Equity rollovers in company sales transactions

published on 22 November 2023 | reading time approx. 3 minutes

There are many reasons why sellers may want to participate in their sold company. For the buyer, these can include the desire to reduce the level of financing required for the acquisition or the intention to create incentives for the seller to support the company also post acquisition. For the seller, this structure can be attractive as it enables him to continue to participate in the success of the company or to reduce the tax expense on the sale. The equity rollover is often also a signal sent out to investors or customers to strengthen their confidence in the company by showing that the seller continues to believe in the company's potential. In this article, we will explain the most important aspects of equity rollover in a company sales transaction.

In the case of a company sales transaction, the aim of the equity rollover is to keep the seller in the company – often as a minority shareholder. This can be achieved by granting the seller ownership interests, for example in the form of interests in the equity of the acquiring limited liability company and thus indirectly in the sold company. This is called equity rollover. One advantage for the seller is that he will continue to benefit from the shareholding in the future and thus from both the profits and the performance of the target company. As a rule, a solution where another portion of the purchase price is realised later as part of a later exit is advantageous for the seller also in tax terms. With the equity rollover, the buyer, again, may use the seller's experience also for the future and this often ensures a smooth transition of management.

Structuring the deal through the so-called Class B ordinary shares is possible

In practice, the seller is often granted a separate class of ownership interests for the equity rollover. These ownership interests must be structured in such a way that the seller continues to economically participate in the target without, however, impairing the buyer's influence on the management of the acquiring company. In the case of limited liability companies, the issue of the so-called "Class B ordinary shares" (also known as "Class B shares") has proved successful.

When drafting the contract, attention should be paid to ensuring that these ownership interests are structured in a manner typical of equity so that they are not recognised by the tax authorities as regular vendor loans and therefore as debt capital. Otherwise, there is a risk that the buyer will have to pay tax on the value of the class B ordinary shares immediately without actually receiving any assets (the so-called "dry income").

As no statutory regulations regulate this issue, the qualification of the class B ordinary shares as equity must be based on literature and, where available, case law and commentaries of the tax authorities. It is particularly decisive that the criteria of subordination, performance-related compensation, long-term nature of the transfer of the capital, sharing in losses and participating in liquidation proceeds are structured precisely and harmonised. Also, when structuring existing option and termination rights in the articles of association or shareholders' agreement, it must be ensured that the buyer does not acquire beneficial ownership of the seller's class B ordinary shares already upon conclusion of the contract.

The contract should also clarify that the seller has a claim for preference dividends or profit distributions only if the company achieves an appropriate net profit for the year. As regards “participating in liquidation proceeds”, it should be agreed in case the acquiring company is liquidated or wound up that class B ordinary shares entitle the holder not only to the repayment of the nominal value (nominal capital plus capital reserve) but also to participate in any hidden reserves.

Advantages and disadvantages of equity rollovers

The advantages of equity rollovers are obvious. The seller can participate in the future increase in the value of the acquiring company and indirectly in the target and continue his entrepreneurial engagement. The buyer can finance part of the purchase price and signal the seller's confidence in the success of the acquiring company. Furthermore, equity rollovers can offer tax advantages by initially reducing the taxable proceeds from the sale.

However, equity rollovers also involve risks and challenges. As with an earn-out, the seller is dependent on the development and success of the acquiring company and thus indirectly also of the target company. When structuring the equity rollover, it is therefore necessary to regulate what influence the seller participating via the equity rollover should have on the management. The buyer should take the seller's interests and expectations into account for structuring purposes and possibly grant him certain rights and guarantees.

Conclusion

An equity rollover is a complex and fragile form of an M&A transaction that requires careful planning, advice and negotiation. It should only be considered if it creates clear added value for both parties and the potential disadvantages are adequately considered. In equity rollovers, particular care should be taken to ensure that the equity rollover is structured as genuine share capital and not as a vendor loan.