Private equity (PE) investors often require certain founders or sellers to exchange or “rollover” in Transactions a percentage of their equity into the buyer of the business (or into a fund or holding company controlled by the PE investor). A similar rollover structure might involve the sellers being required to “co-invest” with the buyer by directly reinvesting (or rolling) a portion of the cash received by the sellers into a minority percentage of the equity of the target company. The value of the buyer equity is then driven by the target company’s post-closing performance.
In addition to other equity-based management incentives (such as participation in an employee equity incentive plan), rollover transaction structures are used to better align the post-transaction interests of the PE investor and the sellers (such as where founders or key executives are expected to remain with the target company in some capacity after the transaction closes).
The Buyer also benefits from a rollover structure as it results in a reduction in the required cash outlay to pay the purchase price. A rollover structure can also be favorable to selling parties by providing them with an opportunity to participate in potentially high upside upon an exit of the post-closing company (think “second bite at the apple”), particularly in instances where PE partners have a track record of creating significant post-closing benefits through their capital, contacts, or operational expertise.
Rollover structures can also bridge potential valuation gaps that may exist between sellers and buyers over the target company.
Rollover Structures in M&A Transactions
A rollover structure is different than (but is sometimes combined with) the grant of post-closing stock options, LLC “profits interests” or other traditional employment-based equity in the target. Stock options and profits interests are usually subject to vesting and other company favorable terms (such as being junior in right and payment) that do not apply to the class of equity held by PE investors.
Conversely, a rollover or co-investment structure often gives the rolled equity a minority interest but the same economic rights as equity held by PE investors.
Among other things, this means that a seller’s rollover contribution will receive the benefit of the same per-share price, equivalent distribution rights and general senior ranking status of the PE investor’s equity in the target (but it also means that the seller’s capital contribution associated with the rollover is equally at-risk as that of the PE investors on a pro rata basis). Sometimes, the roll over equity is junior to the PE equity, though.
Highlighted below are certain key issues often negotiated by the parties as part of agreements relating to the roll over equity:
- Amount of the Rollover. Although 20% is often a targeted number, the specific roll over amount is based on various factors, including the type and amount of other management equity-based incentives being offered to the sellers in the acquisition, the existing equity structure of the target company, the amount of risk the PE investor believes management of the seller should retain in the post-closing company, the PE investor’s financing needs in the acquisition, and tax considerations. In the case of an equity rollover, a Seller will typically seek for the rollover to be made on a tax-free basis, making it important for the Seller to confirm the tax treatment of his or her rollover.
- Repurchase Rights. The PE acquirer will typically seek the right to repurchase a seller’s rollover equity upon his or her termination of employment or services to the post-closing company for any reason. However, because a seller purchases (versus being granted) the equity in the post-closing company through the rollover structure, sellers will typically seek (and should be successful in doing so) in eliminating these restrictions.
- Vesting. Certain aggressive PE acquirers may seek to have the rollover equity vest over time, depending on the type and amount of equity being rolled over by the seller (such as with the rollover of target company equity that was subject to vesting at the time of rollover). However, a seller will normally resist these requirements with rollover structures given that the seller has made the equivalent of a capital contribution equal to the value of his or her rollover equity at the closing of the transaction.
- Transfer Restrictions. Typically, the parties will agree to a right of first refusal in favor of the PE investor on any transfer of seller equity, with limited standard exceptions. In addition, a seller will seek to include a tag along right, while the PE investor will seek to include a drag along right.
- Management Rights. The parties may need to agree on whether the rolled seller equity will have the same voting rights as that of the PE investors, or whether the seller will have any right to appoint directors or LLC managers. In most transactions, the PE investor will maintain control of the board / management, but these agreements will vary by deal and by PE investor.
Counsel knowledgeable on negotiating and structuring rollover or co-investment terms as part of an M&A transaction is often critical to a successful deal outcome. The attorneys at Linden Law Partners have wide-ranging specialized experience with advising buyers and sellers on the various considerations and implementation of M&A transactions with rollover or co-investment elements.