Rollover equity is a mechanism often used in mergers and acquisitions where a seller retains a portion of their ownership in the business after the sale. Instead of receiving the full purchase price in cash, the seller reinvests part of the proceeds into the newly structured entity, allowing them to participate in the company’s future growth and profitability.
The approach is ideal for an owner that wants to take some chips off the table but also wants to stay involved and participate in future success.
How Does Rollover Equity Work?
To illustrate, consider this example:
A business owner is selling their company to a private equity firm for $10 million. Rather than taking the entire payment in cash, they agree to roll over $3 million into equity in the new company formed by the buyer. This means they now own 30% of the restructured business. If the company grows and is sold again at a higher valuation, the seller shares in the upside.
This approach creates a partnership dynamic between the seller and the buyer, where both parties are incentivized to maximize the business’s long-term value.
Creating A Win-Win
Rollover equity can benefit both sellers and buyers, as it aligns their goals and ensures shared success.
- For Sellers: It allows them to stay invested in the company they built and potentially earn a greater return when the business is sold in the future. It also demonstrates their confidence in the buyer’s plans for the business.
- For Buyers: It ensures the seller remains committed to the company’s growth and provides a smoother transition of ownership, leveraging the seller’s expertise and relationships. It also reduces the amount of capital that has to be initially committed to the deal.
Benefits and Risks
Benefits
- Participation in Future Growth: Sellers can enjoy additional returns if the company grows and is sold at a higher valuation.
- Alignment of Interests: Buyers gain a partner who remains invested in the business’s success.
Risks
- Deferred Payout: Sellers receive less cash upfront, which could be a drawback if immediate liquidity is needed.
- Uncertain Future Value: The ultimate return on the rollover equity depends on the business’s future performance, which may not always meet expectations.
Tax Implications
Rollover equity can also have significant tax benefits. By rolling over a portion of their equity, sellers may defer certain capital gains taxes. Instead of being taxed on the entire sale upfront, taxes on the rolled-over portion are typically deferred until the new ownership stake is sold in the future. However, the exact tax treatment varies by jurisdiction and should be carefully reviewed with tax advisors.
Key Considerations for Sellers
When deciding whether to roll over equity, sellers should evaluate:
- Percentage of Equity: How much of the sale proceeds should be reinvested? Retaining too much equity might expose sellers to excessive risk, while rolling over too little might reduce future gains.
- Valuation: Sellers must ensure the valuation of the rolled-over equity is fair and consistent with market standards.
- Buyer’s Track Record: Assess the buyer’s ability to grow the business and achieve a profitable exit.
- Structure: The devil is always in the detail. Financial buyers often try to structure these arrangements so that their equity gets a preferred return before the other equity holders participate. Avoid this if at all possible. I have seen it end poorly several times.
- Legal Protections: Minority ownership in a restructured company carries risks. Sellers should ensure proper legal agreements are in place to safeguard their interests.
Rollover equity can be a powerful strategy for sellers who believe in their company’s growth potential and want to maintain a stake in its success. By understanding the benefits, risks, tax implications, and structuring considerations, you can make informed decisions and maximize the value of their transactions.
Start By Knowing What You Really Need In A Sale
Deciding whether to retain equity when selling your business, starts with knowing what you really need to net in the transaction to fund your desired lifestyle. It is probably more than you think. To properly calculate this number for your situation, take our Freedom Score assessment by clicking here.