Rollover equity is a method commonly employed when a merger or acquisition occurs, where the seller holds a percentage of their stake in the company following the sale. In lieu of getting the entire cost of purchase the seller invests a portion of the profits into the newly formed entity, which allows them to take part in the future growth of the business and profit.
The method is great for a business owner who wants to remove some chips from the table, but would like to be engaged and contribute to future successes.
What is Rollover Equity? How Does It Function?
To illustrate, think about this example:
A business owner wants to sell their business in a deal with a private equity company for a sum of $10 million. Instead of receiving the full amount as cash payment, the owners decide to roll the $3 million to equity in the new entity created through the purchase. They now hold 70% of newly restructured business. If the business grows and is then sold at a greater price the seller will share in the profits.
This method creates a partnership that is between both the vendor and buyer, where both are motivated to enhance the long-term value of the company.
The Making of a Win-Win
Equity rollovers can benefit buyers and sellers as it is a way to align their goals and assures the success of both parties.
To Sellers: It enables them to remain invested in the business they created and could earn a better ROI if the business is eventually sold. It also shows their trust of the buyers’ plans to the company.
To Buyers: It makes sure that the seller stays dedicated to the growth of the business and facilitates a smooth transition of ownership by leveraging the experience and expertise of the seller as well as relationships. It also decreases how much capital needed to be committed at the beginning of the transaction.
Advantages as well as Risks
Benefits
Participation in the future Growth Sellers may get additional income when the business grows and is transferred to a buyer with a higher price.
Affiliation of Interests Buyers get an investment partner who stays committed to the success of the company.
Dangers
Deferred Payment Sellers get less cash in advance and this could be a problem if immediate liquidity is required.
Indeterminate Future Value The final return on equity rollovers is contingent on the future performance of the business which might not always be in line with expectations.
Implications for Tax
The rollover equity may also offer substantial tax advantages. In the event of rolling over a small portion of equity owners can defer certain capital gains tax. While they are not taxed for the whole transaction upfront tax on the rolled-over portion are usually delayed until the ownership stake that was acquired is sold later. However the precise tax treatment of a jurisdiction varies and must be examined with tax professionals.
Important Considerations for Sellers
In deciding whether to transfer equity sellers should consider:
Percentage of Equity How much of the sales proceeds should be invested? Intentionally retaining too much equity could expose sellers to risk, and the transfer of too little equity could limit the amount of future gains.
Valuation Sellers have to make sure the value of the rolled-over capital is reasonable and aligns with market standards.Buyer’s track record Review the buyer’s capacity to grow the business and to make an exit that is profitable.
Structure The devil always lies in the details. Financial buyers usually attempt to structure these agreements to ensure that their equity receives an advantage in return prior to other equity holders are involved. Do not do this if it is possible. I’ve seen it go badly many times.
Legal Security Minority ownership within restructuring a company can pose risks. Sellers must ensure that proper legally binding agreements in order to protect their interests.
Equity rollovers can be an effective option for those who are convinced of the potential for growth of their business and wish to keep the company’s success. If you are aware of the advantages and taxes, risks and structuring issues to make educated decisions that will increase the value of your transactions.