Use of Equity Rollovers Continues to Rise Amid Market Uncertainty

Given the current acute challenges in arranging acquisition financing on palatable terms and a continued focus on ensuring alignment between private equity (PE) investors and portfolio company management, the use of rollover equity continues to be a key deal feature in acquisitions backed by PE investors. As shown by Goodwin’s Private Equity Deal Database (see chart below), there is a clear and steady upward trend in the inclusion of rollover equity in acquisition agreements for mid-market transactions with values of $25 million to $500 million,¹ increasing from 46% in 2020 to 57% in 2023. In this article, we will explore the definition of equity rollover, certain deal dynamics that give rise to the importance of rollovers, and what deal practitioners should be aware of when using rollover equity as part of their dealmaking toolkit.

What Is Equity Rollover?

Equity rollover is an agreement between a buyer and a seller of the target company in an acquisition pursuant to which such seller (typically, a founder and/or member of the company’s management team) agrees to “roll over” (i.e., reinvest) all or a portion of their ownership stake in the target company into an ownership stake in the post-acquisition company in lieu of receiving sale proceeds in another form (e.g., cash). This can involve retaining equity in the target company, contributing their existing equity interests in exchange for new equity in the buyer entity, or any number of similar structures.

Key Drivers of Equity Rollover

Certain common dynamics help to make equity rollover an attractive and useful tool in PE dealmaking:

• Investor-Management Alignment. The typical investment cycle for a PE-backed acquisition is approximately four to seven years. Thus, it is of critical importance to the PE investor that the target’s management team is ready to work hard and enhance the company’s value during this limited window. A management team that rolls over has “skin in the game” (i.e., incentive to grow the company), both to benefit the PE investor and to maximize the value of their own rollover equity.
• Capturing Future Upside. Sellers of a private company will occasionally accept an acquisition bid despite their perception that the valuation doesn’t adequately compensate for the target’s growth potential. In such cases, sellers may wish to monetize only a portion of their equity at closing and to roll over the balance so they can participate in further value accretion (to be monetized at a future liquidity event).
• Non-Cash Source. Including equity rollover as a “use” of deal funding has the added benefit of representing a “source” of deal funding, which may help to reduce the size of the PE investor’s equity check as well as reliance on other sources of acquisition financing. As a form of deal consideration, rollover equity does not require a PE investor to call capital from its limited partners or draw on leveraged financing (particularly in a period of elevated borrowing costs). Even though rollover equity by its nature dilutes PE investor returns, it represents a relatively cheap form of third-party financing at closing that does not carry the costs associated with other financing sources (such as hurdle, interest, etc.).
• Potential for Tax Deferral. Arguably the most powerful factor driving the use of equity rollover is that it can often (though not always) be structured to take advantage of certain tax-deferral mechanisms in the tax code. Management sellers are not always keen to accept that a significant portion of their sale proceeds will take a form other than cash; however, the economic benefit of deferring tax liability on a portion of their sale proceeds to a future date can go far in softening the blow. Rollover also permits holders of “qualified small business stock” (QSBS) to continue their hold period and preserve advantageous tax treatment on such equity for disposition in the future.

Deal Practitioner Considerations

In a climate of economic uncertainty and challenging debt-financing markets, rollover equity can be an important tool for ensuring alignment of interests between a PE investor and a portfolio company’s management team and, ultimately, to get an acquisition done.

While rollover equity offers many useful benefits, it can introduce some complexity to the acquisition negotiations. For example, will the customary post-closing purchase price adjustment encompass “truing up” the value of rollover shares (and thus require that the number of rollover shares issued to sellers be adjusted)? For deals with a traditional indemnity structure, will the rollover equity be a source of buyer recovery (and if so, at what price)?

Additionally, there are issues around how rollover participants fit into the target company’s pro forma capitalization structure. For example, will the rollover equity have the same economic rights as the equity received by the PE investor for its cash investment? Will the rollover participants have any special rights as minority investors, especially with respect to governance and control of the company (for instance, the use of minority blocking or veto rights around certain company actions)?

Furthermore, when the rollover participant is a member of management, it raises new issues to negotiate around the rollover participant’s termination of employment down the line and the knock-on effects for their rollover equity. For instance, will the rollover equity be subject to repurchase by the company at fair market value, or at a discount, depending on the circumstances of termination? Will the rollover participant ever be allowed to cash out before the PE investor actually achieves its exit?

For the benefit of all parties, deal practitioners would be best advised to memorialize the parties’ understanding with respect to these negotiated points when the acquisition agreement is signed (whether in definitive equity documentation or an equity term sheet attached as exhibits to the final acquisition agreement) to minimize disconnect on these complicated issues and to avoid closing risk.

It is also of critical importance for the practitioner to involve tax counsel when structuring and drafting for an equity rollover, especially where the goal is tax-deferred treatment (or where QSBS is involved), to ensure that the statutory requirements set forth in the tax code are properly observed.

 

---

^[1] Data excludes deals in the healthcare services industry, which typically has higher rates of rollover.

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.