Rollover Equity and Equity Deals – Things to Look Out For
Given the prevalence of "rollover equity transactions" in middle-market merger and acquisition (M&A) deals, it has become increasingly important for both sellers and buyers to understand key considerations and implications of “rolling equity”. In this month's blog, we'll start by defining rollover equity and then delve into crucial aspects to look out for, spanning equity valuation and terms, tax implications, signaling effects, future exit strategies, and more. These factors can influence the transaction's outcome, the returns for equity holders in both the present deal and subsequent liquidation events, as well as the rolling shareholders’ engagement with the go-forward entity. A good understanding of equity rollovers and their consequences is vital when undertaking an M&A transaction.
Defining Equity Deals and Rollover Equity
An equity deal, within the context of M&A, refers to a type of transaction where one company acquires ownership in another company by purchasing its shares of stock. In other words, the acquiring company buys a portion of the target company's ownership interest, which is represented by shares of common or preferred stock. Rollover equity is most commonly a feature of equity deals as opposed to other deal structures (i.e., asset sales).
Rollover equity refers to a scenario where the existing shareholders of a target company (the company being acquired) are offered the opportunity to exchange their shares for equity ownership in the acquiring company or the newly combined entity that results from the transaction. Instead of receiving cash or other forms of consideration for their shares in the target company, the shareholders have the option to "rollover" a portion of their equity into the acquiring company. This means that they continue to hold an ownership stake in the new entity post-transaction.
Rollover equity has gained prominence, especially in middle-market private equity transactions, due to its strategic advantages. This mechanism serves several purposes including aligning the interests of existing shareholders, particularly management teams, with those of the acquiring company and can contribute to the financing structure of the deal (i.e., by allowing existing shareholders to retain equity stakes, the acquiring company might require fewer upfront cash resources for the transaction).
When defining rollover equity it is also important to consider earnouts and how the two types of deal structures compare against one another. Covered in our most recent blog post, an “earnout” is a contractual provision in an acquisition deal that links part of the purchase price to the performance of the acquired business post-acquisition. In both cases, the success of ownership relies on the performance of the target company or newly combined entity post- close, effectively aligning the interests of involved parties. However, earnouts typically pay out over several years if certain financial metrics are met while rollover equity generally only results in additional proceeds for those involved if and when the target company is resold.
Next, we will discuss important factors to look out for with respect to equity rollovers.
Critical Considerations
Valuation and Terms: The value and terms of rolled-over equity can change pre- and post-transaction. To begin, the level of leverage is likely to change in the restructured entity (i.e., as is common with private equity deals), thereby reshaping the makeup of a company's ownership interest in terms of equity. Conventionally, a greater use of debt leads to an increase in the proportion of equity ownership held by rollover participants as the buyer is committing less equity as a result. Secondly, factors such as voting rights, representation on the board, priority in distributions, and the expected potential for dilution will all play a role in determining the level of influence an individual holds over the new entity, as well as the treatment they can expect in future distribution and liquidation events.
Taxation: Tax implications are always a crucial aspect to bear in mind, but they become particularly significant when dealing with equity rollovers, as this portion of the transaction doesn't involve cash exchange. Generally, equity rollovers allow participants to defer taxes on the rollover piece of their sale proceeds until the target company is resold by investors at which point the applicable taxes are then owed. Legal and tax experts can help navigate this complex environment by structuring the deal in a tax-efficient manner. Often, tax-free rollovers entail requirements like retaining a portion or all of the equity, or executing an exchange of old equity for new equity within a tax-free incorporation transaction. [1]
Signaling Strength: Although some private equity firms mandate equity rollovers in the range of 10% to 30%, they can also play an important role as a signaling mechanism. Rollovers in this range highlight management's (or other holders of rolling equity) strong belief in the business, whereas the contrary has the potential to raise concerns for both management and investors. Additionally, the rollover indicates to legacy employees that management supports the acquirer and maintains faith in the business, thereby aiding the transition period following the transaction.
Exit Strategy: Rollover equity provides management and other investors a “second bite at the apple”, but to capitalize on this opportunity the company must be able to successfully exit in the future. Various elements will shape this outcome including the investors’ envisioned investment timeline, targeted thresholds for returns, preferred exit methods (i.e., M&A, IPO, etc.), and the feasibility of the exit (i.e., considering active investors in the sector, prevailing market conditions, etc.).
Financial Prospects of the New Entity: The value of the rolled equity hinges on the company’s future performance. Consequently, it is crucial to evaluate the company’s ability to effectively handle its obligations stemming from post-transaction debt and its potential for growth down the line. Some level of financial and legal due diligence on the buyer is strongly encouraged to help rollover participants better understand what governance and ownership of the acquired company will look like on a go-forward basis. Engaging in conversation with the potential buyer can significantly shape these perspectives, particularly when it comes to comprehending their strategies and viewpoints regarding both organic and inorganic growth.
When well understood and implemented in the right scenarios, rolling over equity can foster confidence and establish a strong relationship between the buyer and seller, incentivize and allow management to continue to realize value from company performance, and setup the post-closing entity for successful future liquidity events. For this reason, any individual involved in an M&A transaction should understand the nuances of equity rollovers.
Photo by Amy Hirschi
[1] Osler: Tax Considerations for Equity Rollovers in M&A Transactions