How Are Rollover Equity Transactions With Private Equity Typically Structured?
Rolling equity in a sale transaction remains as popular as ever. Private equity firms believe that having management teams contribute a meaningful share of their equity is a way to align interests. This becomes increasingly more important the more aggressively the deal is priced. A second (probably less discussed) reason is that the rollover equity is a component of the deal financing used to lower the private equity firm’s need to come up with their own cash at close. Given these attractive benefits, the rollover is here to stay.
So let’s explore how a rollover equity participation is typically structured as part of a sale transaction.
Normally, the PE firm will set up a new company to carry out the acquisition – usually an LLC. The document governing the LLC that is distributed to all owners is called an LLC Agreement or Operating Agreement. This will cover all the important considerations of ownership. Read it! That’s where all the things I am discussing below are going to be.
A rollover contribution can be as small as 5% but probably not more than 40% of the total equity of the deal.
Rolling equity in a substantial amount after a sale may lead to a seat on the Board of Directors of the new company, but, as I have warned before, don’t get overly infatuated with this notion. There is no real control in this position.
If possible, there is usually an attempt to structure the rollover in a tax deferred manner – where an owner exchanges his or her current equity position in the existing company for an equity position in the new company.
Remember that an equity interest will create value for its owner when the company is sold again – usually in five to seven years. In general, you should not expect dividends or distributions. You should try to ensure that you have the ability to hold the equity until the sale event – which is generally when the best pricing happens. Sometimes the PE firm has the right to “call” the equity from the shareholders (a call option) before an exit event. Generally, this is bad for the minority shareholder because the value of the company is made by appraisal versus a sale process.
On the other hand, you might be tempted to ask for a “put” – or the ability to give the stock back to the private equity group if you are no longer involved in the company (you are fired, you retire, etc.) I would advise that you hold onto your equity versus asking for a “put” because it typically triggers the PE firm responding with a “call” – which, as we have discussed, is a bad thing for the minority shareholder.
You may want some liquidity protection, but I find that people take this a little too far. If your private equity partner has a good acquisition target and is going to contribute equity to buy it, you are going to be a smaller part of a bigger pie. Is that so bad? Maybe not. You could ask for the right to contribute your “share” of equity so that your percentage of the overall company does not decrease, but you have to have the cash available to do so. It might be just fine to let the PE firm grow the overall entity and participate as a smaller player.
“Put” and “call” options are different than “come-along” provisions – which are pretty standard. These are triggered when there is a full exit of the company. These can be negotiated, but are standard in most Operating Agreements. In general, you should make sure that you get to cash out, on a pro rata basis, whenever the Fund gets to cash out.
You should understand where you are in the capital structure and make sure that your equity shares are pari passu (fancy Latin word for “on equal footing”) with your private equity partners. In some transactions, it ranks subordinate to the PE firm’s equity.
These are some highlights of things to look for when rolling over equity. It is unlikely that a seller will have a tremendous amount of leverage to amend an LLC Operating Agreement prior to a transaction, so it will be important to weigh the structure of the rollover you are faced with and the sale transaction you are contemplating as a package.