What is Rollover Equity?
Rollover Equity refers to the exit proceeds reinvested by a seller into the equity of the newly formed entity post-acquisition. An equity rollover is therefore designed to align the economic incentives among participants in the post-transaction entity.
How Does Rollover Equity Work?
The term “rollover equity” in M&A refers to the sale proceeds reinvested by the seller of a company into the equity of the post-acquisition company under new ownership.
If rollover equity is part of the transaction structure, the management of the pre-LBO company intends to retain an interest in the equity of the newly formed entity post-sale. The seller’s commitment to rollover equity confirms the seller’s belief that there is more upside remaining in the value of the company’s future equity.
An equity rollover implies the seller’s willingness to participate in the “upside” of the transaction post-close.
Participation in the rollover transaction presents the seller with an opportunity to take some “chips off the table” – i.e. realize a portion of the profits – and mitigate the downside risk of holding onto the full value of their equity.
While the management team no longer possesses a controlling stake in the company’s equity, the seller(s) – most often the founders of the company – still retain a piece of the company’s equity and get the opportunity to participate in the potential upside alongside the new owner with their rollover portion.
From the perspective of the acquirer, a seller’s decision to roll over a portion of the sale proceeds into the equity of the post-acquisition company – especially if done on their own accord – is perceived as a positive sign.
Equity rollover aligns the interests of the seller and the buyer post-close and mitigates the risks related to losing key personnel, i.e. the loss of critical employees, most often of corporate executives or department heads that are integral to the company’s continued, long-term success.
The phrase “second bite at the apple” is frequently used to describe the rollover equity concept.
- “First Bite”: The initial sale of the company’s equity, wherein the majority ownership shifts from the seller to the new buyer.
- “Second Bite”: The secondary transaction in which the new owner – the buyer in the prior acquisition – decides to exit and monetize the investment (and any holders of rollover equity would also benefit from such an exit).
How to Model Rollover Equity in an LBO Analysis?
In a leveraged buyout (LBO) model, the sources and uses of funds table outlines the total amount of capital required to fund a proposed transaction, such as in a leveraged buyout (LBO).
The structure of most leveraged buyouts (LBOs) nowadays comes with a rollover equity component, i.e. having the seller rolling over a portion of proceeds into the new entity has become standardized in the private markets.
In fact, financial sponsors, such as private equity firms and family offices, not only encourage but also often require the seller to rollover some equity, as their participation improves the likelihood of a profitable exit. Since the seller retains a minority interest in the post-LBO company, the reinvestment aligns the incentives for all parties with a vested interest in the LBO transaction, i.e. “skin in the game”.
To fund the LBO, the financial sponsor initially obtains financing in the form of debt capital from bank lenders and institutional investors. The total debt raised is determined by the target’s credit profile and debt capacity, as well as the conditions of the credit markets. Once the maximum amount of debt is raised to fund the buyout, the remaining amount of financing needed comes in the form of equity capital.
The purchase price of an LBO is composed of a substantial portion of leverage, however, the debt burden placed on the post-LBO company must still be kept at a manageable level. Otherwise, an unsustainable capital structure can result in the company defaulting from a missed debt payment, such as a periodic interest payment or mandatory amortization per the original lending agreement.
The rollover equity from the existing management team appears on the “sources” side of the sources and uses schedule since the capital contribution reduces the size of the upfront equity investment required by the financial sponsor.
Usually, the financial sponsor is responsible for “plugging” the remaining funding gap in order for the transaction to close and for the “Sources” and “Uses” sides to equal, akin to the fundamental balance sheet equation (Assets = Liabilities + Equity).
The proportion of the sale proceeds that the existing management team reinvests into the new entity can vary widely, however, the traditional range for rollover equity is usually between 5% to 25% of the total deal consideration.
Why is Management Rollover Equity Important?
In most LBOs, the existing management team continues to run the company post-buyout – albeit there are exceptions in which the sponsor might view the existing management’s decision-making as sub-optimal and thus plan to replace them soon after the transaction formally closes.
The existing management team’s past experience with running the company and their understanding of the market are factors deemed invaluable to the financial sponsor.
Therefore, private equity firms tend to retain the current owners and management team and convince them to roll over a portion of their equity in an effort to align their economic incentives, so that the existing management team continues to run the post-LBO company with a vested interest in achieving a successful exit.
Most financial sponsors exit an LBO investment within a three-to-eight-year time frame via a sale to a strategic, a secondary buyout (i.e. sponsor-to-sponsor), or via an initial public offering (IPO).
The seller’s stake in the equity of the new entity provides assurance to the acquirer that the existing management team will continue operating the company with the incentive to create value and maximize the exit valuation since that’ll allow the seller (and thus, the sponsor) to reap more profits on the date of exit.
Rollover equity also reduces the capital contribution necessary by the financial sponsor, which improves the acquirer’s return profile – all else being equal.
What are the Risks of Equity Rollover in M&A?
Considering the risks and rewards associated with rollover equity, the decision by a seller to still participate implies management’s belief that the trade-off is worth the potential upside in returns.
However, the percentage of rollover ownership can become a complicated matter if there are other assets involved in the newly formed holding company. For instance, the private equity firm could acquire more companies in a consolidation play – i.e. add-on acquisitions – which can reduce the rollover equity stake of the owner via the effects of dilution.
Therefore, it is critical for sellers to understand the risks undertaken by performing diligence on the post-acquisition capitalization, which requires full transparency from the buyer regarding the go-forward plan for the business.
Since the seller is no longer the majority owner, certain rights and preferential treatment outlined in the purchase agreement must be negotiated to protect their interests:
- Classes of Shares
- Voting Rights
- Preemptive Rights
- Come-Along Rights (i.e. “Drag-Along Rights”)
- Order of Proceed Distribution (i.e. Seniority)
What is the Tax Treatment of Rollover Equity in M&A?
The seller can prefer to roll over equity into the new entity for tax purposes, as the equity rollover can be tax deferred, i.e. taxes are paid only on the percentage of the company sold, rather than on the rollover equity component.
As mentioned earlier, rollover equity can be an opportunity for the seller to partially “cash out” a meaningful stake in their company while still maintaining some ownership in the new entity. So even after the liquidity event, in which the seller took out some profits, the seller still participates in the potential equity upside, assuming the post-LBO company’s value continues to grow in a positive trajectory.
The arrangement can be appealing to the seller for those reasons, while the financial sponsor’s return profile benefits from the reduced initial cash outlay and the alignment of economic interests. In certain cases, the management team might even contribute additional capital to be even more engaged in the strategic decisions of the post-LBO entity.
The more equity that management decides to roll over, the less reliance on leverage is necessary to fund the acquisition as well as a reduced equity contribution needed from the financial sponsor.
Of course, there are exceptions where rollover equity constitutes a meaningful percentage of the funding required and bridges the valuation gap between the buyer and seller. But in most cases, the appeal of management rollover is the alignment of incentives and to ensure that the most qualified team is running the post-LBO company.
The tax treatment of rollover equity can be either fully taxable or tax-deferred, which is contingent on various factors. While most rollover transactions are tax-deferred – wherein the taxes on the equity rolled over are deferred into the new entity with only the cash component of the transaction consideration fully taxed – there are various complexities that can emerge.
That said, sellers should consult with a certified tax professional to ensure their decisions are made with all factors of relevance considered to avoid any unfavorable outcomes that could have easily been avoided (e.g. protection against dilution).
How to Calculate Rollover Equity?
The formula to compute rollover equity requires two inputs:
- Seller Exit Proceeds → The seller exit proceeds is determined by the pre-LBO equity ownership percentage of the seller.
- Seller Rollover Equity (%) → The equity rollover by the seller into the new entity is calculated as a percentage of the total exit proceeds received post-sale.
If there is sufficient data regarding the pre-LBO ownership, the rollover amount can be estimated by multiplying the total equity contribution by the rollover % assumption. However, to reiterate, the equity rollover determined using this approach is only an approximation until more information is received.
Rollover Equity Formula
The formula to calculate the rollover equity is as follows.
- Seller Exit Proceeds → The amount of sale proceeds received by the seller, net of any applicable fees or assumed debt.
- Seller Rollover (%) → The percentage of the exit proceeds that the seller intends to roll over into the new entity.
Rollover Equity Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
LBO Rollover Equity Calculation Example
- LTM EBITDA = $50 million
- Purchase Multiple = 10.0x
- Purchase Enterprise Value (TEV) = $50 million × 10.0x = $500 million
Our model assumes that there is $25 million in existing debt and $5 million in cash on the balance sheet; thus, net debt is $20 million.
- Net Debt = $25 million – $5 million = $20 million
The $500 million purchase enterprise value minus the $20 million in net debt results in $480 million, which represents our company’s purchase equity value, i.e. the exit proceeds distributed to the pre-LBO ownership group.
- Purchase Equity Value = $500 million – $20 million = $480 million
The management team is assumed to own 80.0% of the pre-LBO equity, whereas a passive investor owns the remaining 20.0%.
Of the two, only the management team is rolling over 12.5% of their exit proceeds into the equity of the new entity.
By multiplying the 12.5% management rollover assumption by the $384 million received in exit proceeds (80.0% x $480 million), we arrive at a rollover equity value of $48 million.
- Rollover Equity = 12.5% × $384 million = $48 million
In the subsequent step, we’ll quickly list out the financing assumptions in our LBO model.
The total amount of senior debt raised is $200 million, while $50 million was raised from the subordinated debt tranche, so there is a total of $250 million in debt in the post-LBO company’s capital structure.
- Senior Debt = 4.0x × $50 million = $200 million
- Subordinated Debt = 1.0x × $50 million = $50 million
- Total Debt = $200 million + $50 million = $250 million
The purchase enterprise value is $500 million, which we’ll link to from our earlier calculation, and we’ll assume that the transaction fees and financing fees are each 2.0% of the total debt raised and the purchase TEV, respectively.
- Transaction Fees = $10 million
- Financing Fees = $5 million
The Cash to B/S is the minimum cash balance necessary to fund working capital needs, which we’ll assume is $10 million.
- Cash to B/S = $10 million
In total, the “Total Uses” section equals $525 million, which we’ll link to our “Total Sources” cell.
The final step to complete our “Sources and Uses” of funds table is to calculate the sum of the debt raised ($250 million) and the rollover equity ($48 million) and then subtract that value from our total uses ($525 million), which leaves us with the financial sponsor’s equity contribution of $227 million.
- Total Uses = $500 million + $10 million + $5 million + $10 million = $525 million
- Sponsor Equity = $525 million – $200 million – $50 million – $48 million = $227 million