Selling your company is the culmination of years of work and investment. For most owners, it’s a once-in-a-lifetime experience and the largest transaction they’ll ever be a part of; it’s also the means of financing their retirement. So it’s important for sellers to understand the structure of the deal they’re signing off on and the implications for their payout.
I’ve written about the pros and cons of seller financing before. Owners who sell to professional buyers (Private Equity firms) are often offered different deal structures than other sellers. The terms “rolling equity” and “second bite of the apple” may come up. Here’s what they mean.
PE firms buy companies with the intent to sell them in 3-5 years. These buyers have capital to invest, but may not have expertise in running the company they’re acquiring. For this reason, they may ask the owner to stay involved in the business while they work to grow it.
The best way to do that is to ask the seller to roll some of their equity – profits from the sale – back into the business. The seller takes their share of the profits in cash, usually rolling around 25% of the equity into the new company. They are retained as a minority owner and as a general manager to keep the company running smoothly and profitably for the next few years.
Three to five years later, when the PE firm is ready to sell, the owner gets to take “the second bite of the apple,” getting 25% of the sale of the now larger company. When it works, it works well for the seller and the investors.
When it doesn’t work, it can mean disaster for the company and the seller. A recent bankruptcy filing in the industry provides a cautionary tale. An HVAC platform made several acquisitions within just a few years with the help of a PE firm. The sellers of the companies almost certainly held either a seller-financed note on the deal or rolled equity into the deal.
Unfortunately, the company grew so large, so fast, that it couldn’t sustain itself. Servicing the debt pulled money away from operations. Reports say that the business units “each had an individualized operating model, which leads to lack of controls, different operating philosophies and margins, and a lack of economies of scale. Combined with other challenges, the businesses have [also] underperformed.”
That’s why I always say that sellers who hold a note or roll equity must be very sure about who they’re going into business with. The ability to raise capital is not synonymous with the ability to run a company well. If the new owner fails, the seller’s capital is at risk.
A second bite of the apple can be very lucrative, but if the company goes under, the net return can be zero. Here’s what’s important to know: when a seller holds a note, they are a lender; they have a lien against the company. In a bankruptcy filing, they are protected and are in line to get at least some of their capital back. If they rolled equity into the deal, they’re an owner of the company. They have no recourse and no protection if the company fails.
There may be good reasons to defer your profit from a sale, such as reducing your tax burden. But if you’re close to retirement age, you’ll be putting a significant part of your nest egg at risk, and there is no guarantee that the PE firm’s growth projections will come through. The company could remain flat, or even contract, and your equity could disappear. You and your family should have a serious discussion about your tolerance for risk before you agree to this kind of deal.
An experienced broker can help you understand all the implications of this kind of deal and avoid costly pitfalls and consequences you might not have thought through.
If I can provide clarity on your specific situation, I would be happy to help.
