What is Rolled Equity?

What is rolled equity? Rolled equity is partial ownership that the selling party maintains after closing. For example, let’s say that John Doe is selling his company, worth $20 million. Rather than receiving $20 million of cash proceeds, John prefers to receive $18 million in cash and maintain ownership in his company equal to the other $2 million (i.e. John has $2 million of rolled equity). If the buyer is funding the purchase entirely with equity, then John’s $2 million of rolled equity equals 10% of post-closing ownership.¹ If, however, the purchase is funded with a combination of debt and equity — let’s say $10 million is funded with debt and $10 million is funded with equity — then John’s $2 million of rolled equity equals 20% of post-closing ownership.²

What are the benefits of rolled equity? There are several, both for the buyer and the seller. On the buyer’s end, it aligns incentives (particularly if the seller sticks around as an officer or director post-closing). On the part of the seller, it is often preferable to maintain a stake in the company in order to participate in the company’s future growth, and in a second liquidity event, alongside the buyer. Additionally, the seller will face the challenge of making investment decisions with his or her proceeds post-closing. Rather than investing all proceeds in the stock market or real estate, sellers often prefer to direct a portion of proceeds to the investment he or she knows best – the company. Finally, the tax treatment of rolled equity can be favorable for the seller depending on the legal structure of the company and the transaction.

While the tax treatment of rolled equity is dependent on the particular facts and circumstances of the transaction, there are two general scenarios:

  1.  Taxable rollover. In this scenario, John receives all $20 million of proceeds in cash, is taxed on the full gain now, and then reinvests $2 million back into the company. This scenario works like any other investment John would make with his proceeds, and isn’t particularly tax-efficient.
  1.  Tax-free rollover.” Don’t get too excited; this structure isn’t actually tax-free. However, it may be the seller’s most tax-efficient option to re-invest a portion of his or her proceeds. The seller can defer a taxable event on the rolled equity until a future liquidity event (rather than paying tax now). Using our example above, John isn’t taxed on the $2 million of rolled equity at the time of sale (John’s taxable gain today is based on the $18 million that he receives in cash). Instead, John will maintain his existing (presumably low) tax basis, meaning that he will have a larger taxable gain in the future when he monetizes the final $2 million investment. Therefore, the so-called “tax-free rollover” may be more appropriately referred to as a “tax-deferred rollover”, but it still presents a favorable option.

The appropriate amount of rolled equity and the corresponding tax treatment are important topics to think through early in the transaction process so that the legal structure can be planned accordingly.

¹ $2 million ÷ $20 million of funded equity = 10%.

² $2 million ÷ $10 million of funded equity = 20%.

About Montage Partners

Founded in 2004 and located in Scottsdale, Arizona, Montage Partners is a private equity firm that invests in established companies in the western U.S. with EBITDA between $1 million and $5 million. Above all other investment criteria, Montage Partners invests in exceptional people. Montage Partners provides liquidity to those who have spent years of their life building great companies, Montage Partners protects those companies through a transition of ownership and Montage Partners supports the next generation of a company’s leadership in executing on growth initiatives. For more information, please visit www.montagepartners.com.