August 28, 2023
For years it has been a common practice for a seller of a business to retain some percentage of ownership along with the new owners. But until recently this practice of “rollover equity” has been prohibited by the SBA. However under the new SBA rules for buying businesses, it is now possible for an individual to use an SBA loan to buy a portion of a business which unlocks many new opportunities including rollover equity for sellers.
I spent 10+ years as an SBA lender, and worked on many small business acquisition deals, and I think these new rules are going to have a pretty dramatic impact on the SBA lending market and the sale of small businesses. So in this article I wanted to do a deep dive on rollover equity. Here is what I plan to cover:
With that as our roadmap, let’s dive in!
What is rollover equity?
Rollover equity refers to the portion of an owner's equity in a business that is used to acquire a new business or is reinvested in the same business after it has been sold or merged with another company. This is a common occurrence in mergers and acquisitions (M&A).
In the context of an M&A transaction, rollover equity often arises when the selling shareholders reinvest a portion of their sale proceeds back into the acquiring company or the newly formed entity. By doing so, the selling shareholders maintain a continuing equity stake in the business post-transaction.
There are a few reasons why a selling shareholder might choose to roll over some portion of their equity:
- Alignment of Interests: By retaining a stake in the business, both the buyer and seller have aligned interests in ensuring the continued success of the business.
- Tax Considerations: Rollover equity can sometimes provide tax deferral benefits. Depending on the jurisdiction and the specifics of the deal, rolling over equity might allow the seller to defer capital gains taxes until they ultimately dispose of their new equity position.
- Future Upside Potential: Sellers may believe that there is significant growth potential for the company post-transaction. By rolling over a portion of their equity, they can participate in the future appreciation of the business.
- Deal Financing: In some cases, the acquiring entity may not have the necessary funds to complete an all-cash buyout. As a solution, they may propose a partial equity rollover to bridge the financing gap.
A common scenario where rollover equity could be used is if the buyer is implementing a roll up acquisition strategy where they buy many similar types of businesses and roll them up into one larger holding company. If each seller retains some portion of the equity that means the buyer will not need to come up with as much cash for each acquisition which would allow them to buy and roll up more business units faster.
The exact terms, conditions, and structure of rollover equity can vary depending on the agreement between the buyer and the seller.
Seller Rollover Equity
When you hear the term rollover equity it is fair to assume that means seller rollover equity. The seller is essentially going to retain some portion of the ownership of the business after the sale transaction is completed. There are several different ways a transaction might be structured.
How does rollover equity work?
Rollover equity works by allowing the seller of a business (or a portion of a business) to maintain an ownership stake in the acquired or merged entity. Instead of receiving the full transaction value in cash or other considerations, the seller accepts a portion of the consideration in the form of equity in the acquiring company or in the newly merged entity. The actual mechanism and specifics of the rollover can vary widely based on negotiations and the desired outcomes for both parties.
Different structures of rollover equity include:
- Direct Equity Rollover: The simplest structure involves the seller directly receiving shares in the acquiring company in lieu of cash. This structure is straightforward and allows the seller to maintain an ownership stake in the larger, combined entity.
- Holding Company Structure: The acquiring company may set up a new holding company that will own both the acquiring company and the target company. Both the buyer and the seller receive shares in this new holding company.
- Preferred Equity: Instead of receiving common shares, the seller might receive preferred shares in the acquiring or newly formed entity. Preferred shares can come with specific rights, such as dividend preferences or liquidation preferences, which can make them more attractive in certain scenarios.
- Earn-outs and Contingent Payments: While not pure rollover equity, earn-outs and contingent payments are mechanisms where the seller might receive additional equity or cash based on the future performance of the business. These structures align the seller's interests with the future success of the business.
- Seller Financing with Equity Kicker: Sometimes, a portion of the sale might be financed by the seller in the form of a promissory note or seller note. This debt might come with an "equity kicker," such as warrants or options, which gives the seller the potential for additional equity upside.
- New Entity Formation: Particularly in merger scenarios, a new entity might be formed to own both the merging businesses. Shareholders from both companies receive shares in this new entity based on negotiated valuations.
How to calculate rollover equity?
Calculating rollover equity involves determining how much of the owner's equity will be reinvested or "rolled over" into the new or combined entity post-transaction. The calculation is typically based on the valuation of the company being sold and the terms agreed upon for the rollover. Here's a step-by-step guide:
Determine the Total Equity Value of the Selling Company:
- First, determine the total enterprise value of the company. This is usually based on a mutually agreed-upon multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) or other valuation metrics.
- Subtract any debt or other liabilities to arrive at the total equity value.
Calculate the Cash Component and Rollover Component:
- Based on the transaction agreement, identify what percentage of the total equity value will be paid in cash and what percentage will be rolled over as equity in the new or acquiring entity.
- Rollover Equity Example - if a seller is receiving 80% of the equity value in cash and rolling over the remaining 20%, and the total equity value of the selling company is $10 million, the cash component would be $8 million, and the rollover component would be $2 million.
Determine the Ownership Stake in the New Entity:
- This involves comparing the value of the rollover equity to the post-transaction valuation of the acquiring or combined company.
- For example, if the rollover equity is worth $2 million, and the post-transaction valuation of the combined company is $50 million, the seller's ownership stake in the new entity would be 4% ($2 million/$50 million).
Remember, the specifics of any rollover equity calculation will depend heavily on the terms negotiated between the buyer and seller, as well as the particular characteristics of the companies involved.
Rollover Equity Accounting
Accounting for a rollover equity transaction can be complex, given the intricacies of M&A accounting and the unique circumstances of each deal. The precise accounting treatment depends on the nature of the transaction and the structure of the rollover. Generally Accepted Accounting Principles (GAAP) in the U.S. or International Financial Reporting Standards (IFRS) globally would typically govern the accounting treatment.
Here is a generalized overview of how you might account for a rollover equity transaction:
Classification of the Transaction:
- Business Combination: If the transaction is considered a business combination, it is accounted for under the acquisition method. The acquirer recognizes the acquiree's identifiable assets, liabilities, and any non-controlling interest at their fair values as of the acquisition date.
- Asset Purchase: If only specific assets and liabilities are acquired (not the entire business), the transaction is accounted for as an asset purchase. The consideration is allocated to the individual assets and liabilities based on their relative fair values.
Determine the Consideration Transferred:
- The consideration transferred in a business combination usually consists of the assets transferred by the acquirer, the liabilities incurred by the acquirer, and the equity interests issued by the acquirer.
- If there's rollover equity involved, the consideration would be the cash paid plus the fair value of the equity interest that the seller retains in the new or combined entity.
Account for Contingent Consideration:
- If there's a future payment based on the performance of the acquiree or other future events (like earn-outs), it's considered contingent consideration. At the acquisition date, contingent consideration is measured at its fair value.
Recognize Assets Acquired and Liabilities Assumed:
- As part of the acquisition method, you'll need to recognize the assets acquired and liabilities assumed at their acquisition-date fair values.
Goodwill or Gain Calculation:
- The difference between the consideration transferred and the net of the acquisition-date fair values of the assets acquired and liabilities assumed is recognized as goodwill. If the latter exceeds the former, then a gain from a bargain purchase is recognized.
- The equity interest that the seller retains in the new or combined entity (rollover equity) is typically valued at fair value as of the transaction date and is considered part of the transaction consideration. On the seller's books, this would be accounted for as a disposal of the old equity interest and recognition of the new equity interest.
- The seller would recognize a gain or loss based on the difference between the fair value of the consideration received (including the value of the rollover equity) and the carrying amount of the assets sold (or net assets of the entity if it's a sale of a business).
- On the acquirer's books, the equity structure would reflect any new shares issued or equity interests created as part of the transaction.
Given the complexities and nuances of M&A accounting and the potential impacts on financial statements, you should consult with an experienced CPA or accounting firm familiar with these types of transactions. Additionally, the accounting treatment may differ based on jurisdiction and the specific accounting framework (GAAP, IFRS, etc.) in use.
Is rollover equity taxable?
First of all, I am not a tax professional, but in general, the tax treatment of rollover equity can be complex and varies depending on the jurisdiction and the specific details of the transaction. Here are some general considerations related to the rollover equity tax treatment in the context of U.S. tax law:
- Deferral of Taxation: One of the primary reasons sellers might choose to roll over a portion of their equity is to potentially defer taxation on the gain. If structured properly, the rolled-over portion might not be immediately taxable since the seller has not fully realized the gain. Instead, the gain might be recognized and taxed when the seller eventually disposes of the rollover equity.
- Tax-Free vs. Taxable Transaction: The tax implications also depend on whether the transaction is structured as a taxable sale or a tax-free reorganization. In a tax-free reorganization, no gain or loss is recognized at the time of the transaction. Instead, the rolled-over equity takes on a "carryover basis," meaning its tax basis remains the same as the equity it replaced. In a taxable transaction, the gain (difference between the sale price and the tax basis) is generally taxable, even if some or all of the consideration is in the form of rollover equity.
- Character of Gain: Depending on how long the original equity was held, the gain might be classified as a long-term capital gain, which typically has preferential tax rates compared to ordinary income. However, certain aspects of the deal or the type of consideration received might impact the character of the gain.
- Future Sales: When the seller eventually sells the rollover equity, the sale will generally be taxable. The tax will be based on the difference between the sale price and the tax basis in the rollover equity. Remember that if the transaction was a tax-free reorganization, the basis in the rollover equity would be the same as the original equity's basis (carryover basis).
- Installment Sales: If the rollover equity comes with rights to future payments (e.g., earn-outs or contingent payments), it might be treated as an installment sale, where tax is paid over time as payments are received.
- State and Local Taxes: Besides federal tax considerations, state and local taxes may also apply. The rules and rates can vary significantly by jurisdiction.
Given the complexities of tax law and the significant financial implications, it's critical to consult with a tax advisor or attorney when contemplating or engaging in a rollover equity transaction. The above is a general overview and might not capture all nuances or recent changes in tax law.
Equity Rollover SBA Loan Rules
Historically, the SBA 7(a) loan program required 100% acquisitions of businesses which did not allow the seller to stay in the business as a partner. In 2023, the SBA changed the rules to allow business buyers like search funds to acquire partial ownership of a business. Although I am not an attorney, I suspect that many SBA borrowers will set up a new business entity to acquire the target company.
Here is a possible example structure for using an SBA loan with seller equity rollover:
- $1 million acquisition price
- SBA loan will be made to NewCo LLC for $800,000
- New owner will invest $100,000 in cash
- Seller will rollover $100,000 in equity and retain 10% ownership in NewCo LLC
- The seller will receive $900,000 in cash
- The new owner will be required to personally guarantee the SBA Loan
- The seller will not be required to personally guarantee the SBA Loan because the seller will own less than 20% of NewCo LLC
Because the SBA loan program requires all owners of a business with 20% or more ownership to personally guarantee the full SBA loan, I imagine we will see many small business acquisitions where the seller rolls over just under 20% of the ownership so that they do not have to personally guarantee the SBA loan.
I like to follow Eric Pacifici - SMB Attorney on Twitter for tips on buying and selling businesses. I expect he would have some great tips to help you structure your seller equity rollover in a way that makes sense for the seller, the buyer and the SBA.
Well I hope this article has been helpful to you, and as you look to play around with different financial model scenarios for your acquisition, please don’t hesitate to reach out, we would love to help!