Apr 29, 2022
Pros and Cons of Rollover Equity in a Business Sale
Mitchell is a content strategist and creative content editor, specializing in financial copy and travel writing. He has experience working for Citi as a head creative writer, LendingTree as an editor, and Investopedia as an editor.
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A number of business owners dream of the day a buyer will arrive and present them with an amazing offer. The seller would know it’s a great deal, but they may not want to completely divest themselves from the business they worked so hard to build.
From the buyer’s perspective, they may be interested in the seller keeping some of their shares in the company, ensuring they still have ‘skin in the game’ as a sign of good faith through the acquisition.
Both of these commonly-occurring issues can be solved with a sale strategy called rollover equity. This strategy involves a seller retaining an equity stake in the business they are selling.
Understanding How Rollover Equity Works
Rollover equity is a term used to describe a process that takes place during a business sale. The owner, or seller, holds equity in the business in the form of shares. When they decide to sell the business, they can either sell 100% of their equity ownership (shares) or, they can ‘roll over’ some of that equity into the business they are selling.
There are a few reasons why a seller might do this:
The seller doesn’t want to divest themselves completely from their company
The seller still wants the option to passively profit from the business
The buyer (usually a private equity (PE) firm) requests that the seller remains financially involved
Both parties want to mitigate downside risk
The seller wants to lower their tax obligations from the sale
The buyer can’t meet the ‘buyout’ purchase price required for 100% ownership
There are other reasons, but the above are the main ones. To better understand rollover equity, it is important to consider why each party would bring the concept forward during negotiations.
The seller: The seller will often request or demand rollover equity for two reasons. The first is they want to remain attached to the business. Since they are remaining invested in the company as a shareholder, they may retain voting rights. They may believe that a transition would be better handled if they were still involved in some way, and rollover equity can allow them to hand over the reins over time instead of all at once. Another common reason for rollover equity is the seller believes the business still has substantial upside, and they want to hold shares in case of a future liquidity event. In essence, they sacrifice some of the outright sale price in order to retain exposure to the company’s value increasing, also called upside exposure.
Selling a business doesn’t need to be a headache as long as each party comes to the table prepared and willing to make a deal stick.
The buyer: A private equity firm is a type of acquirer that commonly requests rollover equity as part of a sale. This is less common in the case of a solo, independent buyer at least partly because they may not want to deal with the hassle of the old owner ‘sticking around’ after they buy the company -the additional payout to the buyer is worth them owning 100% of the company.
However, private equity firms are always concerned with risk, so allowing a seller to roll over what is commonly 10-25% of their equity into the newly acquired company means that the seller is sharing some of the risk with the buyer. It also shows the buyer that the seller still believes in the company if they are willing to remain invested, even if they are not part of the new management team.
There are some notable advantages and disadvantages of equity rollover strategies. When these events occur, it is unfortunately all too common for one party to feel like they are being taken advantage of. Therefore, the advantages and disadvantages of equity rollovers really come down to which side of the table you are on. It doesn’t matter if you are selling to a massive corporation or to an employee, both buyers and sellers need to be aware of the motives behind rollover equity.
Risks for the buyer occur for several reasons. Sometimes the buyer will not read through the terms of their equity agreement in totality or they won’t work with a reputable business advisor, and miss key aspects of rollover equity deals.
For example, the buyer could be planning to acquire additional capital for the target company in the future. If they do this, they will issue additional equity in exchange for working capital. This might be great for the business, but will damage the buyer’s stake as it will become diluted. Those who have seen “The Social Network” will recognize this strategy as the one that Mark Zuckerberg used to oust a cofounder. In this example, the more equity holders, the more diluted the existing shares become.
The seller may lose their investment if the buyer is unable to operate the company at the same margins as it was operating before the acquisition. Their reinvestment into the company will prove to be fruitless if the new buyer runs it into the ground. The seller would have lost the value of all the shares they could have simply sold during the business’s transaction.
This isn’t seen often, but a seller needs to work with a qualified business broker to make sure their contract is rock solid and will never require any involuntary capital contributions. The last thing a seller wants to do when they sell is to be required by contract to bring additional capital into the company. Although it isn’t common, this does happen and can blindside a seller who didn’t properly vet the purchase contract.
The buyer experiences less risk when engaging in rollover equity. They will pay less outright to the seller, and they are limiting risk by having the seller stay invested in the company. The greatest risk for the acquiring company post-transaction is losing out on potential profits. If the seller rolls over 15% of their equity into the new company, assuming their previous stake was 100%, that means the acquiring company will lose out on that 15% of future growth as the company divests profits either periodically or through a liquidity event such as a sale.
Taxes and Rollover Equity
Work with a trusted accountant or tax professional to ensure the sale remains compliant and you aren’t slapped with a massive tax bill.
Tax treatment when selling anything is important, doubly so when it’s a large sale such as a business transaction that delivers significant cash proceeds. Unfortunately, equity purchases are taxable events. The good news, however, is that a seller rolling over equity means that the amount that is rolled over is almost always tax-deferred. It’s important to remember that ‘tax-deferred’ is not the same as ‘tax-free.’
Deferred taxes on the rolled-over equity will be taxed at a future liquidity event, and distributions will be taxed when they are issued. This is similar to why people might roll over their 401(k) into a business purchase, which is to say they value a business investment overtaking an outright payout.
Sellers should not just consider the sale price of the company, but the implications that sales price will have on their taxes. For example, an owner may not wish to sell and pocket, say, $1 million, because it will throw them into a higher bracket when combined with additional income sources. In this scenario, the owner/seller may consider rolling equity of 20%. In effect, they are paying taxes on the 80% they sold, and will pay taxes on the 20% at a future date (as it was deferred).
Reminder: If you are selling the business, make sure to allocate some of the sale proceeds for capital gains taxation.
This can be incredibly advantageous to the seller. Due to the complexities regarding tax law, all sellers are advised to work with a CPA or other tax professional when drafting or reviewing purchase contracts. A savvy buyer knows this, and will sometimes use the tax-deferral argument as a way to convince the seller into rolling over additional equity into the business.
It’s hard to clearly state the pros and cons of rollover equity transactions as the deal structures that may be beneficial to one party would offer no advantages to the other. In reality, equity investments from a previous owner—which is what rollover equity is—offer both parties shared risk and reward. It is up to the buyer to do their due diligence on the company they are looking to purchase, and the seller to make sure the contract is signed in good faith and offers fair terms.
Sellers willing to sacrifice a portion of outright sale proceeds to keep a portion of their equity in their company is something many owners try to do, if for no reason other than to stay involved. In order for sellers to pocket the most cash for the sale of their company’s equity, it is imperative they have an accurate picture of that company’s enterprise value to bring to the negotiating table.
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