When selling a business, maximizing return is the primary goal of most owners. With increasing frequency, owners – particularly those also serving as a key member of management – can increase their returns by retaining an ownership stake in their business or the business of the acquirer in lieu of entirely cashing out their ownership stake. This is referred to as “rollover equity” because the owners roll over a portion of their existing equity into the acquiring company, often a new or existing private equity platform, in lieu of receiving all cash in exchange for such equity. Structuring the purchase price in such a manner provides owners with an up-front cash return on the initial sale of their company, while also offering further potential upside on the anticipated resale of the company or the acquiring entity several years later. Thus, by including an equity rollover component in the sale transaction, owners may get the proverbial “second bite at the apple”. Rolling equity may also be attractive to the owners from a tax perspective, which will be the subject of a later post in this series.
PE Buyers Prefer Equity Rollover
Providing transaction consideration in the form of rollover equity also has significant appeal to buyers. Private equity buyers will often require current owners active in the business to roll over a portion of their equity because it aligns incentives between the buyer and management where current management will help run the post-closing business and will have a vested interest in a successful exit. Furthermore, using rollover equity for a portion of the transaction consideration will reduce the cash portion of the purchase price and allow for the use of greater leverage, which, in turn, will help the buyer increase its return profile. Recent studies have found that the average minimum rollover required by private equity buyers in middle market sale transactions is slightly above 20% of an owner’s proceeds in a transaction.
As an owner considers whether and to what degree to accept rollover equity in a sale transaction, care must be taken to understand the particulars of equity rollover, including the economics of the equity, entity structure and overall risk and benefit. In future posts in this series, we will detail issues related to rollover equity, particularly as it concerns exit planning strategies for middle market businesses and the entrepreneurs and families who own them.
Rollover in Action
The following example illustrates the potential benefits of rollover equity for the current owners / sellers: Three equal partners own and operate a software business with an enterprise value of $30 million, which includes $6 million in outstanding debt. A private equity firm has proposed a $30 million buyout and the partners have agreed to a rollover equity contribution of 20%, expressed as a percentage of sale proceeds payable to the partners at close. At close, the outstanding debt is repaid to the partners who receive collective equity in the acquirer with a value of$6 million ($2 million each) and cash in the amount of$18 million ($18 million cash + $6 million rollover equity + $6 million debt repayment = $30 million). Additionally, the buyer is funding 50% of the purchase price with debt which could increase cash at closing while maintaining the current owners 20% rollover equity stake. With the operational support of their new private equity co-owners, over the next five years the partners remain involved in management and with the assistance of, and investment by, the private equity sponsor, grow the business. A successful exit is then consummated whereby the company is sold to a strategic buyer for $70 million. On this second sale, the equity holders share $60 million in proceeds, with the partners receiving $24 million, or $8 million each. Thus, in this simple example each of the three partners turned a $2 million rollover into an $8 million cash return.
Looking beyond this overview, the next post in this series on rollover equity will further consider the power of leverage in a buyout whereby, as in the above example, current owners can increase their equity stake in the acquiring entity beyond their rollover cash contribution.