Rollover Equity: Keeping a Stake in Your Business After You Sell

The short version

Rollover equity is the part of a sale price that a seller takes as ownership instead of cash. Rather than receiving the full price at closing, the owner "rolls" some of the value of the business into equity in the company that owns it after the deal. The seller gets cash for most of the business and keeps a smaller stake in what happens next.

Owners agree to a rollover for different reasons. Some believe the business will be worth more under the new owner and want a share of that. Some are not ready to let go of all of it. And some buyers ask for it, because a seller who still owns part of the business has a reason to help it succeed.

This article is general information for owners thinking about a sale. It is not legal, tax or investment advice. Rollover terms vary widely from deal to deal, so review them with your own attorney and tax adviser.

How a rollover works

In a typical rollover, the buyer forms or uses an entity to hold the business. At closing, the seller contributes part of their ownership to that entity in exchange for equity in it, and sells the rest for cash (and sometimes a seller note or an earnout).

A simple way to picture it: if a business is sold for an agreed price and the seller rolls over a portion of that value, the seller walks away with cash for the rest and an ownership interest worth the rolled amount on the day of closing. What that interest is worth later depends entirely on how the business performs and what the owner does with it.

Three questions shape every rollover:

• How much rolls over. A larger rollover means less cash today and more exposure to the future. The right amount depends on how much liquidity the seller needs now.
• Into what. The seller may receive the same class of equity as the buyer, or a different class with different rights. "Same price, same paper" is a phrase sellers use when they want their rolled equity to sit on the same terms as the buyer's own investment.
• At what level. Equity can be issued in the company that owns the business directly or in a holding entity above it. The level affects what the seller's stake is exposed to, including debt and other businesses the buyer owns.

Why owners choose it

A second chance at value. If the buyer improves the business, the seller shares in that through ownership rather than through a formula. That is the main difference from an earnout, which pays a set amount if a stated metric is hit.

A gradual step back. Owners who want to stay involved, or who care about how the business is run after they leave the top job, keep a seat at the table as owners.

Bridging a price gap. Like a seller note, a rollover reduces the cash the buyer needs at closing. Unlike a seller note, it is not a debt that has to be repaid. It is ownership, so it can go up or down.

How the tax deferral can work

Sellers often hear that rolled equity is "tax-free." More precisely, it can be tax-deferred if the deal is structured to fit specific rules in the Internal Revenue Code. The two most common routes are:

• Section 351 of the Internal Revenue Code covers transfers of property to a corporation in exchange for its stock. No gain is recognized if the people transferring property are in control of the corporation immediately afterward. Section 368(c) defines control as at least 80% of the total combined voting power and at least 80% of the shares of every other class of stock. Because the buyer is usually also contributing to the new corporation, the buyer and seller are often counted together for this test.
• Section 721 of the Internal Revenue Code generally lets a person contribute property to a partnership (including an LLC taxed as a partnership) in exchange for a partnership interest without recognizing gain.

Neither route covers the cash. Under Section 351(b), gain is recognized up to the amount of money and other property received in the exchange. For partnership deals, the disguised-sale rules in Section 707(a)(2)(B) can treat a contribution paired with a related distribution as a sale.

The result is that a rollover usually defers tax on the rolled portion while the cash portion is taxed in the year of sale. Getting the deferral depends on how the entities are set up, the order of steps at closing and the form of the purchase (stock or assets). That is work for a tax adviser, and it is worth involving one before the letter of intent fixes the structure.

Read the minority-owner terms

After closing, a seller with rollover equity is usually a minority owner. The buyer controls the board, the budget and the timing of any future sale. The rights that protect a minority owner come from the operating agreement or shareholders agreement, not from the purchase agreement, so they deserve as much attention as the price.

Terms to look for:

1. Class and preferences. Does your equity sit behind preferred equity or a return hurdle? If so, a future sale has to clear those amounts before your class gets paid.
2. Dilution and preemptive rights. Can the company issue new equity without offering you a chance to keep your percentage?
3. Tag-along rights. If the buyer sells its stake, can you sell yours on the same terms?
4. Drag-along rights. Can the buyer force you to sell when it sells? Most rollovers include this; the question is on what terms.
5. Repurchase (call) rights. If you leave the company, can it buy your equity back, and at what price? Watch for clauses that let the company repurchase at cost or at a discount if you are terminated "for cause," and read how cause is defined.
6. Put rights. Can you require the company to buy you out at some point? These are less common and worth asking about.
7. Information rights. Will you receive financial statements, and how often?
8. Transfer restrictions. Can you sell, gift or pass your stake to family or a trust?
9. Distributions for taxes. In a partnership structure you may owe tax on your share of profits even if no cash is distributed. A tax distribution clause addresses that.

Rolled equity is a security

Because the seller receives an ownership interest in the buyer's entity, issuing that interest is generally treated as an offer and sale of securities. Buyers often rely on a private offering exemption, such as those in the SEC's Regulation D, and some exemptions depend on whether the recipient is an accredited investor as defined in SEC Rule 501. Your attorney will review this, but expect paperwork that looks more like an investment than a sale, including representations about your own financial position.

Questions to ask before you roll over

• If the rolled equity turned out to be worth nothing, would the cash at closing still be a price I can live with?
• What exactly will I own, in which entity, and what sits ahead of it?
• Who decides when the business is sold again, and do I have any say?
• What happens to my equity if I leave, retire or am let go?
• Is the deal structured so that the rolled portion is tax-deferred, and has my own tax adviser confirmed it?

The first question matters most. Rollover equity is upside, not a substitute for a fair price today.

Other ways to stay involved

A rollover is one of several ways to sell part of a business while keeping a connection to it. Some owners prefer a phased sale, a minority recapitalization or a long-term holder that does not plan to resell. We wrote about one of those options in what a holding company actually does for the businesses it owns.

Talk it through with us

Tage lists rollover equity among the structures it can use when it buys a business from an owner who wants to sell, alongside seller financing, earnouts and SBA-backed financing. If you are weighing how much to take now and how much to keep, start a conversation with us.