Oct 15, 2020
In this episode, Gina Cocking and Jeff Guylay continue their
discussion on deal structuring.
Today, we explore rollover equity, a form of contingent
consideration in which the seller takes a portion of its proceeds
as equity ownership of the new or acquiring company. In this
episode, we cover:
Why is rollover equity important?
How often is it used?
How is it structured?
What happens in platform investments vs smaller add ons?
How does it differ from management incentive pools and from taking
stock as consideration in a publicly traded company?
We talked about how the math works related to rollover equity in leveraged transactions and how we help manage these critical negotiations with buyers. Importantly, we talked about how rollover equity can set up all parties in the transaction for success through the alignment of interests.
Other episodes in our series about deal structuring include price and terms, earn outs, R&W insurance, and roll ups.
More than two-thirds of M&A transactions in recent times
utilize rollover equity. The primary purpose of rollover equity is
to align interests through shared economic ownership. Rollover
equity gives the owner a second bite at the apple, as you’ll hear
in the episode and read in the show notes. Rollover equity is also
tax-deferred.
Later in the episode, Jeff is joined by our guest Vernon Rew, a
partner at Whitaker, Chalk, Swindle & Schwartz, who shares his
perspective on closing conditions and the importance of staying on
task and getting deals to the finish line.
In this episode, Colonnade Advisors addresses the following
questions as related to rollover equity:
What is rollover equity? (00:55)
Gina: "The sellers of the company, the founders, the owners are
going to take some of their proceeds and roll it over into equity
and ownership of what we call Newco. Newco is the new or acquiring
entity."
Why is rollover an important equity component of a transaction?
(01:52)
Jeff: "Probably the most important answer or topic here is that it
aligns interests, particularly when you're talking to private
equity-backed buyers."
How often is rollover equity used in transactions? (02:56)
Gina: "67% of the transactions in recent times have utilized
rollover equity."
What are the tax implications of rollover equity? (05:10)
Gina: "Taking equity as consideration in a deal is tax-deferred.
With equity that you are rolling over, no taxes are paid at the
closing. You're not going to pay taxes until you sell that equity
and convert it into cash."
What are the other advantages of rollover equity? (05:55)
Gina: "Another advantage of rollover equity is that it gives the
owner a second bite at the apple. Rollover equity can be valuable.
With that second bite at the apple, we have seen many cases of
people that have gotten very wealthy with the second turn of the
sale of the business, and even third turn."
What is the seller demonstrating to the buyer when rolling over
equity? (08:40)
Jeff: "Showing commitment and confidence in the forecast and the
business, and just setting up the business for success through
mutual understanding."
What is the role of a financial advisor, such as Colonnade, in
rollover equity discussions? (09:30)
Gina: "Rollover equity introduces a whole other component to
diligence where it's the diligence of the other side. That is where
a trusted advisor's perspective is helpful. In our case, with many
of our clients on the deals we work on, we know the universe of
potential buyers pretty well, so we can give our perspective."
If selling the business to a private equity firm as a platform
company, what type of diligence should be performed? (10:15)
Jeff: "There is due diligence around the private equity firm and
their experience and track record. The dating dynamics of some of
these management meetings are fundamental because these are going
to be your partners."
If selling the business to a private equity-backed strategic
company, what type of diligence should be performed? (10:47)
Jeff: "You have to conduct due diligence and relative valuation on
this private equity-backed firm that already exists and has
operations and that already has a set private market
valuation."
How is rollover equity different from stock options and incentive
pools? (12:05)
Gina: "Stock options and incentive pools are subjective decisions
by the board as to what you get for hitting certain performance
goals. It is very different. Rollover equity is your property, and
you have property rights to it. They cannot take that away."
Are there restrictions on what the seller can do with the rollover
equity? (13:01)
Jeff: "There are almost certainly going to be restrictions around
what you can do with the stock. The operating agreement that your
attorneys will help you review, and you'll sign onto, will
typically have pretty strict covenants related to how you can
dispose of the stock."
What type of securities are used with rollover equity? (15:45)
Gina: "Our goal is to get pari passu, meaning the same type. We
make sure in deals today that the sellers get the same type of
equity as the buyers. If the buyers are getting preferred, we want
the sellers to get preferred."
Typically, what percentage of the total transaction consideration
is rolled over? (18:12)
Gina: "It's a complicated question. Buyers typically look for
10%-40% equity rollover. It depends on who the buyer is. Private
equity buyers will probably want to see a lot of rollover equity.
Buyers look at it as a core part of their strategy to incentivize
everyone."
How do rollover equity considerations differ if the buyer is a
public company? (19:40)
Jeff: "With public companies, the discussion is usually different.
It can be a tax discussion. It is a separate analysis. The thesis
is the same, but it is used really for other purposes.
When do rollover equity discussions typically take place in a
transaction? (20:45)
Jeff: "We usually have it as one of the near-final conversations
with the buyer that we select in exclusivity."
How is the seller's rollover equity percentage ownership of the new
company determined? (22:47)
Gina: "It is based on the equity value of the new or acquiring
company and depends on the leverage in the transaction. The
percentage of your rollover proceeds does not necessarily equate to
the percentage of the new company ownership."
What are the benefits of using a financial advisor in rollover
equity discussions between the seller and buyer? (25:50)
Jeff: "Our experience in working with these types of transactions
is powerful in terms of making sure that they get done well for the
seller. Otherwise, these things can blow up pretty quickly if you
just put people in a room and start talking about rollover
equity."
What effect does any additional equity grants or incentives for
employees have on the seller's equity rollover percentage ownership
of the company? (26:48)
Jeff Guylay: "There'll be diluted pro-rata just like everyone else.
The sellers and buyers have locked arms, and they are in the same
security and position. Any additional equity grants or incentives
will dilute everyone on a pro-rata or equal basis."
Will current sellers of the company be asked to rollover equity at
the next transaction? If so, why? (27:06)
Gina: "Current sellers of the company - who are important to the
ongoing operations of the business - may have to rollover equity
again in the future at the next transaction. For example, a private
equity firm has bought your company, and you rolled over equity.
The private equity firm then sells the company to another private
equity firm in the future. The new owner would like to see you be
equally incentivized or have skin in the game and would like to
have some equity rollover."
Can the owner completely exit the business after a few years
post-transaction? (28:52)
Jeff: "That is usually a good conversation to have with buyers as
long as we're clear and upfront about it. We want to make sure that
everyone knows that the management transition plan has to start
immediately. You have to be in a position where you've got the next
set of leaders up and ready for the next transaction, whether it's
one, three, or five years."
Jeff invites Vernon Rew, a partner at Whitaker, Chalk, Swindle &
Schwartz, to share his perspective on closing conditions in a
transaction.
What closing conditions do you see in M&A transactions, and why
are these conditions so important?
Closing conditions are critical because if a single closing
condition is not met, you're likely not closing
It is important to obtain all necessary third-party consents and
all required regulatory approvals
The material adverse effect and the material adverse change
provisions are essential and often highly negotiated
Focusing on the process and keeping all members of the seller team
on task and focused on getting to the close are critical
Time is critical. A delay in completing a closing consideration
could kill a deal
Featured guest bio and contact information:
Vernon Rew
Email: vrew@whitakerchalk.com
Vernon Rew has over 35 years of legal experience representing
business clients in corporate matters, contract negotiations,
mergers and acquisitions transactions, and securities law
compliance matters. Vernon has represented both public companies
and privately held entities in a wide variety of industries.
Vernon's mergers and acquisitions practice has included
representation of both sellers and buyers in a large number of
transactions throughout his career. He has worked in a wide range
of manufacturing and service industries in his corporate and
contracts negotiating practice. In his securities law compliance
practice, he has counseled clients with SEC filings, tender offers,
public offerings, and going private transactions. Vernon considers
himself a relationship lawyer and is an experienced counselor and
negotiator on behalf of his clients.