Rollover Equity - An Explainer

April 25, 2023

by a professional from Georgetown University in Maryland, USA

With the new SBA 7(a) rule change (potentially) allowing the acquisition of less than 100% of a business, there is a lot of talk of Rollover Equity.

What is it and what are the pros and cons?

Rollover equity is used in practically every middle market private equity deal and during my time doing larger private equity deals they were heavily negotiated.

It means a buyer requires a seller to take part of their purchase price in equity of the buyer’s new business (sometimes the AquistionCo and sometimes the HoldCo). Often this can be as much as 20%-30% in Rollover Equity, but it’s negotiated and included in the LOI.

Here are some considerations:

Pros:

1. Buyer potentially reduces the equity they need to bring to closing.

2. Buyer gets comfort that seller is keeping skin in the game and is (literally) invested in the buyer’s success.

3. Rollover Equity can be offered to key employees as a retention technique.

4. For the seller, they get to own equity in the buyer. This can often be worth much more if the business succeeds.

Cons:

1. It adds another level of complication. The seller will be a part owner in the buyer’s new business, that means they will want certain rights that an investor would usually get (think, long, heavily negotiated operating or shareholders agreements). This is usually negotiated alongside the purchase agreement.

2. Seller will view this as an investment in the business and will want to do a lot more diligence on the buyer. Often, they will ask for a business plan, financing plan, track record, etc.

3. Sometimes a seller will want to restrict or supervise how the buyer runs the business after closing through operating covenants (some lenders won’t allow this).

4. A deal with rollover equity will be more costly in legal fees. As you gathered, all of this negotiation and drafting will make the deal cost more.

5. It adds more tax complications that I will not go into here, but you want to make sure the rollover equity is structured in a tax-efficient way.

From a legal perspective you need to add a Rollover Equity Agreement, an operating agreement/shareholders agreement, and certain provisions in the purchase agreement.

Let me know if you want a deeper dive into any of the above.

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

Based on my experience with completed large deals with rollover equity, my hunch is that rollover equity would be very difficult to achieve in SBA financed deals. Buyer benefit will be too small compared to the headache and complexity. Today, seller does not know of, or care for, buyer's capital stack. With rollover equity he will have to understand the capital stack. This may scare the seller and risk the whole deal. A quick math: 1% rollover of purchase price will give the seller 10% ownership of post-acquisition entity. in typical SBA financed deals if both are pari-passu.
Let's wait few more weeks and hope I am wrong.

Reply by a searcher
from University of California, Berkeley in San Francisco, CA, USA

Good stuff. Above is a great list of key considerations, Equity rollover can be a great way for Buyer to de-risk information asymmetry prior to ownership and if structured properly gain alignment with Seller on future success of the business. To borrow from PE deals, couple other concepts to hone (with help from your experienced deal attorney) 1) think about proper governance including adding outside board members, 2) sweat the details on your operating agreement 3) understand and communicate clearly on expectations and distinction between ownership share and operating roles.

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