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What is equity rollover when selling your business?

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November 14, 2023

In Mergers and Acquisitions (M&A), an equity rollover – or recapitalization (recap) – occurs when a business owner sells their company but chooses to reinvest, or “roll over,” a portion of the proceeds into the newly acquired business.

An equity rollover allows a shareholder to maintain a vested interest in the combined business and benefit from any potential future growth or value creation.

How an equity rollover works
When a business owner is selling their business, a potential buyer may propose a deal structure that includes cash, debt and equity.

Typically, the seller and their advisors will signal in advance whether an equity rollover or recap will be considered, and that factors into buyer offers.

Equity rollovers are common when the buyer is a private equity firm or family office.

These financial buyers are often looking for the seller or their management team to continue running the business for a number of years until the business is sold again.

An equity rollover ensures all parties are aligned, have “skin in the game” and are committed to ongoing success.

By the numbers
Let’s say a private equity firm is acquiring a software company for $20 million.

The seller of the software company agrees to roll over $2 million of the proceeds back into the company.

In simple math, this means the seller would retain a 10% ownership stake in the post-acquisition company, assuming the buyer brought all equity and no debt to the deal.

However, most acquisitions are funded using a combination of debt and equity.

This leverage increases the share value of rollover funds, meaning the seller’s $2 million will translate into a larger stake in the new entity.

For example, let’s say the software company is acquired with 50% leverage, or $10 million in debt, with total shareholder equity of $10 million, the seller’s $2 million now equals a 20% investment.

The seller receives 90% of the transaction value at the time of sale but retains 20% in the future business.

In reality, the calculation must also account for transaction fees, capital gain taxes and working capital, but the above scenario provides a fair baseline estimation.

Equity rollover advantages
There are several reasons why a seller might choose to roll over equity in an M&A transaction, including:

Potential for additional gains: Sellers who roll over equity have the opportunity to benefit from any increase in the value of the merged company’s shares. If the new entity performs well, its equity stake can become more valuable over time.Increased buyer confidence: When a seller rolls over equity, it sends a positive signal to the buyer. It means the seller has confidence in the company’s future prospects and believes in the buyer’s strategic vision for the business.Tax considerations: In some cases, rolling over equity can have tax advantages compared to receiving total cash proceeds from the sale.Gifting strategy: For some sellers, that extra minority stake in the business is bonus money. We sometimes see sellers use structures like this as a way to transition ownership to their children or their management team.
Considerations and risks
Be aware of the following when considering an equity rollover:

Loss of control: When the seller rolls over equity, they give up majority control. This can be a difficult transition, particularly if strategic or cultural clashes arise.Valuation risk: If the new entity underperforms due to integration challenges, market shifts or other factors, the value of the rollover equity could decline, impacting the financial return for existing shareholders.Liquidity risk: In some cases, shareholders’ exit plans may not align, and minority shareholders may not be able to sell their stake when they want to. Be sure you have a clear understanding of your exit options.
Overall, equity rollovers can be a rewarding strategy.

It can be a way for sellers to take some chips off the table and secure their retirement, while still participating in future upside.

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