Banking and Business Monthly – February 2021

Introduction

Private equity firms and other financial buyers have become prominent in the M&A market. Such buyers typically look to hold target companies in their portfolio for a number of years before turning around and selling them for a profit. To that end, financial buyers covet a strong management team, and often desire, for those selling owners who manage the business and thus who are critical to its future success, to roll over a portion of their equity, such that they become minority owners of the acquisition entity or a parent holding company controlled by the financial buyer. Should the selling owners roll over their equity? This article briefly discusses the issues surrounding that question.

Rolling Over Equity in an Acquisition

Before examining the advantages and potential drawbacks for owners rolling over their equity, a brief explanation of how these transactions work is merited. Private equity firms purchasing companies look for ways to differentiate themselves from their competitors, and so offers of future equity in the buyer or the buyer's holding company are becoming more common. Just as there is no “one size fits all” approach to structuring transactions, there is no single prescribed percentage of equity which rolls over in acquisitions. Some deals may offer only around 8% of the total consideration in equity rolled over, while other deals may go as high as 40% of the total consideration. A common amount is around 20%. As mentioned above, selling owners will no longer hold equity in the target company; rather, they will own equity in the buying company (or the buyer’s holding company, if the target is being purchased as part of a portfolio).

Advantages

Several advantages exist in rollover equity transactions for buyers as well as sellers. First, if the selling owners agree to take equity in the buying company, this decreases the necessary cash outlay required by the buyer and can reduce the need for outside financing, converting it to a form of seller financing. The buyer is able to, in a sense, deduct the value of the owner’s future equity from the overall purchase price; thus, the purchase price remains the same, but the required cash is lower. This creates obvious advantages for buyers who may not have the necessary cash up front to acquire a company but who are willing to offer an appealing equity package. In other instances, the rollover equity can be used like an earn-out to cover the gap in the valuation of the target as perceived by a seller and a buyer, which is increasingly the case in a COVID-19 climate.

Another benefit that exists for both the buyer and the seller is that the management team of the selling company gets to keep “skin in the game” by remaining with the buying company and participating in a meaningful way. While some transactions require owners to rollover their equity and become passive shareholders with no impact on the day-to-day nature of the company, many deals allow for the management team to both keep their equity and be retained by the buyer long-term. This is an advantage for sellers who want to continue growing and participating in their business. It is mutually advantageous for those buyers who want to retain management and align their interests with the buyers to grow the target for an eventual sale.

There may also be advantageous tax consequences to the selling owners in a rollover equity transaction. Most equity rollovers are structured in a way to allow for tax deferral. This is because the rollover of the equity is not a taxable exchange, so the owners would not pay any tax until their equity is later sold. It should also be mentioned that the tax consequences may vary depending if the target company is an S corporation, C corporation, or LLC. Various deal structures exist for each of these target entities. Therefore, owners should consult tax advisors when engaged in these discussions to determine the best way to structure the deal for maximum tax benefits.

Finally, the opportunity to rollover equity into a purchasing private equity firm’s vehicle may offer great upside for potential sellers, especially if the private equity firm has a track record of running businesses in the target’s industry, and if the buyer can bring in exceptional operational experience. Sellers essentially get a second bite at the apple- they are able to sell their company for value and also invest in their company going forward under the controlling private equity firm which made the purchase. In addition, rollover equity which is of the same class as the buyer’s equity and is fully vested may be superior to stock options that are offered in a transaction, which may have buyer-favorable rules about vesting or may allow only for the purchase of equity of a class inferior to the class held by the private equity investors.

Disadvantages

Much of the downside for sellers can be avoided through a careful and meticulous diligence process. When considering a potential purchaser, it is important for the sellers to be assured they are partnering with a buyer who will make their equity investment worth it. The sale is most likely the beginning of a long business relationship with the private equity firm sponsoring the buyer. Thus, it is key to ask the correct questions about the buyer and its plans for the target during the due diligence process.

First, sellers should negotiate the repurchase rights with respect to the equity and the terms thereof by the acquiring company. Buyers typically have the right to buy out the equity of selling owners and pay it over time if their employment is terminated, which would end their investment. Thus, sellers should negotiate favorable repurchase terms, especially if the triggering events are termination without cause, resignation for good reason, death, or disability.

Next, the purchasing company may have a litany of fees (such as management fees, transaction fees, or future compensation structures) which may hurt the target company’s ability to make a profit. These fees should be carefully inspected before allowing the purchase to go forward.

Another issue to cover during due diligence is how the private equity firm behaves towards its management. The acquiring firm has an incentive to make its proposed management team seem as appealing as possible, but sellers should still request to interview them to see how they are treated by the private equity firm. Furthermore, if the buyer has any portfolio companies, selling owners can ask to interview those management teams as well. It is imperative to ensure there will be a good working environment for all parties going forward following the sale.

The final downside for sellers is the most obvious one -- the sellers will receive less cash at closing if they determine to rollover their equity. While a seller could stand to potentially make even more through its equity investment, perhaps the reason a seller is looking to sell is to cash out and use the capital to fund an entirely new venture. This becomes more difficult for a seller if a significant portion of the consideration is held in future equity and unavailable for immediate use.

Conclusion

A selling owner’s decision to roll over its equity in a transaction can be a very good one with many advantages. However, selling owners should be cautious before they agree to rollover equity, and they should conduct significant due diligence and negotiations to ensure they are not agreeing to unfavorable terms in the future. If you or someone you know is considering whether to sell or purchase a business involving rollover equity and needs legal advice, please feel free to contact me for a free initial consultation at 847-705-7555 or smigala@lavellelaw.com.