How Does Rollover Equity Work? A Primer for Sellers

Key insights

• Sellers retain partial ownership with rollover equity, aligning the long-term interests of buyer and seller.
• Determining the right percentage to roll over and negotiating protective terms are key to maximizing benefits while managing risks.
• Maximizing returns often depends on selecting buyers with resources or strategies to expand the business.

Rollover equity is a powerful tool that can provide unique benefits to business owners who are selling their company in an M&A transaction. This practice ensures sellers maintain a stake in their business post-transaction and allows them to continue to see value from their company for years to come.

Understanding how rollover equity works, when it is used, and its impact on deal structuring is crucial for business owners preparing for a sale. Here, we’ll break down the fundamentals, addressing key questions and considerations to help you understand the ins and outs of rollover equity.

What is rollover equity?

Rollover equity occurs when a seller retains a portion of their ownership stake in the business after selling it to a buyer. Instead of cashing out entirely, you “roll over” part of your equity into the new ownership structure. This rolled-over equity allows you to participate in the future growth and success of the business.

For example:

• You sell 80% of your business to a private equity (PE) firm but retain 20% ownership.
• Your 20% is “rolled over” into the new entity created as part of the transaction.

This mechanism aligns your interests with the buyer’s, as both parties benefit from the future performance of the business. Rollover equity can increase the chances of a profitable long-term partnership between buyer and seller.

Why is rollover equity important in M&A?

Buyers often use rollover equity to ensure sellers remain invested in the long-term success of the business, and such equity can be a major part of the overall payment a seller receives for their business.  

Rollover equity accomplishes the following:

• Align incentives: Your continued ownership motivates you to contribute to the company’s growth post-sale.
• Reduce upfront costs for buyers: By rolling over equity, buyers can allocate less cash toward the transaction.
• Provide upside for sellers: If the business grows under new ownership, your retained equity could significantly increase in value.

Rollover equity works best in certain circumstances

Rollover equity is not a one-size-fits-all solution, and it’s most advantageous in the following scenarios:

1. You believe in the company’s future potential: If you’re confident the business will thrive under new ownership, retaining equity can yield higher returns.
2. Future growth potential matters: Maximizing returns often depends on selecting buyers with resources or strategies to expand the business.
3. The buyer has a strong track record: Partnering with an experienced buyer, such as a reputable PE firm, can increase the likelihood of future success.
4. You want to stay involved: Rollover equity often works best if you’re interested in maintaining some role in the business, whether operational or advisory.
5. You want a second payout: If the buyer plans to exit the business in the future, you could benefit from a “second bite of the apple” when your rolled-over equity is cashed out during the next transaction.

How does rollover equity work in practice?

The rollover process typically unfolds as follows:

1. Valuation agreement: You and the buyer agree on the company’s total valuation.
2. Equity allocation: The buyer outlines how much of the purchase price will be in cash and how much will be rolled over as equity.
3. New entity creation: A new entity (often called a NewCo) is formed, and your equity stake is transferred to this entity.
4. Ownership percentage: The percentage of equity you retain will depend on negotiations and the total deal value.
5. Future exit planning: Terms for selling or cashing out your retained equity are typically outlined during this phase.

For example:

• Your business is valued at $10 million.
• The buyer pays $8 million in cash and asks you to roll over $2 million as equity.
• You now hold a 20% ownership stake in the new entity.

What percentage of equity should be rolled over?

There’s no fixed rule for how much equity should be rolled over. The percentage varies based on:

• Buyer preferences: Some buyers prefer a higher rollover percentage to ensure seller alignment.
• Seller goals: Your willingness to retain a stake and risk your equity.
• Industry norms: In PE deals, rollover percentages often range from 10% to 40%.

In some cases, buyers may request a specific rollover percentage to match their investment strategy. Sellers should evaluate their liquidity needs and confidence in the business before agreeing to a percentage.

Negotiating the right percentage requires balancing your desire for liquidity with your confidence in the company’s future.

How does rollover equity affect deal negotiations?

Rollover equity introduces additional complexities to deal negotiations. Key considerations include:

1. Control terms: Define your level of involvement and decision-making authority post-sale.
2. Exit strategy: Establish clear terms for how and when you can cash out your equity in the future. This may include predefined exit timelines or conditions for liquidity events.
3. Risk assessment: Understand the risks of holding equity in a potentially illiquid or underperforming business.
4. Governance structure: Determine how your role and influence will evolve in the new ownership structure. For example, will you have a board seat or voting rights? You must set clear expectations with the buyer over how involved you will be once the deal closes.

Reexamining the pros and cons of rollover equity

Benefits:

• Potential for higher returns: If the business grows, your equity stake appreciates.
• Continued involvement: Stay connected to a business you built.
• Tax advantages: Rolling over equity may defer some tax liabilities.
• Second liquidity event: You could benefit from additional payouts if the business is sold again.

Risks:

• Illiquidity: Rolled-over equity is often tied up until the buyer’s exit.
• Market risks: Economic downturns or industry challenges could negatively impact the company’s value.

Your M&A advisor will assess any risks and help you determine how to move forward with rollover equity.

Common scenarios for using rollover equity

1. Private equity acquisitions: Rollover equity is a staple in PE transactions, where buyers aim to keep sellers invested in the company’s future.
2. Family business transitions: Sellers who want to maintain a legacy stake while bringing in new investors often use rollover equity.
3. Growth-focused partnerships: Entrepreneurs seeking capital to scale their business may opt to sell a majority stake while rolling over equity.
4. Management buyouts: Rollover equity can facilitate transitions where existing management teams acquire ownership with external funding.

How advisors can help with rollover equity

Navigating rollover equity policies in an M&A deal requires expertise and strategic guidance. Relying on experienced M&A advisors can make a significant difference in securing advantageous terms. Here’s how advisors can help:

1. Maximizing value: Advisors can help negotiate the best valuation for your equity, ensuring you’re not undervaluing your stake when rolling it over.
2. Structuring deals effectively: They can identify the right percentage of equity to roll over based on your financial goals and risk tolerance.
3. Protecting your interests: Advisors are skilled at crafting agreements that safeguard your equity stake, such as including anti-dilution clauses and ensuring clear exit terms.
4. Facilitating buyer alignment: With their market knowledge, advisors can vet buyers to ensure they have the resources, expertise, and strategic vision to grow the business and maximize your equity’s future value.
5. Simplifying complexities: Rollover equity policies often involve detailed financial and legal structures. Advisors can simplify these complexities, ensuring you fully understand the implications.

By leveraging their expertise, M&A advisors act as advocates for your interests, increasing the likelihood of a favorable outcome.

Make your rollover equity structure a success

1. Hire experienced advisors: Engage M&A experts to guide you through negotiations.
2. Understand the buyer’s strategy: Ensure the buyer’s growth plans align with your expectations.
3. Ensure protective terms are in place: Include clauses that protect your equity stake, such as anti-dilution provisions and preferred equity rights.
4. Clarify your role: Define your post-sale responsibilities and level of involvement.
5. Evaluate tax implications: Consult a tax advisor to understand how rollover equity affects your tax liabilities.
6. Diversify your risks: Avoid rolling over too much equity if it jeopardizes your financial security. Balance liquidity needs with potential upside.
7. Set clear exit terms: Agree on mechanisms for future liquidity events, such as buyer exits or IPOs.

Final thoughts

Rollover equity offers a unique opportunity for sellers to remain connected to their business while benefiting from future growth under new ownership. However, the strategy’s success hinges on thoughtful planning and expert guidance. By thoroughly evaluating the buyer’s capabilities, aligning on a shared vision for growth, and structuring the deal to protect your interests, you can maximize the potential of your equity stake.

Collaborating with experienced M&A advisors ensures that you fully understand the complexities and risks involved while negotiating terms that align with your goals. With the right strategy and partnership, rollover equity can turn a business sale into a stepping stone for even greater prosperity.