- The fair value of rollover equity may be different from the value stated in the agreement and needs to be considered in calculating total purchase consideration.
- In a leveraged buyout, the ratio of equity value to total invested capital value may change, and the dollar value of rollover equity will be a different percentage of pre- and post-transaction equity.
- When the purchase agreement states the total amount of rollover equity at a set share price, it is important to understand the difference in value between any recently performed Accounting Standards Codification (ASC) 718 valuations.
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What is rollover equity and what does it mean?
Rollover equity, frequently used by private equity firms, is the amount of target equity rolled into the acquirer at an acquisition. It can include founders, equity holders, and key management that roll their “would be” proceeds into the equity of the acquiring company through the receipt of acquirer shares.
Post transaction, these stakeholders retain a minority equity interest in the future of the new company. This helps the acquirer through reduced initial cash outlay, as well as aligning the seller's future interest with the buyer. The seller can also benefit from the future performance of their former business.
When confronted with rollover equity, be mindful of some factors that can affect fair value now and down the road.
Capital structure seniority can create disparity
Consider the relative rights and preferences of rollover shares issued compared to the acquirer's shares. Acquirers often structure their investment as preferred shares with a senior liquidation preference that may also include a preferential return. Their investment receives priority status and must be satisfied before the rollover shares participate in any future value.
Yet, in many instances, the stated value of the rollover equity assumes the rollover shares have the same value as the acquirer's shares. When the acquirer is issued preferred shares, liquidation preferences and preferential return rights create disparity in value between the acquirer's shares and other share classes.
The option pricing method (OPM) is often used to allocate the fair value of equity to the different share classes to appropriately capture the differences in rights and preferences. As a result, the fair value of the rollover equity may be different from the value stated in the agreement and needs to be considered in calculating total purchase consideration.
Post-transaction leverage can alter equity value
The fair value of rollover equity should consider the post-transaction expected financial leverage of the company. For instance, using the OPM to estimate the fair value of the rollover equity requires expected equity volatility to be estimated in the model. All else equal, greater financial leverage will result in greater required equity returns and equity volatility.
Assume a company with no debt is acquired for $25 million. The buyer finances the acquisition with $10 million in cash to sellers, $5 million in rollover equity to sellers, and $10 million in debt issued by the company.
The $5 million in rollover equity would have represented 20% of the total equity value in the company prior to the transaction, but due to the issuance of debt to finance the transaction, it represents 33% of the equity in the company post-transaction.
In a leveraged buyout, the ratio of equity value to total invested capital value may change, and, as a result, the dollar value of rollover equity will be a different percentage of pre- and post-transaction equity.
Share price may contain material differences
When the purchase agreement states the total amount of rollover equity at a set share price, it is important to understand the difference in value between any recently performed Accounting Standards Codification (ASC) 718 valuations for those shares.
In some cases, there may be material differences in the calculated per share price of rollover equity and the actual fair value of equity. Specifically, in the aforementioned issues, an allocation to share classes may need to be performed under the OPM.
How we can help
Rollover equity presents distinct challenges in a business combination, specifically in determining the total consideration transferred. For example, ASC 805 requires the acquirer to measure the fair value of the issued equity instruments on the acquisition date and include that amount as part of consideration transferred.
CLA's complex securities professionals within our Valuation, Forensics, Litigation & Investigations (VFLI) group can shed light on current and future risk areas and growth opportunities and help you understand your business worth across a variety of valuation scenarios.