The term “rollover equity” is frequently used in discussions about the sale of middle market companies (which often is described as meaning companies with enterprise values from $10 million to $1 billion[1]), but frequently is not well understood by people selling middle market companies (particularly founder or family-owned companies). It generally means the ownership / equity interest that the seller(s) will own in the buyer after the sale transaction closes. It is not part of every sale transaction. However, private equity funds and other “financial buyers”[2] (including “family office” and certain “strategic" buyers) very often require rollover equity as part of the purchase price delivered in exchange for the acquisition of middle-market companies.[3]
There are two aspects of rollover equity that need particular attention from the seller(s). The first is the structure of the commercial terms comprising the rollover equity. As a technical matter, most middle market transactions are structured so that the seller(s) will exchange a portion of the equity securities held in (or the tangible and intangible assets held by) the target company prior to closing for new equity securities in the buyer issued as part of the closing (i.e., the rollover equity).[4] This often is described as a co-investment made by the seller(s) alongside the buyer.[5] Accordingly, the rollover equity generally should be either the same class of security as the other equity in the buyer held by its other investors, or provide the seller(s) with essentially the same or comparable rights and benefits as such other equity, including with respect to the price paid by the seller(s) in exchange for obtaining the rollover equity. The significance to the seller(s) of any differences in the terms and conditions of the rollover equity from the terms and conditions of other equity in the buyer will depend on the circumstances, but generally will be based on the overall valuation placed on the target company by the buyer, the portion of the purchase price that is paid at closing in cash (and other forms of consideration), and the importance to the seller(s) of ultimately monetizing the rollover equity in order to validate the transaction as one that the seller(s) should enter into with the buyer.
The second is the tax-planning structure associated with receipt of the rollover equity by the seller(s). Most rollover equity is in the form of membership interests in a limited liability company (or, less often, limited partner interests in a limited partnership) that is classified as a “partnership” for US federal income tax purposes, but sometimes is in the form of shares of stock in a corporation (or, less often, ownership interests in a limited liability company or limited partnership that is classified as a “corporation” for US federal income tax purposes). It just depends on the buyer’s corporate structure.[6] In either case, the seller(s) usually want to receive the rollover equity on a tax-deferred basis for US federal income tax purposes. If the rollover equity is an ownership interest in a tax partnership, that is relatively easy to achieve. All that basically is required in such case is that the seller(s) transfer property (which includes equity in the target company and an undivided portion of the target company’s ownership interests in its tangible and intangible assets) to the tax partnership in exchange for issuance of the rollover equity.[7] It generally does not matter what else might be happening with respect to any other buyer equity at such time.
It is more difficult to achieve if the rollover equity is an ownership interest in a tax corporation. In that case, the analysis depends in part on whether the target company itself is a tax partnership or tax corporation (including a S corporation), and can very much depend on what else is happening with respect to other buyer equity at such time. If the target company is a tax partnership, the only transaction structure path that allows the rollover equity to be obtained in a tax-deferred manner requires that shareholders (including the seller(s)) in the buyer holding at least 80% of the total combined voting power of all classes of buyer voting stock, and 80% of the total number of shares of all other classes of buyer stock, after the transaction closing must participate in the exchange transaction.[8] That can be relatively easy to achieve if the transaction is a so-called “platform” investment by the buyer, but can be harder to achieve if the transaction is a so-called “add on” investment by the buyer.[9] In any event, the tax consequences to the seller(s) depends very much on what is happening with other transaction participants. If the target company is a tax corporation, certain “merger” transaction structure paths can provide additional flexibility that can allow the tax consequences to the seller(s) to be less dependent on what is happening with other transaction participants.[10] However, such merger transactions have their own complexities that can be challenging depending on the circumstances. Most buyers that are tax corporations thoughtfully consider the foregoing issues in connection with submitting their acquisition proposals. That said, it is incumbent on the seller(s) to independently verify the analysis.
We advise target companies and their owners, management teams, and investors, and provide specialty middle market M&A support to legal, accounting, and financial advisors who are assisting target companies and their owners, management teams, and investors.
1 See, Capstone Partners, “Defining the Middle Market” (Feb. 14, 2024) https://www.capstonepartners.com/insights/defining-the-middle-market/ .
2 “Financial buyers” often are described as buyers that view the opportunity to buy a company from the standpoint of the cash flow (from operations and an eventual re-sale of the company) that the company can generate, and thus the rate of return that the company can provide for the cash equity that the buyer will contribute to the purchase price paid. See, Benchmark International, “Who are Financial Buyers and What Opportunities Do They Present?” (Aug. 16, 2021), https://blog.benchmarkcorporate.com/who-are-financial-buyers-and-what-opportunities-do-they-present .
3 The reasons for this requirement can vary, but often include a desire to inspire a shared commitment in the seller(s) to help the target company continue to grow after the closing.
4 The remaining equity in (or tangible and intangible assets held by) the target company ordinarily will be exchanged for some combination of cash, a promissory note issued by the buyer, and/or other deferred payment arrangements (such as a so-called “earn-out”).
5 This co-investment concept often is reflected in a so-called “sources and uses” table / summary for the transaction by including the rollover equity as part of the equity investment in the transaction (alongside the cash equity investment by the buyer, and sometimes the value of transaction fees that are satisfied with buyer equity and thereby “invested” in the transaction).
6 It is very common for financial buyers to be structured as a parent company that is a tax partnership, which issues the rollover equity, and that in turn has a wholly-owned subsidiary that is a tax corporation, which acquires / ends up owning all target company equity interests / assets as part of the transaction. It is less common for the parent company itself to be a tax corporation.
7 The tax consequences associated with receipt of the rollover equity is governed by Section 721 of the Internal Revenue Code (“Code”) if the rollover equity is an ownership interest in a tax partnership.
8 The tax consequences associated with receipt of the rollover equity in this type of transaction is governed by Section 351 of the Code. The other principal requirement under Section 351 is that the seller(s) (and other participants in the transaction) transfer property to the buyer in exchange for issuance of the rollover equity (and other shares of stock in the buyer), after which the seller(s) (and such other participants) must hold shares of the stock in the buyer satisfying the “80%” requirement. The concept of “property” for this purpose is essentially the same as under Section 721 (see above discussion).
9 A “platform” investment generally is a transaction in which a financial buyer makes its first investment in a target company (often as an initial investment in a particular business sector). An “add-on” investment (including so-called “bolt-on” or “tuck-in” investments) generally is a transaction in which an initial target company (i.e., the “platform” portfolio company) is the vehicle for acquiring an additional target company (and, thus, is the buyer in such subsequent transaction). At the time of an add-on transaction, the platform portfolio company often has rollover owners from the platform and other prior add-on transactions, in addition to the financial buyer. See, MidStreet Mergers & Acquisitions, “What is a Platform Company in Private Equity?” (Aug. 23, 2022) https://www.midstreet.com/blog/what-is-a-platform-in-private-equity .
10 The tax consequences associated with receipt of the rollover equity in these types of transactions is governed by Section 354 and Section 368 of the Code.
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