If you’re considering selling to a private equity firm or strategic buyer, knowing the details of rollover equity is essential.
In this post, we’ll explore what rollover equity is, cover benefits and drawbacks, and walk through a tangible example of how it works.
Let’s dive in.
What is Rollover Equity in Sale of a Business?
Rollover equity is when a business owner takes some of the proceeds from the sale of their business and reinvests them into the company that the buyer is using to acquire the business.
This gives the business owner an ownership stake in the company and allows them to continue their entrepreneurial journey, retain the value they’ve built, and participate in future upside while taking some chips off the table.
It can also be a useful tool for business owners who are planning for retirement and want to maintain a level of involvement while reducing their exposure to the ups and downs of the market.
Keep in mind that financial buyers and private equity groups typically prefer that sellers roll over at least 20% of their proceeds into the new company (usually the amount is in the range of 10-40%).
What are the benefits of rollover equity?
- Participate in future growth: equity rollovers allow you to stay connected with the company after the sale. If the acquiring company is successful in driving growth, you’ll be able to share in the upside.
- Continuity: allows you to retain a portion of the company’s equity and continue to be involved in the business. This provides an opportunity to help guide and grow the business after the sale.
- Tax advantages: can be structured as a tax free rollover and allow business owners to defer the massive tax bill they would have paid if they had sold their business outright.
- Access to capital: allows business sellers to take “chips off the table” and provide the capital they need to start a new business, invest in existing ones, or have funds for retirement.
- Aligned incentives: can help align the incentives of private equity buyers and the seller, making sure that both parties have a vested interest in the success of the company. As another benefit, a willingness to do an equity rollover shows the seller believes in the company’s future, which often can lead to a higher deal value from the PE firm.
What are the drawbacks of rollover equity?
- Risk and uncertainty: the primary drawback is that it exposes you to further risk and uncertainty by investing in the private equity firms’ new company. If the new company struggles, then it’s possible to lose your full equity rollover investment.
- Limited liquidity: rolling equity gives you in an minority ownership interest in a private business, which can limit your liquidity. This can make accessing your capital difficult if you need it quickly in an emergency situation.
- Complexity: can be a complex and highly structured transaction that requires a thorough understanding of tax laws and financial regulations. I highly recommend seeking out the advice of a financial advisor, accountant, or attorney to navigate the complexities involved.
- Decreased control: often involves ceding control of the invested capital to the management team of the new business. This can make it difficult for business owners to make decisions within the future company.
Rollover Equity Example
Let’s say you have a business that you’ve built and grown over the years. While you’d like to continue to increase the enterprise value of the company, you’d like to take some risk off the table with a liquidity event.
You decide to sell your business to a private equity group for a purchase price of $10 million, which is acquired with 50% leverage (i.e. $5M in debt from the private equity firm).
Instead of taking the entire amount as cash proceeds, you decide to roll over 20% of equity. Since this acquisition is leveraged with debt, the amount needed to acquire a 20% stake is lower.Â
The total equity portion is $5 million, and a 20% equity stake requires a $1M investment.
To summarize:
- In this scenario, the business seller receives cash proceeds of $9 million (90% of the deal value) and retains 20% of future appreciation of the business.
- You now have an equity stake of 20% and defer capital gains on this portion
- You’ll be able to share in the future success and growth of the new company, but will also be taking a risk on the ability of the private equity buyer ability to continue it’s success.
Do You Pay Taxes on Rollover Equity?
One of the major benefits of rollover equity is that it allows you to defer the capital gains tax you would have paid on the rollover portion of the sale.
With that said, you’ll eventually have to pay taxes on this equity when you have an exit event down the line.
If you decide to move forward with an equity rollover, you’ll have more time to plan for and manage the tax implications of the transaction in a way that best suits your individual situation.
You’ll want to consult with tax professionals before making any decisions so that you understand what taxes may be due and how they will affect your overall financial situation.
How Do You Calculate Rollover Equity?
To calculate rollover equity, you need to first determine the total value of your business. This includes both tangible and intangible assets like intellectual property, customer relationships, and brand recognition. Once you have determined the total value, you can then calculate how much equity you are willing to roll over into the new company.
Calculating the new equity portion itself depends on the equity/debt breakdown, but it’s ultimately the portion of the sale proceeds that you choose to roll over into the new business. For example, if you sell your business for $10 million and roll over $2 million, then your rollover equity is $2 million.
You can use an equity rollover calculator to pressure test different scenarios and get a sense for tax implications related to the transaction.
At the end of the day, the amount of equity that you rollover typically depends on the terms of the deal and your individual needs. When deciding on the amount, I’d suggest considering factors like the expected return on investment (ROI), liquidity needs, and your risk tolerance.
Generally speaking, it comes down to a risk/reward decision – if you’re willing to take more risk with your investment in the new company, you have a greater possibility for high return payoff.
Finally, it is important to remember that when calculating rollover equity there are no hard and fast rules or formulas that will guarantee success. Each situation is unique and requires careful consideration before making any decisions.
Equity Rollover: 11 Tips
1. Know the Basics
Take the time to understand what rollover equity is, how it works, and the potential deal structures for this type of transaction. It’s important to do your research and get a clear picture of how rollover equity fits into your overall exit strategy.
2. Understand your goals
Before entering into a rollover equity agreement, it’s important to understand what you want out of the transaction.
- Do you want to maintain control over your business?
- Are you looking for long-term financial security?
- Are you planning to use cash proceeds to fund your retirement?
- How does this move impact your estate planning and succession strategy?
Knowing your goals will help you determine if rollover equity is right for you and aligns with your overall financial objectives.
3. Negotiating terms with private equity firms
When negotiating the terms of a rollover equity deal, it’s important to consider factors such as the structure of the new business, the terms of the equity ownership, responsibilities of the management team, and any potential risks.
4. Be mindful of the tax implications
Before considering rollover equity, it’s important to understand the tax implications involved. This can include the capital gains tax, depreciation recapture, and other taxes that may apply.
Make sure you understand the tax implications, and that you’re prepared to handle them. Consult with a tax professional to ensure you understand all the implications of your specific situation.
5. Consider your timing
Rollover equity is a tax-deferred transaction, meaning that the taxes on the sale of your business will be deferred until you take the money out of the new investment. Keep in mind that there are time limits for reinvesting the proceeds, so be sure to plan ahead.
6. Understand the risks
Rollover equity is not without its risks. Make sure you understand the risks involved, and that you are comfortable with the potential outcome of your new investment.
For starters, I recommend thinking about about market volatility, liquidity risk, and the ensuring you find the right buyer.
Keep in mind that the new equity you have will be significantly restricted under a new operating agreement or other agreements. To counteract these restrictions, I recommend you negotiate for “tag along” and “drag along” rights. These rights ensure that if the buyer sells its interest, the rollover equity will also be sold. In simpler terms, the buyer cannot sell their stake without offering you the chance to sell yours.
7. Determine how much rollover equity to invest
Once you understand the risks involved, determine how much rollover equity you’re willing to invest.
A few things you might want to think about:
- Your liquidity needs (both current and projected)
- Overall investment goals
- Risk tolerance – risk/reward
- Your confidence level in the new owners and equity holders
8. Make sure you understand the terms and conditions of the sale
When you are selling your business, make sure that you understand the terms and conditions of the rollover agreement. This includes understanding what kind of stock or other equity you will receive in exchange for your ownership in the company, as well as any restrictions on when you can use or access it.
Ensure that all parties involved have access to accurate financial information about the company prior to entering into any agreements related to rollover equity transactions.
9. Review performance history of PE firm
It’s important to review the track record of any companies whose stock or equity you may consider investing in before making a decision about whether to roll over your own equity with them.
If you move forward, you’ll be hitching your wagon to them, so pay close attention to the performance history of any private equity groups you may be considering to ensure that they have a good track record in terms of returns, management, and other factors.
10. Have an exit plan
Make sure you understand what kind of return on investment (ROI) you’re expecting and how long it may take for the ROI to be realized. This will help dictate when you should sell or divest your rollover equity investments.
It’s also important to consider how you will exit the investment. This may involve a sale of assets, liquidation of the business, or other options.
Once you have decided which company’s stock or other investment vehicle you will be rolling over into, it’s important to devise a plan for when it might be beneficial (or necessary) to sell those shares again in order to release some cash value later on down the road if needed.
It’s also important to keep in mind that there may be restrictions on what actions can or cannot be taken when exiting an investment. Make sure you understand these parameters before committing any capital.
11. Be prepared for unexpected outcomes
Despite all good intentions, any sale transaction can still lead to unexpected outcomes. It’s important to consider how you will respond if the investment does not go as planned.
Be prepared with a contingency plan in case your rollover equity is not performing as expected and to be prepared for potential pitfalls.
In a worst case scenario, are you comfortable losing the portion of the purchase price rolled over equity? How will you protect yourself and your investment in the event of a downturn?
Conclusion
Rollover equity transactions can be a powerful tool for business owners as they transition from one chapter of their entrepreneurial journey to the next.
As we covered, there are quite a few benefits: you can retain a portion of your ownership and participate in future upside while taking some chips off the table.
With that said, it’s crucial to do your research and be sure to understand the associated risks to determine if rollover equity is the right move for your situation.
As I mentioned above, be sure to consult a qualified M&A advisor before making any decisions. Please note that the information provided in this blog post is not intended to provide tax or financial advice.
If you’re interested in diving deeper, this post is part of a series I’ve created to help you sell your business:
