Understanding the Risks and Rewards of an Equity Rollover

Private Equity buyers are often going to prefer that a selling shareholder retain a minority stake in the business through what's called an equity rollover. Now, an equity rollover is essentially a reinvestment by you, the selling shareholder, in the business post transaction close. My name is Joe Anto and I'm with PCE Investment Bankers and today we're going to talk about the risks and rewards associated with potential equity rollover and what you need to consider when looking at it as part of an overall transaction. Now, a private equity buyer is going to want an equity rollover for two primary reasons. First, they're going to want to see that the selling shareholders who remain with the business continue to have skin in the game so that everyone's aligned and trying to make sure that they can maximize the value of the business post transaction close. Another reason that they're very interested in equity rollover is it reduces the amount of cash that they have to put up to finance the transaction. It's always going to be an important consideration for a private equity buyer. Now, while an equity rollover reduces the amount of cash that you're going to receive at close, if the value of the business appreciates over time, that amount of equity that you roll can be worth significantly more than whatever you were able to receive in the initial transaction. So, that's something to consider as you look at an equity rollover. Another thing that you want to consider when you're looking at an equity rollover is what does the capital structure of the business look like post transaction. Specifically, how much debt is going to be on the balance sheet. If the business is going to take on a significant amount of debt, you really need to assess whether you think that the debt service on an annual basis is going to stress cash flow because that'll impact the future value of the equity that you're taking in the business. Another thing that you're going to want to consider when you look at an equity rollover is how is your equity stake structured relative to the private equity funds. Many times, private equity funds are going to structure their equity stake as a preferred equity stake where they will take a preferred return before any other common shareholders receive a distribution on their equity. So you really have to evaluate what that looks like in the context of what your return could be post transaction. You're also going to want to think about what your role is with the business post transaction close. If you're only going to be around for a year or two without much decision-making control you're going to be inclined to want to take a smaller stake of equity whereas if you're staying around for the long term, and you feel like you're going to have a significant amount of influence on what the business is doing, you might be more willing to take on a bigger stake. Another important consideration is doing your due diligence on the private equity group themselves. What's their investment horizon? What's their track record? How have they worked with previous management teams to create value? You also want to talk to references. Talk to other sellers about what their experience has been like with that group. Doing your due diligence is an important part of the process; especially when equity is involved. Now in an equity rollover there are potential risks, but also potentially significant rewards if the value of the business appreciates over time. And understanding the items that we discussed today will help you evaluate equity rollover as part of an overall transaction.