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To Roll or Not to Roll: Equity Roll Issues in Private Company M&A Deals

This article is the first in a series on common issues of critical importance to sellers in private company M&A

An equity roll is an agreement between a Buyer and a Seller in an M&A deal where the Seller (typically a founder or senior management team member) agrees to reinvest or “roll over” all or a portion of their ownership stake in the target company in lieu of receiving cash at Closing. Equity rolls are a key component in most sell-side M&A deals with PE buyers, involving a complex interplay of financial, strategic and personal factors that can significantly impact the Seller's decision. Sellers often desire to roll at least a portion of their equity in order to get a second (sweeter) “bite of the apple” and defer taxes. Buyers often insist that Sellers roll in order to “align interests” and ensure that Sellers have “skin in the game,” as well as to reduce cash outlays at Closing.
 
Below in chart form is an overview of certain key factors Sellers should consider when deciding whether to participate in an equity roll.
 

Issue	Implications/Considerations for Seller
Future Growth Potential	Consider whether rolling equity aligns with personal financial goals Honestly assess the real potential for increased value of the equity stake over time and the growth prospects of the post-Closing merged entity
Equity to be issued	What equity will be issued?  Will it effectively represent only Seller’s business post-Closing or instead represent a larger enterprise including other businesses?  Common or preferred?  If preferred, what are the preferences? Is the rolled equity the same equity as the Buyer’s PE fund investors purchased?  On the same terms?  Is it truly pari passu (with all of the same rights)? Understand the fully diluted post-roll Cap Table
Valuation and Pricing of Equity to be Issued	Understanding the valuation of the rolled equity to be issued is crucial Need to assess whether the new equity being offered is fairly valued compared to the existing equity  Mispricing is common and can very negatively affect the potential return on a rolled investment If rolled equity is for an entity representing only Seller’s business post-Closing, is it priced on the same terms as the purchase price? If rolled equity is for an existing entity with other operating businesses, is it priced based on the same documented terms as a recent M&A transaction, equity award, financing or other objective event?
Other Terms and Conditions of the Rolled Equity	Understand key post-roll investment terms which are typically set forth in a detailed LLC Agreement or LP Agreement; other agreements sometimes at play Key terms include transfer restrictions, buy-out rights/obligations, tax and other distributions, drag-along and tag-along rights/obligations, preemptive/participation rights and informational rights May have limited ability to negotiate as a practical matter depending upon the percentage stakes of both the roll involved and that of existing investors
Tax Implications	Carefully analyze the tax consequences of rolling equity vs. cashing out Consider the potential for deferring capital gains taxes Pre-Closing reorg or other transaction often needed to achieve tax efficiencies Consult with a tax advisor to understand the specific tax considerations
Dilution of Ownership	Understand how the equity roll will affect current ownership percentage Consider the impact of future financing rounds, M&A activity and equity awards on rolled ownership stake Assess the control implications of a smaller ownership percentage
Reverse Due Diligence Findings	Since an equity roll is the “deal within a deal,” Sellers should conduct meaningful reverse due diligence on the post-Closing entity Conduct diligence early in the process so the findings are incorporated into the overall decision to roll (or even sell the Company) Consider any “red flags” or areas of concern that may impact the future performance of the new entity Assess the quality of the new entity's assets, liabilities, and potential synergies          Understand plans for equity and debt funding and capital raising, M&A and organic growth for the next 3-5 years
Management & Governance	Determine your desired level of involvement post-Closing Consider whether rolling equity may come with continued (wanted or unwanted) management responsibilities or board positions Evaluate the post-Closing management team and governance structure of the entity issuing the new equity Assess the compatibility with the new management team and Seller’s culture
Your Liquidity Needs, Investment Horizon & Risk Tolerance	Balance your need/desire for immediate liquidity against the potential for future gains  Align your decision with your personal investment time horizon How long are you willing to have capital tied up in the new entity?  Assess personal risk tolerance for investing in the new entity Consider the general industry risks and the specific risks associated with the post-Closing company
Alignment of Interests with Other Stakeholders	Ensure that your interests align with other stakeholders in the new entity Consider how the equity roll aligns with the strategic direction of the company Assess whether the incentives for management and other equity holders are conducive to driving value
Exit Strategy	Investigate the exit strategies for the new entity Evaluate the likelihood of a future sale, IPO or other liquidity event Assess the specific terms that may apply to an exit, including drag-along or tag-along rights and indemnity obligations

Equity rolls can be a powerful and valuable tool for Sellers in M&A transactions, potentially aligning interests, deferring Seller’s taxes and providing a real opportunity to realize additional significant returns when the Buyer later sells the acquired company.  Consequently, it is crucial for a Sellers to carefully consider all of their financial, strategic and personal goals in any decision to roll.

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The above executive summary has been prepared for general informational purposes only and is not intended as legal advice.  Sellers are urged to consult their legal counsel concerning any particular situation and specific legal questions.

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