Can you cash in and still enjoy future enterprise value?

Business owners frequently weigh the value of what they have today against what they could achieve with additional investment. Some choose to run their current operation as efficiently as possible to maximize profitability before selling. Others spot an opportunity, envision a transformed enterprise and bet heavily on their company’s future. They might take on debt, reinvest profits to grow business lines, expand their management team and staffing and work for many more years.

The cost-benefit analysis differs for every business owner. There is no “right” answer.

Fortunately, many owners of middle market businesses have the opportunity both to cash in on the company’s enterprise value and take advantage of a buyer’s investment in future growth. This is accomplished through rollover equity. While less commonly traveled, rollover equity is a powerful avenue to further wealth-building for companies in the heating, cooling and in-home services sectors.

What is Rollover Equity?

Rollover equity, in its simplest form, is an agreement whereby the seller of a company agrees to reinvest, or “roll over,” a portion of its ownership stake as a minority investment in the buyer’s acquired company. To reinvest, the seller generally contributes a portion of their equity for a new stake in the successor entity. Commonly, the rolled amount will range from 10% to 40% of the equity in the new legal entity, depending on the desires of the seller.

Equity rollover in middle market deals — where the vast majority of the home heating, cooling and in-home services business reside — has grown in recent years. According to the Goodwin Private Equity Deals Database, it was a component of 57% of middle market merger and acquisition deals in 2023, an 11% increase in just the last four years.*

So why haven’t you heard of rollover equity? Typically, regional consolidators, cross-town competitors and comparable strategic buyers don’t offer the option of rollover equity and the resulting minority stake in the ongoing business enterprise. These buyers tend to downsize staffing and operations by folding acquired businesses into their own larger entities. By contrast, financial buyers like Notch Capital often seek to retain one or more of the principals of the seller, the management team and the existing staff to maintain cohesiveness for continued growth.

What are the Benefits of Rollover Equity?

There can be considerable advantages to pursuing a rollover equity arrangement with a financial buyer, including the following:

  • Better alignment with the buyer and potentially recognizing significant economic gains. You can retain a stake in a growing business bolstered by the substantial capital resources and management expertise of a specialized financial buyer — typically, without needing to work daily with the business after the sale.
  • A “second bite of the apple.” The growth in value from a successful rollover arrangement can result in a second cash payout for the seller. This payout can be comparable to or even higher than the initial cash consideration the seller received at the closing.
  • Reducing the buyer’s need for financing. This can support a higher sale price. Buyers also benefit from the lower closing capital requirement at the outset and can focus on aggressive investment to grow the business.
  • Deferring a portion of the capital gains tax bite. The portion of taxes associated with the rolled equity amount that otherwise would have been incurred from a higher cash payment at the closing will be deferred until a future liquidation event. In addition, the equity rollover can even result in tax-free growth if certain structuring conditions are met. (See our December 1, 2023, blog post on Qualified Small Business Stock here.)
  • Bolstering buyer confidence. Buyers appreciate a seller who believes in their company and industry, continues to share their deep understanding of the business and strives for continued success along with the management team.

Tips for Those Considering a Rollover

Keep in mind that there is a distinction between the enterprise value of a purchased business (i.e., the total “purchase price” for the business based on a purchase multiple, irrespective of debt on the company) and the purchase equity value in the acquired company, which is determined net of seller’s debt and cash in the business.

For example, if a company’s enterprise value is $20 million and the company carries $6M of debt and $1M of cash at the closing, the purchase equity value is $15M (net of these items). In this example, a 10% rollover would equal $1.5M, and the minority position would be equal to the corresponding $1.5M investment in the buyer’s total cost to purchase the business (all sources of funds, including those used to cover the various transaction costs).

Such rollover arrangements vary in complexity depending on the desires of the buyer and seller. As always, it is important in an M&A transaction to consult with legal and accounting professionals to ensure you understand your rights and corresponding tax treatment.

If you are contemplating a sale and want to learn more about the potential financial impact of rollover equity, Notch Capital can prepare a calculation specific to your company’s situation. Reach out to us today.

* Goodwin Law article, “Use of Equity Rollovers Continues to Rise Amid Market Uncertainty,” Z. Lupo & A.J. Goldman, Feb. 26, 2024