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What to know about rollover equity before selling your business

Posted by Kanika Sinha

December 14, 2021    |     4-minute read (806 words)

Before you decide to accept an offer to buy your business, know that you will need to make several important decisions before you finish the sales journey. These include identifying the right buyer and building the right advisory team to execute the deal. And finally, you’ll need to decide how much rollover equity you want to invest.

What is rollover equity?

Simply put, rollover equity is the amount of money that a business seller is expected to reinvest from sale proceeds into the future equity of the company. It gives the owner(s) a second bite at the apple, that is, to participate in the future appreciation of the business.

Rollover equity transactions continue to be common in private M&A transactions, particularly those involving financial buyers such as private equity firms — the most active class of buyers in today’s market. 

PE buyers often prefer that business owners retain minority ownership in their business through an equity rollover. They do it for a variety of reasons, the primary one being the seller’s asymmetric information advantage. Also, with the seller accepting an equity rollover, it signals confidence to PE buyers that continuity will be assured, and the interests of both the seller and buyer will be aligned. 

Additionally, partnering with the business seller provides investors with some comfort that those who built the business will help if things go bad as they still retain an economic interest in the business. Lastly, in some cases, the rollover is advantageous for the investor because it requires less capital to be invested.

How does it work?

Typically, PE firms expect a minimum rollover equity stake of 20%. But that does not mean that business sellers need to leave behind 20% of their cash proceeds. As most acquisitions are funded by a combination of debt and equity, this leverage increases cash proceeds and whittles the amount required to acquire a 20% stake.

For clarity, consider a hypothetical sale of a business worth $100 million and acquired with 50% leverage, that is, $50 million in debt by a PE firm. The total equity being $50 million would mean requiring a $10 million investment to get a 20% rollover equity stake. Thus, total proceeds would be $90 million, with the business seller getting 90% of the deal value in cash and still retaining 20% of the future appreciation of the business.

How much rollover equity to invest?

Generally, equity rollovers result in post-transaction ownership by the seller in the range of 10% to 40%. A stake of up to 30% or 40% can help you drive a better valuation and earn a greater return from the future growth of the business.

In the above scenario, if the business seller agrees to roll over 30% equity, they would end up with $85 million in cash proceeds, while a 40% rollover will result in $80 million cash proceeds. Thus, they can take home 80% of the value of the business in cash and still retain a 40% share of the business. 

Though the difference between $80 million and $90 million in cash is not likely to make a major impact on the quality of the business seller’s post-sale life, the rollover equity will make a huge difference if the company appreciates in value substantially in the coming years.

Wait, there are more benefits

It can help you fetch a higher acquisition price: It is the seller’s proven confidence that increases PE buyers’ confidence in the future and, in turn, the price they are willing to offer.

A seller who believes the company is headed into rough waters would only roll over the minimum required. But retaining a larger rollover equity stake into the future signals confidence and commitment of the seller, which buyers greatly value.

In the above-mentioned hypothetical sale of a business, if the price rises by 10% to $110 million and the debt unchanged at $50 million, then a 30% or 40% rollover would require an $18 million or $24 million investment. Net proceeds would be $92 million and $86 million, respectively. 

And this is incredible, a 30% rollover stake causes a 10% price increase and lets the seller get $2 million more than a 20% rollover scenario. Even if a 40% rollover is required to fetch a 10% higher price, the seller doubles the equity stake to 40% while only giving up $4 million in cash.

It can be structured as a tax-free rollover: The capital gains from the sale of business involving rollover can be deferred until a future sale of the equity. 

For instance, getting another $10 million in cash would trigger capital gains taxes and leave only $7.5 million with the business seller. But they get the full upside on all $10 million rolled over into the equity of the continuing company.

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