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.
Rollover Equity: M&A Transaction Structure
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).
LBO Rollover Equity: Sources and Uses Table
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” side 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.