Rolling Over Without Getting "Rolled" – Points To Consider In Connection With Rollover Equity

The decision to sell your business comes with many matters to consider, such as the purchase price that will be paid by the buyer, the impact of the transaction on your business relationships (including those with customers, suppliers, and your own employees), and your post-closing involvement (if any) in the business. While there are a variety of decision points, one of the most important to carefully think through is the implication of accepting "rollover equity" from the buyer in lieu of cash for a portion of the purchase price. This consideration has become all the more relevant given that much of current M&A activity is being driven by private equity firms that long ago embraced the use of rollover equity. Sellers who are offered the opportunity to receive rollover equity in an M&A transaction should not necessarily shy away from this option; however, in order to avoid getting "rolled" in connection with a rollover investment, sellers should keep a few principles and concepts in mind.

What Is Rollover Equity Anyway?

Before diving into an analysis of things to consider in connection with rollover equity, we should probably answer the question of "what is rollover equity anyway?" In short, rollover equity is equity of the buyer that a seller receives in an M&A transaction in consideration of contributing a portion of the seller's business to the buyer. In a transaction where a rollover is involved, a buyer will typically pay a portion of the purchase price in cash, but a portion of the purchase price is "paid" in the form of equity of the buyer. So, the seller essentially trades ownership of the seller's current business for a piece of the buyer's overall business, and takes a calculated risk that the buyer's business will be worth more at a future date when the buyer sells its business – the tricky part is that the buyer typically is a private company without publicly available comps that can be used to evaluate the buyer in the manner you might with respect to a publicly traded company.

The opportunity to receive rollover equity can be appealing because the potential exists for strong future returns and a "second bite at the apple" when the buyer's business is ultimately sold in the future – many sellers who have participated in rollover transactions have realized significant earnings resulting from such transactions (sometimes multiple times for the same business). However, as with all things, while there are plenty of sellers who have succeeded in the rollover arena, there are scores of sellers who are not so fortunate (this is investing, after all, which isn't exactly a risk-free endeavor).

A rollover contribution from a seller can come in the form of either equity interests or assets of the seller's business depending on the structure of the M&A transaction with the buyer – while contributions of equity are comparatively more common, contributions of assets can often come with the same advantages of equity contributions if the underlying M&A transaction that is being pursued is an asset deal rather than a stock deal. Depending on the structure of the buyer, these rollover contributions can often be structured in a tax-deferred manner that allows the seller to defer recognition of taxable gain with respect to the portion of the business that is "rolled" into the buyer's business. While careful consideration should always be given to the tax implications of an M&A transaction as a general matter, this is one area where good tax and legal advice can truly be worth the investment for a seller.

Why Do Buyers Offer Rollover Equity to Sellers?

While in theory nearly any buyer can offer a seller the opportunity to receive rollover equity in exchange for a portion of the seller's business, the reality is that much of the action in this area comes from buyers backed by private equity firms. Private equity-backed buyers have been employing this approach for many years, and for a variety of reasons. Two of the biggest reasons for offering rollover equity as part of an M&A transaction, however, would be financing flexibility for the buyer and attempting to align post-closing incentives of the buyer and the seller.

The financing flexibility point is fairly self-explanatory – if the buyer doesn't have to come up with the cash to pay for a portion of the seller's business and instead offers its own equity to the seller to cover that portion of the purchase price, this obviously simplifies the buyer's efforts to obtain financing for the transaction from a third-party lender (think the principle of "cash is king," but applied from the buyer's perspective instead of the seller's).

With respect to incentive alignment, the buyer is hoping that the seller's continuing investment in the buyer's business post-closing will drive efforts from the seller to enhance the value of the overall post-closing business (to the benefit of both the buyer's existing owners and the seller in a future sale of the buyer's business). This is more relevant in a situation where the seller is going to remain involved in the business as a key employee of, or consultant to, the buyer, but it can come into play even in situations where the seller is not expected to play a significant role in the business post-closing (the theory being that most rollover sellers will want the business they just invested in to be successful and will take affirmative steps to help ensure that where possible).

Key Points to Consider When Rolling Over

Now that we know what rollover equity is and why it is used, let's get to the heart of the matter at hand – key points that sellers should consider when making the decision to accept rollover equity from a buyer. While every seller's relative leverage in an M&A transaction will be different, there are a few general points every seller should think about in order to avoid getting "rolled" by a buyer.

Preemptive Rights: One of the most common protections available to rollover investors (who are likely to be minority investors in the buyer without much say or ability to control important business decisions) is the concept of preemptive rights. Put simply, preemptive rights give a seller the ability to maintain its pro rata ownership of the buyer in the event the buyer issues additional equity in the future (whether to fund a future M&A transaction, to fund ongoing operations, or otherwise) – so long as the seller exercises its preemptive rights and agrees to contribute additional funds to the buyer in line with its pro rata ownership of the buyer, the seller is protected from dilution resulting from the issuance of additional equity by the buyer. While preemptive rights are fairly standard these days, note that they may be cold comfort for sellers who do not have a significant amount of liquidity, given that they only help a seller if the seller actually comes up with the cash needed to fund this further investment. That said, they are an important protection for sellers, and at least offer the opportunity to avoid dilution.

Tag-Along Rights: Tag-along rights give a seller the opportunity to participate in a liquidity event that does not involve the sale of the entire business of the buyer – this would often come into play when the private equity sponsor of the buyer sells some (but not all) of its equity interests of the buyer. In such a circumstance, tag-along rights would allow the seller to participate in that partial sale on a pro rata basis (the rationale being that if the private equity sponsor is able to cash out part of its investment, the seller should not be "left behind" in the buyer without the ability to obtain proportional liquidity). While less common than a full sale of the buyer's business, these partial sales are becoming less unusual, and a seller will be well-served to have negotiated for this right.

Information Rights: Information rights give a seller exactly what it sounds like – ongoing information about the buyer that would be relevant to the seller's investment. The level of information rights available to a seller can vary widely depending on the type of business and the seller's relative post-closing ownership percentage of the buyer, but a well-advised seller can often seek copies of financial statements of the buyer (annual, quarterly and/or monthly) and annual tax returns of the buyer. Certain sellers who roll over a significant portion of the purchase price and become meaningful owners of the buyer post-closing can sometimes go a step further and obtain board observer rights (or potentially even a board seat), though these types of rights are often fiercely negotiated.

"Call Option" Mechanics: An entire article could be dedicated to "call option" mechanics that are included in nearly all equityholder agreements of a buyer. However, in short, a "call option" is an option available to the buyer to repurchase the equity of the buyer held by a rollover seller in certain circumstances (often triggered by a termination of employment of the seller post-closing). While a full discussion of all the nuances of the mechanics of a call option is beyond the scope of this article, this is one area where sellers really need to pay attention to avoid ending up in a situation the seller may not have bargained for at the time the deal closed. Buyers can use a call option as a future negotiating tool and a significant source of post-closing leverage over a seller, given that the consequences of exercising the call option may lead to less than desirable outcomes for the seller (for example, the potential in some circumstances for repurchasing the buyer equity held by the seller at a purchase price less than fair market value, the ability to pay any purchase price over an extended term of years, etc.). While certain rollover sellers may have the leverage to negotiate an elimination of the call option, that may not be possible for many (most) sellers. Therefore, careful consideration should be given to call option mechanics to ensure that, at the very least, the seller understands the "rules of the game" and appropriate limitations on the buyer's ability to exercise the call option are included where possible.

Don't Get Rolled

Accepting rollover equity from a buyer can be a strategic and potentially lucrative decision, both from a tax and economic perspective. However, sellers should make sure to engage sophisticated M&A counsel to ensure that their rights are appropriately protected in a rollover transaction – the failure to do so can result in a rollover seller (who may not have experience with M&A transactions) getting "rolled" by an M&A-savvy buyer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.