If you’ve ever bought or sold a business (or are just a follower of publicly announced mergers and acquisitions), you’ve likely heard the term “rollover equity." Rollover equity is basically any ownership stake the seller of the business will retain in that business after the merger or acquisition is completed. (For clarity’s sake, “rollover equity,” “retained equity,” and “rolled equity” are all used interchangeably, but we’ll stick with “rollover equity” in this post).
We’re seeing rollover equity used as a financing mechanism more frequently (usually as a way to better align the long-term interests between the seller and buyer). So we wanted to explore when a seller (or buyer) should consider it as an attractive option when selling/buying that respective business.
Rollover equity has become more common across private equity transactions — deals involving rollover equity have increased from 46% in 2020 to 57% in 2023.
Its use is even more prevalent in the lower middle market (e.g. businesses with $5M to $50M in annual revenue). In this market segment, about 70% of deals used rollover equity as a funding source (this is also the market segment our City Different Acquisitions strategy focuses on).
So why would a seller consider retaining an ownership stake in the business they’re looking to sell? And conversely, why would a buyer want the seller to stick around?
There are a few noteworthy benefits that can justify rollover equity for both parties:
Expressing your willingness to maintain an ownership interest after the transaction tells buyers you have confidence in the long-term endurability of that business. Not only are you signaling to the buyer that this business has long-term potential, but you’re putting your money where your mouth is by deferring compensation from the transaction until later down the road. That confidence can lead to more favorable valuations and increase the pool of potential buyers.
The colloquialism we hear a lot for sellers retaining rollover equity is “getting a second bite at the apple” — but what does it actually mean?
If the buyer has strategic expertise to help grow the business, a seller can still benefit from this prospective new growth… but only if they retain some equity. If selling 100% of the business, the seller will be watching from the sidelines if/when the business does scale.
The second bite of the apple can come when the business is sold again later down the road, or it could come in the form of profit distribution along the way (or in an ideal scenario for the seller, both).
At City Different Investments, we purchase businesses with the intent to hold them indefinitely. We return capital to our investors by paying out a portion of the profits of a business (usually on a quarterly or an annual basis).
If a seller in one of our deals maintains a significant ownership stake, this can mean a continued income stream even after most of the business is sold (this is akin to multiple second bites of the apple if the business continues to perform).
Often, we see that a seller is burnt out from running their business on a day-to-day basis. Just as often, though, those same sellers still feel an intimate connection to the long-term success of what they’ve helped build (oftentimes from scratch).
Depending on the details outlined in the transaction agreement, the seller can often move into the back seat and allow the buyer to run the business (while still remaining part of the team).
The rolled equity percentage does not define the level of day-to-day involvement a seller must provide to the business going forward, but rather highlights their ongoing share of risk and reward as it relates to the overall business.
In addition to signaling confidence to the buyer, a seller rolling equity in a deal has benefits for the business's purchaser, too.
Every dollar of equity rolled into the new enterprise is one fewer dollar the buyer needs to raise to complete the purchase (whether in the form of new debt or equity capital). Rolling equity helps reduce the financing burden for the buyer, which usually has the knock on effect of increasing the likelihood of the transaction closing.
Rolling equity helps reduce the ownership transition risk because it aligns the long-term incentives of the buyer and seller. In some cases where rollover equity is not part of the transaction, a seller might not always operate in the company’s best long term interests (usually in favor of enriching themselves personally in the short term… they’re getting out of the company soon anyway).
If the seller continues to own part of the business, though, the buyer has more confidence that the seller will continue to operate in the company’s long term interest both leading up to and in the wake of the sale.
In most cases, the business / owner is doing something well enough to warrant buying said business. The owner has key vendor and client relationships forged across years of working together. The business’s tech stack, systems, operations, and processes have been established across years of serving customers and partners (usually successfully). As the old saying goes, it can be difficult to rebuild an airplane mid flight.
Rolling over equity — and keeping some level of seller involvement — can often reduce that knowledge burden on the buyer (aka, you don’t have to rebuild the whole plane).
Depending on the level of involvement you negotiate, the seller can continue to help with some aspects of the business or serve in an advisor capacity. While the seller might have no interest in running the business day-to-day anymore, they can still provide a well of institutional knowledge to the buyer as needed.
As we’ve discussed here, rollover equity can benefit both sellers and buyers; when used collectively and in good faith, it can help all parties win, simultaneously. The sum of the combined efforts between the seller and buyer working together can outweigh the efforts of either group managing the business on their own.
Our approach to small business acquisitions is all about being great long-term partners to both our investors and our portfolio companies. As such, we’re always open to discussing rollover equity arrangements in our transactions when they make sense.
If you’re a business owner looking to sell your business (or are just curious to learn more about our strategy), don’t hesitate to contact our Director of Private Investments, Joel Van Essen. He’d be more than happy to set up an introductory call!
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