Private equity buyers and their money are everywhere these days. Private equity firms (also known as financial buyers) are looking to acquire companies that they can grow or improve with an eye towards re-selling the business at a higher value.
If you are a business owner and you sell to a private equity group, you may be asked to roll your own equity back into the transaction and remain a stakeholder after the sale is complete. This catches some business owners by surprise, but it is a very common practice among private equity buyers.
Here are some things that sellers need to know about this fairly common practice.
Advantages of Remaining a Shareholder Post-Transaction
1) You can lower your tax bill
If structured properly, you can avoid paying taxes on the amount of equity you roll back into the company. The taxes won't be due until a future liquidity event. Rolling equity back into the company can be an attractive way to reduce your tax bill post-transaction.
2) You are an owner of a growing business
Private equity groups grow businesses both organically or through acquisition as a means toward driving the value of the business up for its future sale. So here's a business you know and understand and someone is investing dollars and time to grow it substantially. That can be a very attractive investment for many business owners.
3) The second bite of the apple can be significant
When the private equity groups sell the business it will most likely be a bigger, better run business than it was during the first transaction. This should garner a bigger purchase price for the business. Do not underestimate how a relatively small investment back into your business after a sale (say 5%) can yield a return larger than the proceeds you received after you sold a majority of the business. We see it over and over again. Many times, the second sale for the business owner that remained a shareholder results in the most dollars.
4) You will be aligned with the new private equity buyer
Instead of every decision as a seller being driven by maximizing your dollars at the end of the transaction, when you roll equity, you will be forced to continue to think about the health and welfare of the business going forward. Things that might drive value on this first sale, say, leveraging the business to the hilt, might not make sense if you are going to continue to own a part of it.
Disadvantages of Remaining a Shareholder Post-Transaction
1) There will most likely be restrictions on that stock you now have
The reason private equity buyers like management to roll equity back into the company is because it keeps those employees focused on the continued success of the business. For that reason, and for the avoidance of weird shareholder complexity, there will be restrictions on your ability to transfer that stock. Some agreements will allow you to transfer the stock into trusts for estate planning purposes, but you will not be able to sell your shares willy-nilly.
2) You might have a different class of stock than the private equity group
A lot of private equity buyers will structure the roll so that the management team or owner/seller will receive common stock, while they receive preferred shares. This means that in a liquidity event, they would get paid all of their money back before the common shareholders. Before you begin demanding preferred stock in your deal, consult with your tax expert. A preferred structure might negate any tax benefits you receive as part of rolling equity.
3) There will be drag-along rights
While the term sounds caveman-like, what it really means is that if your private equity partner decides to sell the business, they have the ability to force you to sell your shares as part of that process. They don't want your equity to preclude them from making a sale decision in the future. Thus, they "drag" the management shares along with the transaction.
If there are drag-along rights for the private equity group, there will most likely be tag-along rights for management that holds shares. Tag-along rights open a window for shareholders to sell their shares if the private equity group is selling equity to a third party. Remember those transfer restrictions mentioned above? This equity is very illiquid, so a tag-along right may give you the ability to sell some shares without waiting for the total business sale in the future. So, if the majority holder sells shares, the minority gets the right to participate at the same terms and conditions.
4) Your ownership will not necessarily translate into control
Although you are an equity owner, you may not have a seat on the Board. Even if you do, you will not have the ability to evoke major changes without the approval of the new owners. Private equity will want you to be invested in the future success of the business, but they will want to make (or approve) decisions regarding the company's direction, new hires, etc. These might be decisions that an owner, who previously had total control, will find difficult to pass along to another party.
Remember, rolling equity into the transaction is a very common request when private equity groups or financial buyers are purchasing your business. This can be an excellent way for a business owner to generate additional returns, but he or she must be aware of the potential issues that come along with owning those shares.