Rolled Equity: The Rose or the Thorn?

While no two business sales are exactly alike, many deal structures incorporate incentives, such as rolled equity. But is rolled equity a sweetener or a string that’s attached?   

With rolled equity, the buyer of a business—typically a private equity firm— requires or allows a seller to reinvest, or “roll,” a portion of the sales proceeds into a newly capitalized post-sale company (NewCo). Assuming the NewCo shares perform well over time, the exiting entrepreneur enhances the sum pocketed from the transaction. By adding this upside potential, deals combining an upfront cash payment with a significant percentage in rolled equity (e.g., 25%) can prove very lucrative for sellers.

Yet, as the saying goes, “every rose has its thorn.”

Rolled equity introduces new questions while adding complexity. Consider that there is typically no active market for NewCo’s shares. So even if the company proves its viability, business sellers can’t be sure what their rolled equity will be worth if and when it’s eventually monetized. For instance, transferring rolled equity into a trust requires an appraisal of its current value. Given this uncertainty, how can exiting entrepreneurs plan effectively?

What Are You Trying to Achieve?

The “best” thing to do with your rolled equity depends on your goals.  For example, a family interested in transferring wealth to their children and/or grandchildren could make a gift of the rolled equity (all or in part) to a trust for their benefit.1 In contrast, a family that leans more towards a philanthropic legacy may gift shares to a donor-advised fund, foundation, or charitable trust.2 Once the seller—in consultation with his or her advisor—has identified the best approach, determining when and how much to fund a given strategy represents a crucial next step.

Timing Is Everything

While the optimal time to fund a strategy depends on your personal circumstances, in most cases, transferring wealth as early as possible tends to be most effective. Doing so allows more time for the assets to appreciate outside of your estate. Proactively funding your gift will also use less of your lifetime exemption since the value of your shares is likely lower now than at some future date.

What Size?

Determining how much to give away may be the thorniest issue. Sellers who know their core capital requirement—or the amount they need to support lifelong lifestyle spending, with a high degree of confidence—only have half the equation. Remember, the future value of the rolled equity can’t be known for sure until sold. And the fact that gifts made by business sellers are often irrevocable (and cannot be undone later) further complicates matters.

For example, if a seller gives 100% of their rolled equity to their children’s trust and the shares from an eventual NewCo sale are valued at $100 million, the trust will receive $100 million. But special care must be exercised if the children’s trust is created as a grantor trust. In that case, the grantor (exiting entrepreneur) would be treated as owner of the trust’s assets for income tax purposes. That means he or she will be responsible for paying the trust’s income tax liability on the sale. A $100 million payday for the trust could result in a tax bill exceeding $20 million for the business seller.

Trimming the Thorns

How can exiting entrepreneurs ease their tax burden? It may be possible to trim this thorn by “holding back” a portion of the rolled equity to serve as a tax reserve. That is, a seller may earmark a portion of the rolled equity such that—when purchased for cash—it provides liquidity to pay the income taxes associated with the rolled equity’s sale (including amounts given to family members, friends, or grantor trusts).

Beyond establishing a reserve, there’s a more structured framework sellers can use to quantify the amount they can safely give away. Consider Micah and Mimi, a 60-year-old couple selling their business for $30 million in upfront cash and $10 million in rolled equity (to potentially be sold in five years).

Our analysis contemplates various rolled equity growth scenarios (1x–5x) and gifting percentages (25%–100%) after the initial sale (Display). For each scenario, we determine how much the couple would be able to afford to irrevocably gift while still meeting their lifestyle needs and safely funding the grantor trust’s ongoing income tax bill.

 A Structured Framework for Sizing Gifts

 

After reviewing the results, the couple could see that as long as they transferred assets valued at $25 million or less (blue cells), they’d be able to cover their lifetime spending needs without touching the trust. Ultimately, the pair chose to transfer 50% of their rolled equity to the trust, which would allow them to avoid tapping those assets even if the secondary sale was completed at the highest end of the valuation range.

Alternatively, Micah and Mimi could’ve considered strategies like an installment sale of the rolled equity to the children’s trust or contributing the rolled equity to a Grantor Retained Annuity Trust (GRAT). Unlike an outright gift, these approaches would transfer only the future growth of the rolled equity, rather than the entire value. These techniques can be attractive for sellers who are uncertain about their spending needs. By giving away only the growth of the asset—and retaining the principal—a seller will have more readily accessible wealth, even if it does increase the magnitude of their estate. 

Let Opportunity Unfurl

Proactive planning is important for any exiting business owner—but especially when it comes to rolled equity. By scoping out your options well before you consummate a transaction, you can ensure thorns are avoided while the equity continues to bloom.

Authors
Elizabeth Sohmer
VP/Associate Director—Wealth Strategies Group
Sean Sullivan, CFA
AVP/Senior Analyst—Wealth Strategies

1 This assumes transferability of rolled equity for estate planning purposes has been negotiated with the private equity sponsor and meets all registration exemptions under securities law.

2 Certain charitable vehicles or organizations may have restrictions as to what form of private ownership can be contributed. 

The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.

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