Rollover equity

What is rollover equity?

Rollover equity or rolling equity is a type of M&A deal structure in which founders, other key executives or other shareholders of an acquired company forgo full liquidity from the cash price of a sale and instead take a portion of the sale proceeds in the form of an equity stake in the company post-transaction.  This arrangement is common in M&A deals in which private equity firms (PE firms) acquire corporations and limited liability companies (LLCs).

How does rollover equity work?

In an M&A transaction, shareholders at the target company may be given the option to transfer (“roll over”) part of their sale proceeds into new equity in the post-sale enterprise with the expectation that the new equity will appreciate in value when the acquiring PE firm later sells the company or the company goes public at a profit. These equity rollover arrangements are typically negotiated as part of the acquisition transaction itself.

What are the advantages of an equity rollover?

Rollover equity has certain benefits for both the buyer and the seller.

For buyers: 

Incentivizes key employees

The main potential advantage for the buyer (most often an investment firm or other private equity buyer) is that rollover equity aligns incentives among investors and key employees. The selling business owner or management-team member is encouraged to remain with the enterprise post-acquisition and to focus on building the company in order to maximize the value of the rollover equity. The private equity firm gets the benefit of continued involvement from experienced executives who understand the company and the industry.

Reduced cash outlay

Another advantage for buyers is that they can spend less cash on an acquisition by offering equity for part of the purchase price. 

For sellers:

Strong potential for future growth

The main potential advantage for the seller (company management), or any recipients of rollover equity, is that they can participate in the upside of a company’s growth under the PE firm’s ownership. Depending on the deal and the acquirer, this can be a good bet—PE firms conduct thorough due diligence into companies and acquire those most likely to return a healthy profit a few years later. Firms typically hold their portfolio companies for a few years before selling them, and in that time they aim to boost their resale value through a variety of strategies, including rolling up similar companies to develop a platform, increasing revenue, slashing costs and taking other steps to make them more attractive targets for later buyers.  

Potential tax benefits 

Sellers who receive rollover equity may have the chance to defer taxes on the equity portion of their sale proceeds, depending on the structure of the M&A transaction.

What are the disadvantages of rollover equity?

For buyers, rollover equity may eventually cut into the firm’s profits once they sell the company a few years later. Firms see this as a beneficial trade-off, since it means the company’s value grew and that the remaining equity holders  likely had a hand in that growth.

For sellers, rollover equity means less cash upfront because they get some equity instead of the full cash price. There is also no guarantee that the company’s equity can eventually be liquidated for a price that matches or exceeds the cash that the recipient of rollover equity gave up in the deal.

Another possible disadvantage for sellers is dilution—their equity may decrease in value if the buyer is combining the company with other assets, for example. Sellers should seek to fully understand the post-acquisition ownership structure, or capitalization, to avoid their shares being diluted.

With rollover equity, both sides are taking a calculated risk—buyers give up equity with the expectation that they will make it up on a later sale, and sellers give up cash with the same expectation. In both cases, a  subsequent sale of the company at a premium to the original sale price serves both interests.    

Rollover equity tax treatment

Sellers receiving rollover equity may be able to defer some taxes, because typically only the cash portion of sale proceeds is taxable at the time of the sale. The rollover equity portion is generally taxable when sellers cash out their equity at a later date, for example when the company is eventually resold. 

This potential tax advantage depends on the structure of the M&A transaction and on the tax status and business structures of the buyer and seller. 

Any appreciation of the equity is generally taxed at capital gains rates rather than higher ordinary income rates if held for the requisite time period to qualify for capital gains treatment.