How to Maximize Your Personal Wealth with Rollover Equity

Have you been offered rollover equity as part of a deal to sell your business? How can you determine if it’s the right fit for your goals?

Rollover Equity is becoming an increasingly common tool buyers use to entice and incentivize business owners to sell their businesses. But what has brought about this rise in use? And what exactly is rollover equity? As a seller, what are the factors–both good and potentially risky–to consider when presented with a transaction consideration that includes rollover equity? 

As the Chief M&A Officer at Ntiva, a private-equity-backed managed IT services provider (MSP) that is scaling quickly by utilizing M&A as our key tool to drive inorganic growth, I am intimately familiar with the advantages, opportunities, and risks of utilizing rollover equity when we look to bring new businesses into Ntiva. In this article, I will walk you through everything there is to know about rollover equity.

The Rise of Rollover Equity

Private Equity (PE) has become an increasingly active participant in the managed IT services (MSP) sector, as it has in many other sectors, over the last 10-15 years. By acquiring smaller MSPs at lower multiples and consolidating them, PE firms create larger entities that are valued at higher multiples, driving significant returns. The reason for PE interest is due to a compelling business structure (highly predictable revenue stream), a highly fractious industry (over 20,000 MSPs in the U.S. alone), and the growing demand for managed IT services and cybersecurity protection among the customer base.

Against this backdrop, PE investors have swarmed the space and have sought to deploy this proven strategy again and again. While the use of equity is deemed by many participants to be “expensive” (given the dilutive effect and having to incrementally share the value appreciation potential), when compared to ‘stable’ value transaction components like cash, debt, and earnouts, it provides a powerful incentive to align interests post-close of a transaction while also affording buyers the ability to limit their upfront cash outlay (many times funded by debt, an increasingly attractive tool in this high interest rate environment).

When PE investors acquire a business, they will allocate a portion of their purchasing equity to be utilized as incentives for company leadership/management and incoming (future acquired) business owners. PE investors will continue to maintain a majority ownership share of the business but now they ‘partner up’ alongside company leaders and selling owners to hold ownership in the business.

What are the Considerations a Seller Should Understand?

At first glance, the value creation opportunity offered to sellers can be quite compelling. But how should a seller evaluate the provision of rollover equity to best fit his or her specific financial, company, or personal wealth goals? Since the seller becomes a shareholder in the buyer, the first place to start is to understand the growth strategy and financial performance (both historical and especially forecast) of the business. Think of this, and other questions, as a form of ‘reverse’ diligence in which the seller asks questions of the buyer.

Next consider the track record–hopefully successful–of the PE owner. How have their past investments performed? Did they, and fellow investors, outperform expectations? How long do they typically hold their ownership in the business before selling? Are the shares that the seller is granted at the same class (often called pari passu) as the original PE investors or that of previous holders (like management or prior acquired business owners)? Meaning, does the seller enjoy the same rights, terms, and conditions as that of other investors?

Is there a cap on the percentage of the transaction value that can be allocated as rollover equity? Is it capped at 10% of total consideration, or does the buyer allow 20-30%, or more, in equity consideration for a transaction?

Other important things to consider include what role the seller will take in the acquiring company or even if the seller stays with the buyer post-close,  particularly since the seller will no longer have total control over business decision-making at the buyer. 

Are there other transaction structure components to consider, and what risk appetite does the seller have since no equity investment is 100% certain (just look at the stock market)? Lastly, think of the seller's personal wealth goals and ensure that the tax profile of the investment is optimized for the seller.

What are the Advantages of Rollover Equity for a Seller?

The biggest advantage is the opportunity to generate transformational wealth, often starting from a modest initial investment. This “second bite of the apple” means that the seller is generating value from the business long after it was sold. And if a seller continues to carry forward their equity investment through multiple iterations of PE ownership, there are future opportunities for successive “bites of the apple”. In many cases, a $1M of rollover equity (valued a transaction close) can become $3M, $5M, or even a lot more over time.

The further benefit, if structured correctly (and please consult with the appropriate tax and investment professional), is the incremental value generated through rollover equity, which is done on a tax-deferred basis. Taxes are not due until the investment is ultimately realized.

Both the “bites of the apple” and tax deferral are a reflection of the Power of Compounding, which the legendary investor Warren Buffett and businessman Mitchell Rales (co-founder of Danaher Corp.) often speak about as a way to maximize investment returns. Continuing to invest, and invest more, even at higher valuation levels during successive rounds of PE ownership, can be a far more advantageous strategy. It is a lesson our CEO, Steven Freidkin, speaks of personally when reflecting on a missed opportunity with Ntiva’s first PE investor.

As previously mentioned, the power of rollover is that it can be a powerful incentive to align individuals toward the growth strategy and goals of the business.

With subsequent acquisitions made by the buyer, the original seller can contribute incremental equity alongside the buyer to maintain his or her ownership percentage, further enhancing the value generation potential.

What are the Advantages of Rollover Equity for a Buyer?

The power of incentive alignment has already been stated and can’t be overstated. It’s a powerful maneuver that can provide significant rewards to all those involved. Another benefit stated previously, is the ability for the buyer to reduce the upfront cash needed to be spent at the time of transaction close (and since, many times, the cash is funded by the issuance of debt, it reduces the debt outlay or the cost to service that debt). This can be especially advantageous when the cost of debt (interest) is high or the buyer is limited in how much more debt it can issue due to covenants with its lender.

How Should the Buyer Present Rollover Equity to a Seller?

Simplicity in the message is critical. Focus on the value opportunity. Focus on the execution success of the buyer with previous acquisitions. Focus on the PE investor’s past track record in realizing its investments for optimal value. Focus on the equal standing–in rights, terms & conditions–to previous equity investors in the buyer. Focus on clarity in the role and responsibility of the seller–whether inside or outside the buying company–and the ability to maintain equity ownership. Focus on the opportunity to see an immediate upside in value at the time of transaction close based on the valuation uplift (e.g., the seller is valued at 6x EBITDA, the buyer is valued at 15x EBITDA; the seller sees immediate value increase, more than double, in this case to their rollover equity contribution). Focus on highlighting that the earliest equity investments have the greatest degree of value enhancement potential over the remaining life of the PE investment.

What are the Risks of Rollover Equity?

The risks inherent in this form of equity investment have some similarities to that of a more traditional equity investment (in the stock market, for instance) in that there is no perfect certainty of performance. However, there are some important considerations to be mindful of since a rollover equity investment does not enjoy the same liquidity flexibility as investing in the stock market. Buyer company performance and the seller’s lessened state of direct control to overall buyer business performance are very important considerations to assess. This is manifested most directly in that the seller CEO will most likely not be the buyer’s CEO post-transaction and now likely have control or influence over a smaller portion of the business.

Cash proceeds to the seller are reduced due to consideration in the form of rollover equity combined with the longer hold period (which can be upwards of 3-5 years in many cases). This can impact a seller’s liquidity profile, especially since in most transactions the salary of the seller will be normalized based on their go-forward role. Meaning, that annual income is likely to decrease notably from what was enjoyed prior to the sale. This could impact the lifestyle and spending habits of the seller.

And lastly, as previously mentioned, it is important for the seller to understand the equity shareholder rights that he or she will enjoy, including what protections and/or limitations may come with the equity investment.

Conclusion 

Rollover equity can be an especially powerful tool to generate wealth and align incentives, and the hope is that this post can provide a useful perspective to someone contemplating rollover equity in a future transaction. Be sure to do the homework, consult with an advisor, and discuss with others who have been through a similar process. This will help identify the unasked questions as well as potential considerations and risks, and allow the right questions to be asked of the buyer. At the end of the day, when done correctly, the use of rollover equity has the potential to generate transformational wealth for the business owner who sells into a company when they are paid, in part, utilizing rollover equity.