Is the business owner willing to consider reinvesting in their company post-sale? We often ask this obvious yet important question early in the sale process. A business owner’s decision to reinvest in their company after a sale is not one the owner should take lightly. Nor is it a decision the owner can make at the 11th hour. The reinvestment decision is something the owner must start thinking about as early in the sale process as possible (if not long before the sale process commences), and they should be clear about their reasons for and understand the ramifications of their decision as the sale process begins to unfold.
Granted, the topic of owner reinvestment — also known as “rollover equity” — has been written about to death. These articles often include “second bite at the apple” language, meaning that by reinvesting in their company post-sale, the owner has an opportunity to reap even more profits in the next sale of the company. Most articles talk about the usual considerations the owner must weigh against their decision to reinvest: invest with pre-/post-tax proceeds, minority investor rights, anti-dilution rights, repurchase rights upon termination, voting rights, restrictive covenants, etc.
We intend to take a slightly different approach to the topic of rollover equity. There certainly will not be any “second bite of the apple” metaphors in this article. In all seriousness, however, we will address some of the less-discussed aspects of owner reinvestment, including the role the owner’s age and ownership horizon play in their decision to reinvest, the impact of the reinvestment decision on the buyer universe, target net proceeds vis-a-vis the owner’s sale objectives, and post-sale obligations in terms of potential capital calls.
For those unfamiliar, rollover equity or owner reinvestment means that the owner “rolls over” a portion of their sale proceeds in their company in exchange for a minority equity stake — usually between 10% and 49% — in the new company after the transaction has closed. The advantages of rollover equity to both the buyer and seller are many, including:
- The sale de-risks the owner’s net worth; however, rollover equity provides the seller with the opportunity to continue to benefit, post closing, from the appreciation in their company
- The owner’s decision to reinvest in the new company aligns the buyer’s and seller’s interests post-sale
- The valuation may only be realizable if the owner reinvests with the buyer, i.e., the company may be worth less if the owner does not reinvest
- It may represent a significant portion of the deal terms if the transaction is aggressively priced, or if there is a large gap in valuation between the buyer and the seller
- It functions, in part, as seller financing, potentially reducing the buyer’s up-front investment
While there are numerous benefits of rollover equity to be sure, the owner must consider several other factors as well, such as their ownership horizon for the rollover equity. The seller’s risk profile is often influenced by their age and availability of other assets. If, for instance, the owner is 68 and ready to retire, they may be less likely to reinvest/may be more risk averse than an owner in their 50s who may desire to keep some “skin in the game” post-sale. In other words, while an older owner may wish to liquidate all or most of their equity and provide a transition before “riding off into the sunset,” an owner with a longer time horizon may have more interest and a more aggressive rollover equity strategy because it enables them to be an active participant in the company’s management post-sale. It also provides them with the opportunity to “let some of money ride” and hopefully, reap the rewards of that strategy down the road.
The impact of the rollover decision on the buyer universe is another aspect for the owner to consider. Typically, a true corporate, privately-held, non-private-equity-backed entity is not likely to offer the seller the opportunity to reinvest in their company post-sale. Those buyers are generally seeking to own 100% of the target. Of course, publicly-held companies can use their stock as currency for some, or all of the purchase price if this is attractive to the seller. On the other hand, private equity groups (PE Groups) are much more likely to be amenable to an owner who wants to reinvest in their company post-sale, for the reasons mentioned above. In fact, many private equity groups will not consider an acquisition opportunity if the seller is not willing to roll a meaningful amount of the sale proceeds, particularly if the company represents a new platform company. As a result, flexibility with regard to the reinvestment decision will maximize the potential buyer universe (both strategic and financial buyers) while being a contrarian – insisting on reinvesting with a strategic buyer or refusing to invest with a financial buyer – will limit the buyer universe.
While reinvesting may create substantial upside for the owner, they must confirm that they are able to achieve their net proceeds objective after reinvesting with the buyer. So, for example, if the owner’s goal is to realize $10 million after tax, then proceeds in excess of $10 million would be available to reinvest with the buyer. If they cannot achieve their net proceeds objective, then they may need to focus on buyers that do not require reinvestment (or as much reinvestment) or evaluate whether their objectives are attainable or need to be reevaluated.
Finally, the owner must be cognizant of whether or not there is the potential for capital calls to fund the equity portion of future acquisitions (or for other reasons). If the buyer is acquisitive, as PE Groups tend to be, they may ask all investors, including the owner, to fund a portion of future acquisitions. Of course the owner can decline to fund the capital call and endure the dilution. The potential for future investment to retain the ownership percentage should be thoroughly vetted as part of the re-investment decision so that the owner is not faced with the uncomfortable decision of investing more than they had intended or being diluted and owning a smaller percentage of the company than they would like. If capital calls are likely, then the owner should keep dry powder on hand for the eventuality that they will be asked to participate in a capital call for future acquisitions.
Choosing to reinvest with the buyer post-close, or to go the rollover equity route, as it is often called, is a complex decision with both near- and long-term ramifications. Therefore, the decision should be made early on in the sale process, in accordance with the seller’s time horizon, age, objectives, and buyer preference. Does the owner want to leave any of the sale proceeds at risk by reinvesting with the buyer? Is reinvesting something they can stomach given their risk tolerance? For how long? Can they be partners with the buyer post-sale? Going into the sale process, the owner must be prepared to answer all of these questions (and more) about reinvesting. If they choose to proceed, they must make sure that they understand the likely outcomes – good, bad, or otherwise.
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