In many mergers and acquisitions, sellers walk away with more than just a check or a promissory note. Increasingly, they also retain a stake in the newly formed or acquiring entity—a concept known as rollover equity. This structure allows sellers to reinvest a portion of their sale proceeds into the buyer’s company, giving them a continued interest in the business.
While the potential for future upside is appealing, rollover equity also introduces complexity and risk. This article explores how rollover equity works, who benefits from it, and key considerations the seller and buyer should keep in mind.
How Rollover Equity Works in an M&A Transaction
Rollover equity is typically structured as a partial reinvestment of the seller’s ownership into the buying entity. Instead of receiving the full purchase price in cash and a note, the seller contributes a portion of their equity to the buyer. For example, in a $10 million transaction, instead of receiving the full amount in cash, the seller might receive $8 million at closing and a $2 million equity interest in the acquiring entity.
Who Benefits from Rollover Equity?
Rollover equity can be beneficial for both parties.
For sellers, it gives them a chance to take a second bite of the apple. If the acquiror performs well, the value of their equity interest could appreciate significantly, leading to a second liquidity event. Sellers can also benefit from tax deferral, assuming the transaction is structured thoughtfully.
Buyers value rollover equity because it can align incentives. When sellers remain financially invested, they’re more likely to stay engaged and committed to the company’s success. This continuity can be critical in founder-led businesses or situations where operational knowledge is concentrated in a small leadership team.
Additionally, rollover equity allows buyers to reduce their upfront capital while still offering competitive deal terms.
Tax Considerations
As mentioned earlier, one of the most significant benefits of rollover equity for the seller is the ability to defer taxation on the value of the equity received. In many cases, tax-deferred status can be achieved, but doing so requires thoughtful planning and close coordination with advisors well ahead of the transaction to ensure all the pieces fit together. Often, this process involves creating new entities that must be established in advance of the transaction.
Sellers should also have a clear understanding of the business and profit structure they are entering. As partial owners of the new entity, they may be allocated profits and losses—particularly in the case of a partnership or S corporation. In a C corporation structure, they may instead receive dividends.
To avoid unpleasant surprises, sellers should familiarize themselves with the operating agreements, how profits are calculated and any potential for phantom income or other allocations. For example, even something as straightforward as distributions need to be figured out to ensure sellers receive sufficient cash distributions to cover taxes. Having this understanding ahead of time will help sellers make a fully informed decision when rollover equity is on the table.
Risks and Pitfalls
While rollover equity can be potentially rewarding, it is not without its drawbacks. Sellers should be aware of two key risks before committing to this structure.
1. Rollover equity is typically illiquid
Sellers may be locked into their investment until a future exit event, which could be years away. This lack of liquidity can be problematic if personal financial needs change or if the business underperforms. The new operating agreements can be drafted to mitigate this, especially if a former owner is looking at a shorter holding period before their exit or retirement.
2. The buyer’s financial health is vital information
As the seller will have ownership in the buyer, the seller should understand the buyer's financial health before committing. The buyer's financial situation directly affects the value of the rollover equity. As a result, the seller should perform their own due diligence on the buying entity to ensure their equity is adequately valued and not subject to undue risk.
Key Takeaways for Sellers and Buyers Considering Rollover Equity
Rollover equity is a strategic tool that can create meaningful upside for sellers while aligning interests with buyers. It offers the potential for future growth, tax deferral, and continued involvement in the business. But it may also introduce complexity, illiquidity, and governance limitations.
Given the complexity, sellers and buyers should engage with their CPA early and often to make sure value is preserved while avoiding real pitfalls. Sellers considering rollover equity should approach it with eyes wide open. For more information on rollover equity, please contact us at Email.