In previous blog posts, we have explored the benefits of rollover equity when selling a business, particularly the potential opportunity of a “second bite at the apple.” For selling equity owners, however, the potential upside to be earned upon the second transaction involving the company or its acquirer is not without risk. Inherent in any equity rollover transaction are those systemic risks associated with retaining a piece of any business in lieu of entirely cashing out, including threats of recession, increased competition and similar adverse events – many of which may be outside of the control of the rollover participants control. Other risks, particularly those concerning the governance, operational and financial structure of the new private equity-backed business, are easier for a potential seller to control and mitigate provided that they are identified and addressed early on in the sale transaction. We consider a few of these risks and mitigation strategies here:
Do Your Homework
Since owners are rolling over their existing equity into the acquiring company, they are well served to treat the transaction not as a ‘sale’ but as an equity purchase akin to the stock purchase of a new business or investment in a stock portfolio. Accordingly, rollover participants should do their homework on their potential private equity investment partners, conducting the same level of due diligence and investigation as they would in any other significant equity investment. Matters that should be investigated early on include:
- Management Team. Research the private equity platform’s management team, including their reputation and track record. This may include reaching out to the owners / rollover equity participants of the buyer’s other portfolio companies, if any. If the potential buyer does not feel like a right fit on a personal level, it is unlikely that the buyer will transform into a well-suited business partner going forward, which is critical to the continued future growth of the business.
- Understanding and Aligning Objectives. Misaligned objectives create tension and increases the risk of failure. Sellers should identify early on the buyer’s expectations and objectives, including the expected level of responsibility of rollover participants in the company’s day-to-day management and decision making. Similarly, rollover participants should understand and seek alignment with buyer’s specific strategy to drive growth towards exit, whether it is access to new markets, operational expertise, economies of scale, new lines of business, etc.
- Know the Market. Knowing what is “market” practice for rollover equity transactions will insulate the risk of a less favorable deal for rollover participants in terms of ownership, valuation, dilution, fee structure and other key considerations.
In a previous post, we examined the power of leverage in increasing a rollover equity participant’s equity share. Rollover participants should also understand, however, the inherent risks of an overly leveraged capital structure which may lead to difficulties in meeting the company’s debt obligations. Similarly, rollover participants should scrutinize the post-closing equity to be held by the seller, including whether such equity is the same class of equity as that acquired by the buyer, in order to determine whether seller’s equity may be overstated. Based on the foregoing, rollover participants should review carefully the pro-forma capital structure proposed by the buyer.
Invariably, rollover participants’ equity interest following a buyout will be a minority interest. As such, rollover participants’ control over important decisions may be minimal, and with that comes the risk that actions taken by the company and/or its new owner may benefit the majority owners to the detriment of the rollover participants. Care should therefore be taken to ensure that the rollover participants’ role in ongoing operating, financial and strategic decisions is clearly defined and adequately protected, particularly as delineated under the company’s governance documents. Some typical protections may include:
- Consent rights regarding significant corporate actions
- Board participation via a board seat or observation rights as well as, or alternatively, the right to receive financial information about the company on a regular basis
- Preemptive rights to participate in subsequent equity offerings in order to prevent dilution of rollover participants’ equity interests
- Co-sale rights permitting rollover participants to sell on the same terms and conditions as the majority owner is selling
Significant tax liabilities to selling shareholders is a risk in any rollover equity transaction. Ideally, the rollover equity transaction should be structured in a manner that allows existing shareholders to rollover their equity on a tax-deferred basis. Care should be taken in this regard to thoroughly understand the tax implications of the deal structure proposed by the private equity buyer. A more in depth look at tax-deferral and other important tax implications of rollover equity transactions will be the topic of the next post in this rollover equity series.