Rollover Equity in Private Equity Deals – Considerations and Implications

Most Private Equity deals in the lower middle market are structured where at least a portion of the sale proceeds paid to the seller(s) are rolled back into a new capital structure of the company, alongside the equity provided by the PE firm. This provides a source of financing for the Private Equity buyer and lowers the amount of equity they need to invest, but more importantly, it demonstrates that the target company’s founders, owners, and/or management are confident in the business’s future.  When combined with an ongoing role in the new partnership, it is an opportunity for the seller to contribute to the business’s future success without taking on all the risk themselves.  Of course, besides the fact that the seller does not receive “all cash” at the close of the transaction, it has many other financial, legal and, tax implications that should be clearly understood by the seller.

The first consideration that is usually top of mind with sellers, is whether the PE firm will take a majority or a minority equity position in the newly capitalized business.  Some entrepreneurs are accustomed to making all the key business decisions and can be uncomfortable in giving up control while staying involved.  On the other hand, many PE firms that participate in the lower-middle market are not able to take non-controlling positions, and those that do, only do so in special or specific circumstances.

From a practical standpoint, whether the PE firm has a major minority position (i.e. at least 25-30% ownership), or a majority, it will only be successful if both sides have a common vision and clear alignment on strategy.  The last thing a PE firm wants is to have a falling-out with legacy owners, based on a major disagreement on the strategic direction of the company.  While disagreements can occur during the common ownership period, it is important to get off to a strong start, so that those disagreements can be worked out respectively and amicably regardless of who is in ultimate control.

It is also important to clearly understand the respective roles and responsibilities of each party.  Most PE firms will say that they don't want to run the business, but what that means from a practical standpoint, can vary from firm to firm.  Rarely will a PE firm be a truly passive investor.  The best outcomes are usually where an entrepreneur is looking for the professional support and experience that is provided by a PE partnership, and where both parties are focused on building value for an eventual full exit.  Entrepreneurs need to be comfortable with the added reporting, planning, and governance that usually accompanies a PE deal.

One of the key benefits of rolling equity is that the lower risk for the PE firm can translate into a higher value the PE firm is willing to pay.  And of course, if during the period of common ownership, the capital and resources provided by the PE partner can help scale the business and build value, the value for the legacy owner’s rollover stake can be much higher when the business is sold down the road.

Often the PE firm will use some degree of leverage to finance the deal as well. While many business owners view debt as risky and have avoided its usage wherever possible, its use along with the shared risk taken by the PE firm can further enhance the legacy owner return on their rollover equity.  For example, if a PE firm structures the deal with 50% debt, and legacy owners agree to a 25% equity stake, funding the rollover portion requires only 12.5% of the pre-tax net proceeds.

A PE-backed business also can often negotiate preferred terms with lenders that legacy owners can benefit from. Furthermore, if the new business partnership is highly successful, legacy owners can sometimes benefit from dividend recaps, sale lease-backs of assets, or other refinancing deals that provide cash disbursements to all shareholders.

There are also often significant tax deferral benefits for the portion of the equity that is rolled.  Engaging an advisor that is familiar with the tax implications of equity rollovers in your jurisdiction is critical.  Normally the PE firm will be open to structuring a transaction to help reduce or defer taxes when it has a neutral impact on them.  There also could be significant tax implications if the deal is structured as an equity sale vs an asset sale.

The legal implications can be complex, and it is critical to have legal counsel that is experienced with PE rollover transactions and how they should be structured.  Besides the obvious legal implications of majority/minority positions, preferential voting and liquidity rights can be sources of consternation.  One way to ensure that the interests of the PE firm and the rollover equity shareholders are aligned is to structure the shares on a pari passu (equal footing) basis.

The key is finding both tax and legal advisors that have deep experience in getting PE deals done.  All too often, advisors without enough experience in rollover transactions with PE firms are so risk-averse and so protective of the sellers' rights, that a successful close is not possible.
Rounding off your “A” team with the marketing expertise and deal experience of an Investment Bank and/or M&A Advisor will help ensure you have multiple PE firms to consider rolling your equity with, by running a professional, competitive process and determining “what’s market.”

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