There was a significant decline in mergers and acquisitions (M&A) in 2023, as they hit their lowest level in a decade. Global M&A activity dropped by 20% compared to 2022, primarily due to the challenges buyers and sellers faced in reaching price agreements amidst rising interest rates. One strategy to facilitate deals under these conditions is for business owners to roll over part of their equity into the new entity. Rollover equity is a transaction structure that lets sellers reinvest a portion of their sale proceeds into the acquiring entity. This approach offers the seller an opportunity for continued growth and wealth creation but also comes with some risks.

What is Rollover Equity?

Rollover equity occurs when a seller retains a stake in the newly combined entity by selling less than 100% of the business. The seller “rolls over” a percentage of their equity into the acquirer’s company, becoming a minority shareholder. This method allows the seller to benefit from future success of the business and offers tax advantages by deferring capital gains taxes on the reinvested portion of the sale proceeds.

What are the potential benefits of rollover equity when selling a business?

  • Potential for Future Profit – Private equity firms typically aim to sell the business they purchase within 3-5 years. If the buyer is a private equity firm, this offers the original owner another chance to profit in the relatively near future.
  • Debt Management – While interest rates are high, if the seller sells more than a controlling stake in the business, the ability to keep low-interest debt may be attractive to potential buyers.
  • Trust in New Management – Sellers may believe that a particular buyer can add value beyond their capabilities, potentially increasing the business’s intrinsic value and leading to a higher buyout price later.

When do rollover equity transactions make sense?

  • Belief in the Acquirer’s Vision – For those who believe in the acquirer’s strategic vision and growth potential, rollover equity can be appealing. It is especially beneficial if the buyer has a track record of acquiring and growing businesses. Keeping ownership stake in the business allows the buyer to benefit from synergies and economies of scale.
  • Wanting to Stay Involved – Business owners who are passionate about their companies might find it emotionally challenging to sever ties completely. Rollover equity allows them to maintain a connection and stay involved, but in a different, less burdensome role.
  • Tax Advantages – Rollover equity transactions can defer capital gains taxes on the reinvested portion of the sale proceeds, resulting in significant tax savings for the seller. They can then reinvest in the new combined entity, or in different opportunities.

When should you avoid rollover equity?

  • Lack of Confidence in New Ownership – If there are doubts about the buyer’s ability to manage and grow the business, tying personal wealth to the combined entity’s performance may be risky. As a seller you must do your due diligence on the buyer before deciding to invest in their ability to run a business.
  • Desire for a Clean Break – Some business owners may wish to start fresh without any ties to their former business. In such cases, a rollover equity strategy may not align with their personal goals, and a clean break may be more ideal.
  • Need for Diversification – Concentrating wealth in a single entity can increase the seller’s financial risk. Rollover equity limits portfolio diversification, a fundamental principle of risk management.

What are other key considerations with rollover equity?

  • Percentage to Roll Over – Typically, rollover equity percentages range from 5% to 25%. It’s crucial to negotiate a fair percentage that aligns with the seller’s objectives and risk tolerance.
  • Vesting Schedules and Exit Mechanisms – Vesting schedules ensure the seller’s equity stake is earned over time. Exit mechanisms, such as put options or redemption rights, provide a path for the seller to eventually cash out their equity stake.
  • Due Diligence and Legal Considerations – Engaging in a rollover equity transaction requires thorough due diligence on the acquirer’s performance and legal implications. Experienced legal counsel and an experienced M&A advisor, such as a business broker, can help navigate these complexities.

How to negotiate favorable terms with rollover equity transactions

  • Valuation and Pricing – Ensure the valuation reflects the true value and growth prospects of the business. Engaging valuation experts and negotiating with the acquirer is crucial. A business broker can provide you with an accurate valuation based on current industry-specific market conditions.
  • Governance and Control Provisions – As a minority shareholder, negotiate provisions that protect your interests and provide some influence over strategic decisions, such as board representation and voting rights.
  • Anti-Dilution Protections – Rollover equity transactions can involve equity issuances and capital raises, which can dilute ownership stake. Negotiate anti-dilution protections to preserve the value of the rollover equity.
  • Non-Compete and Non-Solicitation Clauses – Buyers will want to negotiate time and geographic limitations as part of non-compete and non-solicitation clauses. As a seller it’s important to make sure these clauses are reasonable, to protect potential future business interests.
  • Leverage Third-Party Support – Negotiating any deal alone is a daunting task that opens a seller up to costly errors and oversights. Utilize the experience and expertise of a business broker and financial advisors to protect your financial interests.

Rollover equity presents both opportunities and challenges for business owners selling their companies. It provides the potential for continued growth, wealth creation, and involvement but also comes with risks. The decision to accept or reject rollover equity should be based on a thorough evaluation of factors such as the buyer’s vision and capabilities, personal goals and risk tolerance, tax implications, and diversification needs. By seeking professional advice and conducting rigorous due diligence, business owners can make informed decisions that align with their long-term objectives and financial well-being.

If you are preparing to sell a business in Southwest Florida and are considering a rollover equity transaction, don’t try to do it alone. Rollover equity deals are especially elaborate and require a lot of term negotiation and due diligence. If you have any questions about these types of transactions, or selling a business in general, consult with us at Corporate Investment Business Brokers (CIBB). We are business transaction specialists, focused on helping business owners in Fort Myers, Sarasota, Naples and the surrounding areas to maximize the profit from the sale of their business. We can ensure that your deal is negotiated in favorable terms. Contact us to discover how much your business is worth. We offer a free business valuation estimate that can help you decide your next course of action.

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