Last week, I covered how rollover equity can be a powerful tool when selling (or buying) a business (click here for the article).  Between taking advantage of the potential for deferring taxes and offering continued upside and aligning incentives for continuing employees and business managers, buyers and sellers can certainly benefit in many cases from this structure.  However, like all M&A structures, it is not without risk and potential downsides. This week I focus on three potential disadvantages of rollover equity that can impact value, control, and long-term outcomes. 

1. Lack of Liquidity Rights

First, I’ll state the obvious – unlike receiving cash at closing, rollover equity is generally illiquid and the recipient may be dependent on future events that he or she does not control before realizing the value of the rollover equity.  Unless you are able to negotiate specific terms that allow you to sell your rollover equity, you may be indefinitely locked into a position holding equity that you cannot monetize.  Additionally, the rollover equity could be diluted if the company takes in additional investments or rendered worthless if the company underperforms.  To mitigate those risks, sellers with strong leverage may negotiate for protections around their rollover equity, including those listed below.  That said, especially when the buyer is a private equity (PE) backed firm or if the seller is not receiving a significant percentage of the newco at closing, these protections can be very challenging to get in this market.

• Put rights that can be exercised after a certain period of time (e.g., after a date certain or a milestone has been achieved, you have the right to require the company to buy you out of your position using an agreed upon formula);*
• Tag along rights in a sale;** and
• Approval rights over certain significant decisions.

While these protections can be helpful, they do not completely eliminate the impact on the value of, or ability to monetize, rollover equity in cases where the company is never sold, or is sold at a steep discount.  As with all investments, equity comes with potential upside if the company is sold at a multiple and downside if it is not.

* Note, it is not uncommon for PE-backed buyers to request the counterpart to the put right – namely a call right, whereby the buyer can buyout your rollover equity under certain circumstances.

** Note, PE-backed buyer usually a drag along right, whereby if they sell a majority of the company to a third party, they have the right to drag you along in the sale (e.g., require you to sell your stock as well).

2. Subordinated Position

Rollover equity is typically structured as common stock*, while investors (current investors and/or new investors in the future) may hold preferred stock with preferential financial and voting rights over common stock.  This is commonly referred to as the equity “sitting at the bottom of the cap stack” (or capital stack).  Generally speaking, this means that you are the bottom of the stack (or last in line) to get paid if and when a liquidation event occurs – debt holders, preferred stockholders, etc. all ahead of you, and you simply have to hope that after they receive the monies they are owed, there is enough of a balance (and a hearty balance, if you are lucky) from the proceeds of the liquidity event remaining for the common stockholders.  If not, you can be in a position where the debt holders are repaid in full, the preferred stockholders receive their preferred return, and there may be little if any money to go to the common stockholders.  As such, when receiving your rollover equity, it is imperative that you understand where in the cap stack your equity will sit and whether you are pari passu (on equal footing) with others or not.

Dovetailing off of the above, unlike preferred stockholders, common stockholders typically do not have any rights to a preferred return or a guaranteed right to receive distributions.

* For purposes of this article, we discuss the issuance of common stock in a corporation, but this can also be structured as membership interests in a limited liability company.

3. Risk of Dilution

The percentage ownership of the company represented by your rollover equity would be reduced if the company issues more equity, whether through future rounds of financing or management incentive pools.  Unless the rollover equity is protected with anti-dilution rights (including capping the size of any incentive equity pools), preemptive rights (allowing them to purchase their pro rata share in any future financing rounds), or veto rights over new issuances, your stake could shrink materially over time—even as the company grows.  That being said, as with item 1 above, these protections are not commonly provided to rollover equity holders unless they have significant leverage in the negotiations.

Including rollover equity as a component of a sale of your company can be an advantageous way to participate in the future, post-sale growth of the business you built. However, if the terms are not thoughtfully negotiated, you may end up with an illiquid, non-controlling ownership position in the post-sale company, and be subject to further dilution if the company issues more shares.  In addition to ensuring you have a full understanding of the risks and trying to negotiate the best terms you reasonably can, it is imperative that you obtain reliable advice as to any tax-related aspects of receiving rollover equity, which can be complex.  As always, please feel free to contact me if you have any questions or would like to explore whether rollover equity may be right for you in the sale of your business at LKaplan@mosessinger.com.