For many founders, selling to private equity is not a complete exit. The buyer may ask - or require - the founder to reinvest a meaningful portion of the sale proceeds into the post-closing business through rollover equity.

That can be attractive. Rollover equity allows a founder to participate in future growth and potentially benefit from a second liquidity event when the private equity sponsor ultimately exits its investment.

But founders should think about rollover equity differently from the cash portion of the purchase price. Once the transaction closes, the founder is no longer simply a seller. The founder has become an investor - usually a minority investor - in a private company controlled by someone else.

That means the rollover deserves its own diligence and negotiation.

In our experience representing founders in private equity transactions, four questions deserve particular attention.

1. What Is My Rollover Equity Actually Worth?

The first question sounds basic, but it is often difficult to answer.

A founder may be told that several million dollars of sale proceeds will be “rolled” into the buyer’s holding company. The documents will specify the number of units or shares the founder receives and may assign those securities a stated value.

But what supports that value?

In many transactions, the rollover entity is a newly formed holding company with no historical financial statements. In others, it owns an existing PE-backed platform that the founder may know very little about.

That can create a significant information imbalance. The private equity buyer may have spent months reviewing the founder’s financial statements, customer relationships, projections, tax matters, contracts and liabilities. The founder, meanwhile, may be asked to reinvest a substantial amount into an entity for which much less information has been provided.

Founders should therefore conduct diligence on the investment they are receiving.

Relevant information may include the post-closing capitalization table, sources and uses, a pro forma opening balance sheet, historical and projected financial information for the businesses owned by the rollover entity, acquisition debt, other outstanding indebtedness and the methodology used to establish the value of the rollover securities.

At what valuation is the private equity sponsor investing its own capital, and does the sponsor hold securities with the same economic rights as the founder?

The answer matters because a stated per-unit price does not tell the full story if different investors have different rights.

The broader point is straightforward: if a founder is reinvesting millions of dollars, the founder should receive enough information to understand what is being purchased.

The buyer should not be the only party conducting due diligence.

2. Where Do I Sit in the Capital Stack - and How Does the Waterfall Work?

A founder also needs to understand where the rollover equity sits in the capital structure.

Private equity transactions can involve several layers of capital, including debt, preferred equity, common equity and management incentive equity. Some investors may have preferential rights to distributions or sale proceeds before the founder’s rollover equity participates.

The critical question is not simply whether the founder and sponsor both own “equity.”

It is:

Who gets paid first, and what must be paid before my rollover equity receives proceeds?

Preferred investors may be entitled to a return of invested capital, a preferred return, a liquidation preference or some other priority. Those preferences can materially affect the value of the founder’s rollover, particularly if the company’s next exit is successful but not spectacular.

A founder should understand how the economics work across a range of outcomes, not just in the sponsor’s base-case model.

One practical way to do that is to request a spreadsheet showing the distribution waterfall at several hypothetical exit values.

The model should reflect outstanding debt, preferred equity, accrued preferred returns, incentive equity, dilution from future issuances and the proceeds ultimately payable to the founder.

Founders should also understand what can change after closing. Can the sponsor issue additional securities that rank senior to the founder? Can the company incur significant additional debt? Can the waterfall or other economic rights be amended without the founder’s consent?

This is not an argument that founders should expect control rights comparable to those of the sponsor. In most PE transactions, they will not have them.

It is an argument for understanding the bargain before making the investment.

3. What Rights Do I Have as a Minority Owner?

Before closing, the founder may control the business. After closing, the founder typically owns a minority interest in an entity controlled by the private equity sponsor.

The founder’s protections are therefore largely contractual.

Founders should understand their information rights, governance rights, transfer restrictions, tag-along rights, drag-along rights, preemptive rights and protections against amendments that disproportionately affect their securities.

Information rights are especially important.

An illiquid minority investment becomes much harder to monitor if the investor does not receive meaningful financial information. A founder should consider whether the governing documents require delivery of periodic financial statements, annual budgets and other information sufficient to evaluate the company’s performance.

This becomes even more important if the founder later leaves the company but continues to hold rollover equity.

Pay Close Attention to Repurchase Rights

The treatment of rollover equity when the founder’s employment ends is another area that deserves careful review.

Private equity transactions often include separate management incentive equity that vests over time and may be forfeited if employment terminates. That is conceptually different from true rollover equity.

A founder acquired rollover equity by giving up cash consideration that otherwise could have been received in the sale. Founders should therefore be particularly cautious about provisions allowing that investment to be repurchased for less than fair market value simply because employment ends.

Important questions include:

• Can my rollover equity be repurchased if my employment terminates?
• What happens if I am terminated without cause?
• What happens if I resign for good reason?
• Does a “bad leaver” concept apply to rollover equity?
• How is fair market value determined?
• Who controls the valuation process?
• Can I challenge the valuation?
• Is the purchase price paid in cash, or can payment be deferred?

A repurchase right stated at “fair market value” can still be problematic if the sponsor controls the valuation process or the company can pay the price over several years through a subordinated note.

These issues should be negotiated before closing, when the founder still has meaningful leverage.

4. When - and How - Do I Actually Get My Money Out?

Rollover equity is often described as the founder’s opportunity for a “second bite at the apple.”

That may happen. But it is not guaranteed.

There is generally no public market for rollover equity, and a founder usually cannot independently decide when to sell. Liquidity depends largely on the private equity sponsor’s timing, strategy and ability to complete another transaction.

A founder should therefore distinguish between an expected exit and a contractual liquidity right.

Important questions include:

• Do I have tag-along rights if the sponsor sells?
• Can the sponsor force me to sell through drag-along rights?
• If I am dragged into a sale, do I receive the same economic treatment as other holders of the same securities?
• Can the sponsor transfer its ownership to an affiliate without giving me liquidity?
• Can I be required to roll my equity again in the next transaction?
• What happens in a recapitalization?
• What happens if the business is moved into another sponsor-controlled vehicle?
• Is there any outside date by which I can require liquidity?

For most founders, the answer to the last question will be no. That makes the other protections more important.

The founder should understand not just what happens if the company is sold in three or five years, but what happens if the sponsor holds the investment much longer.

Why Separate Founder Counsel Can Matter

Founders should also recognize that the company’s lawyer represents the company. That does not necessarily mean company counsel is representing the founder individually.

In a private equity sale, the company and its shareholders generally share the objective of completing the transaction on favorable terms. But certain issues are uniquely personal to the founder, including rollover equity, employment arrangements, restrictive covenants, repurchase rights, post-closing governance and future liquidity.

Those interests can diverge from those of the company, other shareholders or management.

At Bean Kinney, we often serve as separate Founder-counsel, including on very large transactions where sophisticated M&A counsel already represents the company. The goal is not to duplicate company counsel’s work. It is to focus specifically on the founder’s personal economics and post-closing rights and to coordinate with company counsel where appropriate.

For a founder reinvesting a substantial portion of sale proceeds into an entity the founder will no longer control, that separate perspective can be important.

The Four Questions to Ask

Rollover equity can be valuable and can create substantial additional wealth for a founder. It can also align the founder and the private equity sponsor around the next stage of the business.

But it should be treated as a significant investment decision, not simply another line item in the purchase price.

Before agreeing to a rollover, a founder should be able to answer four questions:

1. How was my rollover equity valued, and what financial information supports that valuation?
2. Where do I sit in the capital stack, and how does the distribution waterfall work?
3. What rights do I have as a minority investor, particularly if my employment ends?
4. How and when can I obtain liquidity from the investment?

If those questions cannot be answered clearly, they deserve attention before the transaction closes - not after.

Important Disclaimer

This article is for informational purposes only and does not contain or convey legal advice. Consult a lawyer. Any views or opinions expressed herein are those of the authors and are not necessarily the views of any client.