When selling your business, it’s common for buyers - especially private equity firms - to ask you to “roll over” a portion of your equity into the entity the buyer uses to acquire your company (often, a newly formed holding company referred to as “Newco”). While rollover equity can be a smart move for some buyers with the potential for long-term upside, it also carries hidden complexities that deserve close attention.

Three reasons why rollover equity may be attractive to buyers and sellers:

1. The buyer gets to conserve cash.  Using a very simple example, if the parties agree on a purchase price of $100 million for the target company on a cash-free, debt-free basis, instead of paying $100 million in cash to the seller at closing, the parties can structure this as the buyer would pay $80 million in cash to the seller at closing (80% of the purchase price) and the seller would roll over $20 million in equity into Newco at closing (20% of the purchase price), thereby reducing the cash outlay for the buyer at closing.
2. The seller partakes in the upside, if any, of a potential sale of the entity in which it holds the rollover equity – said differently, the seller potentially gets a second bite at the apple.  If the value of Newco (and, in turn, the seller’s rollover equity) increases after the seller sells the target company to the buyer, then the value of seller’s equity stake could significantly increase as well, making the pay day for that equity more valuable in a future sale than it would have been at the initial sale of the target company (typically speaking, although of course this is dependent on the deal terms and facts and circumstances in each case).  Using the example above, if Newco significantly appreciates in value to $400 million and the seller maintains its 20% rollover equity (and assuming that there is no debt, liquidation preferences for other holders or any other complicating factors), then the seller could receive $80 million for that 20% rollover equity ($400 million multiplied by 20%) (whereas if it sold it for cash at closing using the example above, that 20% would only be valued at $20 million (20% of the $100 million purchase price)).
3. If structured properly, the seller will not pay tax on the rollover portion of the sale at the time of the sale.  Said another way, if the rollover is structured properly (typically through a Section 351 or Section 721 tax-free exchange, depending on the entity type), the seller potentially can defer capital gains taxes on that portion.  Instead, the seller would pay capital gains tax (typically) on the rollover equity when it is eventually sold, usually in a future exit by the private equity owned Newco.

Stay tuned for my next blog post on reasons why rollover equity may be unattractive to buyers and sellers, and my blog post after that on questions sellers should ask before agreeing to rollover equity.  As with all of my posts, these are only three of the top areas of concern and are not intended to be an all-inclusive list.  For more insights or for any questions you may have, please contact me at LKaplan@mosessinger.com.