, suppose the owner of a profitable and growing tech company sells his company to a PE firm for $30 million. The PE firm gives the seller the opportunity to roll 15% of the sale proceeds ‒ in this case, $4.5 million ‒ into the acquiring company. The seller pockets $30 million, and by rolling that 15%, the seller now has a 15% stake in the now PE-owned company.
Investing part of the proceeds this way has many potential advantages for the seller. Corum Senior Vice President Jeffrey Bunting points out that rollover equity can be a great deal for the seller, particularly if they want to stay involved in the business. The rolled equity makes the seller a minority owner, so it keeps the seller involved in the company. And because the seller is no longer a majority owner, it reduces personal risks because as Bunting puts it, “All of your eggs are no longer in one basket.” Rollover equity can also have tax advantages because it can be structured as a tax-free rollover where the proceeds that are rolled are not taxable until the acquired company is sold in the future.
Perhaps most attractive, rollover equity offers the seller a "second bite of the apple" ‒ the opportunity to realize additional returns when the buyer later sells the acquired company at an increased valuation. For example, suppose after five years, the PE firm sells the acquired company for $150 million. The seller’s 15% stake now puts an additional $22.5 million into his or her pocket. For the buyer, rollover equity means less cash that they need to provide to close the deal.
However, sellers and buyers need to consider some of the potential issues related to rollover equity. Here are some of them.
Who runs the acquired company?
In addition to offering rollover equity as part of an acquisition, PE firms often want the seller to continue running the business after it's purchased, or at least take a leadership position with the acquired company. Sometimes the PE firm may also want the seller’s management team to stay on. According to Bunting, in these cases the buyer sees the CEO or founder who is selling the company as a really good talent, someone they want to work with. Furthermore, the buyer wants the seller to have skin in the game, that is, a personal stake in the acquired company’s future success. For the seller, staying on with the company gives him or her the opportunity to work with a savvy partner who will likely grow the business. Bunting notes that it’s telling for a seller to stay with the company because it means the seller believes in the future and thinks the new entity can do really well. “It's kind of a win-win for both the buyer and the seller from that perspective,” says Bunting.
For some sellers, continuing to run the business might be exactly what they want. However, some sellers may want to make a clean break from the day-to-day grind of operating a company. Or perhaps they need to leave for health-related reasons. In those cases, Bunting says a straight buyout or a buyout can make more sense.
Even if the seller wants to continue running the acquired company, or be there in a leadership role, the philosophy, strategy, and approach of the buyer to running a company may be so different from those of the seller, that it makes the seller's continued role in the company problematic. While the buyer will necessarily go through a thorough due diligence process prior to the acquisition, it's also good practice for the seller to do some investigation to assess the buyer. This is particularly important if the buyer does not have a strong track record of getting the kind of return that the seller expects for his or her equity contribution. And part of that assessment is understanding if the buyer's philosophy, strategy, and approach to running a company mesh well with the seller's ‒ in other words, if it's a good fit for both parties. From the buyer's point of view, requiring the seller to invest in the acquired company through rollover equity is a way to align the interests of both parties in working towards the company’s future success. And keeping the seller in a leadership position ensures that the seller’s experience and expertise continues to guide the company post-acquisition.
Who gets to roll equity?
Typically, in a rollover equity scenario, the CEO of the selling company is given the option of rolling equity into the new entity. However, Corum Executive Vice President and Director, David Levine, notes that if some of the seller's management team, who are also shareholders, are going to be active in running the new business, the buyer may also offer them the option of rolling equity. However, Levine points out that in general the buyer is going to be particular about who they want rolling equity into the new entity. In some cases, this could engender some contention. For example, if the seller, out of loyalty to his management team, wants them to have the option to roll over equity, but the buyer, wanting to control their cap table, restricts that option only to the seller, or extends the option to only a few of the seller's managers.
How much equity will be rolled over?
Another consideration is the amount of equity to be rolled over. Levine says that the amount the buyer will allow the seller to roll over is sometimes heavily negotiated. A buyer may want the seller to only roll up to 20%, but seller might want to roll 30%, or vice versa. Levine puts it like this: "It depends on what the seller is going to do with the proceeds of the sale. Where are they going to invest their dollars? If they get $10 million in the sale of their company where are they going to put it? That will be the calculus for them. What's the amount of roll they want to do? You also have private equity firms that might want the seller to have more skin in the game. So maybe they'll want the seller to roll 49%. It just depends on who the investor is and what the goals of the seller are.”
What class of stock is offered?
PE firms may propose different classes of stock for their investors and for employees of the companies in their portfolio. Typically, sellers are on an equal footing with others who are investing in the company being acquired. Sellers need to carefully review with the buyer the Letter of Intent and shareholder and operating agreements regarding the type of shares they will receive if they roll equity.
In some cases, the capitalization table may include preferred stock. Levine has guided sellers in transactions where the buyer utilized preferred shares to structure the deal. To be on the same footing, the seller was also offered preferred stock. But Levine stresses that this needs to be negotiated. He says, "It depends on who the investor is, what their preferred approach to rolled equity would be, and the seller’s goals."
Note that the seller's equity can be diluted if the buyer has an additional stock offering or capital call. To retain the same percentage of their equity, sellers need to ensure they have the right to purchase a proportional amount of the new shares being offered or increase their investment, at the same price and terms offered to other investors. Sellers also need to ensure that they are on an equal footing with others on the cap table. The way to achieve that is through come-along rights, sometimes called tag-along rights. If the PE firm sells shares, come-along rights allow the seller to sell their shares on a pro-rated basis and with the same terms and conditions as the PE firm. It's important that sellers ensure they have come-along rights that cover situations where the PE firm sells part of the company's equity as well as in cases where the PE firm does a full exit.
Can the seller's shares be bought before a liquidity event?
Sometimes, a PE firm will insert a call option in the rollover equity terms. This gives the PE firm the option to buy the seller's shares prior to a full exit. This may be disadvantageous to the seller because it's likely that the seller's shares will be purchased at a lower price than what the seller would get if the company is sold. Remember, a main reason for rollover equity is for the seller to get a "second bite of the apple" when the buyer sells the acquired company at an increased valuation. Sellers should be careful about agreeing to call options in the rollover terms because they can undercut the seller's future gains when the company is sold.
Can the seller sell shares before a liquidity event?
Sometimes a seller will negotiate to have a put option included in the rollover equity terms. This gives the seller the option to sell his or her shares. Levine was involved in a deal where the seller was close to retirement and wanted to ensure that they could sell their shares if the buyer was not willing to sell the company in a specified amount of time. Because the seller did not have the luxury of waiting for an extended length of time for an exit, a put option was negotiated giving the seller a way to sell shares before a liquidity event. Levine says that in this case, both put and call options were included in the rollover terms. However, he stresses, "The timing and valuation of put and call options need to be negotiated. These options can be very effective tools to get the buyer and the seller aligned. But it's not always easy."
Will it make the buyer more attractive to the seller?
Giving the seller the option to roll equity can make a prospective buyer more attractive to a seller. Bunting recalls a case where a potential buyer offered more money to acquire a tech company, but the seller chose another buyer because they allowed the seller to roll equity ‒ even though the second buyer made a lower offer than the first.
It's all about mutual trust and flexibility
Rollover equity is a negotiable part of an M&A agreement. And sometimes the negotiations around rollover equity can be complicated. Levine points out that negotiations related to rollover equity can continue all the way through to the close of a deal because there are aspects of the rolled equity negotiations in addition to the timing and the price. For example, he says, "What happens if the seller becomes incapacitated or dies? What happens if not all the shareholders in the seller's company get the option to roll equity? Those are just a couple of potential issues that come to mind."
In any event, it is in both the seller's and buyer's interest to be flexible and agree on an arrangement that gives both sides a fair and equitable amount of benefit. Being flexible regarding rollover equity also has reputational benefits. Corum Vice President Alden Mendoza puts it this way: "Provisions around rollover equity tend to look similar to a lot of financial buyers. But those who go into negotiations with latitude to differentiate themselves through less rigid mandates tend to reap the greatest benefits and build for themselves a reputation for fairness in the M&A community."