Rollover equity: what could your stake actually return?

In short: Rollover equity is a new investment in a different company, usually one with debt and an investor whose instruments are paid before yours. Its value depends on the entity and share class you receive, the entry valuation, the preference and debt ranking ahead of you, dilution, your rights as a minority holder, the leaver terms and when you can sell. The percentage of proceeds you reinvest is not the percentage you own, nor the share of exit value you receive. The waterfall below shows the same stake returning half, three times or five and a half times its cost depending on the exit value.

What you receive

The first question is which company you are buying into: the acquiring subsidiary, the group holding company or a new topco created for the deal. The second is which instrument. Investors commonly hold a mix of preference shares or loan notes, which carry a fixed return and are paid first, and ordinary shares, which take what is left. Founders are usually offered ordinary shares, sometimes with a smaller amount of the preferred instrument, and sometimes a further incentive class for management. Each instrument has its own rights, and the documents decide what yours are worth, whatever the headline says. Ask for the capitalisation table showing every class, the amount invested in each and who holds it.

The terms that decide the outcome

• Entry valuation. The price per share you pay, and whether it is the same price the investor pays for the same class.
• Capital structure and preference. How much debt the group carries, how much preference capital sits ahead of the ordinary shares, and whether the preference accrues a return each year.
• Leverage. Debt magnifies the ordinary equity’s outcome in both directions.
• Dilution. New shares issued to fund further acquisitions, to an incentive pool or in a rescue round reduce your percentage unless you have, and use, pre-emption rights.
• Governance and information rights. What you are entitled to know and what, if anything, you can influence as a minority holder; drag and tag rights.
• Leaver terms. What happens to your shares if you leave, are dismissed, fall ill or die; the good and bad leaver definitions and the price paid for each.
• Liquidity. When and how you can sell: usually only on the group’s exit, which you do not control.

Three percentages that are not the same

Suppose your share consideration after the sale is £6 million and the buyer asks you to roll £1 million. You have reinvested about 17 per cent of your proceeds. In the example below that £1 million buys 25 per cent of the ordinary equity, which is about 8 per cent of the total equity capital, which is 5 per cent of the enterprise value at entry. None of those figures tells you what you will receive at exit. The waterfall does.

A simplified entry capitalisation

One invented capital structure, chosen for arithmetic clarity. It is not a description of standard market practice, and real structures vary widely.

Three exit waterfalls

Assume an exit some years later with net debt of £5 million at that date and no other adjustments, costs or new shares.

Read the shape. The enterprise value falls by a quarter in Exit 1 and the founder’s stake halves. The enterprise value rises by a quarter in Exit 2 and the stake triples. That is what preference and debt ahead of the ordinary shares do: they make the ordinary equity a geared bet on the plan. Nowhere does the founder receive 25 per cent of enterprise value, or 25 per cent of every class.

What would change the result

• An accruing preference. If the £8 million preference accrued at 10 per cent a year compounding for four years it would stand at about £11.7 million at exit. In Exit 2 the ordinary pool would fall from £12 million to about £8.3 million and the founder’s share to about £2.1 million.
• New issuance. If shares were issued to fund bolt-ons or an incentive pool and the founder’s holding fell to 20 per cent, Exit 3 would pay the founder £4.4 million instead of £5.5 million.
• Additional debt. If net debt at exit were £8 million instead of £5 million, Exit 2 would pay the founder £2.25 million instead of £3.0 million.
• Transaction costs. Exit costs of £0.5 million in Exit 2 would reduce the founder’s receipt to about £2.9 million.
• Leaver provisions. A founder who leaves before the exit and is treated as a bad leaver may be bought out at the lower of cost and market value, which caps the return at £1 million or below regardless of the exit. A good leaver usually keeps market value, sometimes with a delay in payment.

Each of these is decided in the documents at the time of the original deal. The time to read the articles of association and the shareholders’ agreement is before signing, with advice.

What to do next

Before accepting rollover, get the capitalisation table, the instrument terms, the leaver provisions and the investor’s plan, and build the three exit cases with your advisors. Understanding deal structure places rollover among the other components; choosing the right buyer covers the questions to ask an investor backed buyer. The tax treatment of rollover differs from cash and needs specific advice.

Written by Rick Palmer and Rob Reid, founding partners of Motion Advisory Partners. General guidance, not advice on any specific business or transaction. Legal and tax points vary by jurisdiction and should be checked with appropriate advisors.