In Part I of this article, in the November 2019 issue of Auto Laundry News, we explored what an equity rollover is and the motivations behind it. In Part II of the article, we will discuss the true implications of this deal structure as it relates to sellers.
The truth with any acquisition transaction, especially one that includes a rollover equity component, is that it must be considered on an individual one-off basis. Making gross generalizations as to “equity rollovers are good” or “this is a good offer,” is both dangerous and reckless. However, of all rollover equity acquisitions there is this fundamental truth: The seller is truly making a second and largely separate investment in a new company and, debatably more importantly, the new operators.
This is best illustrated through a hypothetical example where there are three potential offers on the table.
Let’s imagine you own a car wash that currently does $1MM in EBITDA. You have it in your head that you want $10MM for the wash. Let’s assume three different buyers approached you, each with their own offer:
• Buyer A comes and offers you what you want. They offer you $10MM in cash — straightforward deal with no payout period, contingencies, conditions, or anything of that nature.
• Buyer B comes with an offer that has the same total purchase price, but less cash in lieu of offering a component of rollover equity in the deal.
• Buyer C comes with a higher “total purchase price” offer, but this time with an even higher proportion of rollover equity as total compensation.
In order to meaningfully examine and exemplify the takeaways here, certain assumptions must be set that allow for a true comparison and conclusion(s):
• No non-stated unusual contingency or conditional terms on any of the offers.
• Car wash does $1MM in EBITDA.
• Secondary exit opportunity is defined as the next instance of offered and executed liquidity in the way of subsequent sale and acquisition of the business.
• Seniority and terms on rollover equity are as simple and straightforward as possible. The sellers’ rollover shares in the pro-forma company are common shares (same as all others) and the seller is issued a pro-forma allocation proportional to the amount the seller is withholding as said equity in relation to a summation post-money based at time of close of first original sale (aka no funny business).
• No dividends are paid to equity shareholders in the pro-forma resulting company post initial acquisition.
SPECIFIC SCENARIO WALK THROUGH
“Upside” and “downside” scenarios are predicated on the assumption that the seller receives the same class of equity as the general and rest of the equity capital structure of the pro-forma business. This assumption is in the seller’s favor and is sometimes not the case. If the seller were to receive a different class of more junior equity, the downside scenario(s) would be grimmer. During these scenarios, there is a chance the seller would be entitled to no payout at all, coming in as a junior holder with the more senior equity having a preferred payout in what is essentially a “down round.” This would not impact the seller’s payout in the upside scenarios so much but could, to some extent, dependent on the specific differences in equity classes.
The payout a seller and holder of rollover equity will receive from this component of their compensation will largely be based on the success (or lack thereof) of the resulting company after sale. Success must be defined both by way of performance and a subsequent liquidity event (second sale).
Two different performance scenarios are painted below. Both of these make large generalizations to illustrate the different ends of the future possibility spectrum.
This scenario depicts a future where the company is sold again later down the road for even more. This is a simplification of all the moving parts (future acquisitions, margins, valuation metrics, dilution, etc.) but will serve all the same in illustrating the meaningful points. The upside scenario is the future where the company that you sold is now worth more on a apples-to-apples comparative basis than what it was valued for when you originally sold it. In other words, your “stock price went up.”
A treasure trove of variables can cause this including accretive acquisitions, multiple expansion, margin improvement, top-line growth, etc. But for this discussion, suffice it to say that the resulting company was successful in increasing the value of what they bought compared to how much they paid. The seller, as an equity holder in this resulting company, is indeed a beneficiary of this increase in value.
What is often overlooked by many with private investments is liquidity and the ability to realize value. Let’s say that the resulting company ended up buying no additional car washes after buying yours, but increased EBITDA by 10 percent. That is wonderful, but does not mean your equity is worth 10 percent more. Your equity is worth whatever someone is willing to pay for it. Which brings us to the second part of how “successful” (and the upside scenario) is defined: the ability to achieve a liquidity event at this favorable valuation. As mentioned, this secondary liquidity event will most likely be when the resulting company sells itself to another larger acquiror in the space.
In conclusion, the upside scenario depicts a future where the company you sold is sold again for even more later.
Not all companies are more successful, or successful at all, after being acquired. The downside scenario is simply defined as a future where the acquiror of your company ends up later selling the company for less than what they originally purchased it for from you. This can happen for pretty much all the reverse reasons that can cause the upside scenario.
Rollover equity holders don’t just share in future upside and success, but also future downside and failure. The downside scenario depicts a future where your “stock price went down.”
Buyer A: The Control
When a car wash is sold for all cash, with no contingencies or deferred payouts, it’s simple. The seller gets paid and gets all of it on close. This is our “plain vanilla” control group for this examination and exploration.
In this scenario, the buyer is offering 10x EBITDA resulting in a total purchase price of $10MM. The seller receives all of this.
Buyer B – Lesson: Equity ? Cash
Buyer B brings to the table a total purchase price of $10MM – which will undoubtedly be pitched as buying the company for 10x (which is not wrong). But this is different than receiving 10x for the wash in all cash up front, as Buyer B is proposing a $3MM slug of rollover equity as a portion of that $10MM total purchase price.
As per the assumptions, equity stakes are proportional to post money valuation, with no difference in seniority or security class, resulting in a 30 percent ownership stake in the pro-forma company ($3MM ÷ $10MM).
In this scenario the resulting company ends up being sold in the future to a second buyer for 30 percent more than it was bought for. The original seller, as an equity holder, is indeed a beneficiary who now sees the gains from their successful and savvy investment — resulting in an extra ~$900K (30 percent increase in $3MM of rollover equity) over and above what the seller would have received in total from Buyer A (who paid all cash up front). However, the $3.9MM the seller receives on the backend is after an uncertain amount of time and is not received on the day of sale.
In this scenario, the resulting company does experience a liquidity event through a rollover equity is an independent additional compensation form — not equal to cash.second sale but sells for less than the post-money “total value” it was originally purchased for. Put simply, you are a stockholder, and the stock price has gone down. Commiserate with the seller who sees their $3MM of rollover equity now being worth $2.1MM (down 30 percent from the value attributed to the equity when they originally sold). In this future, the seller ends up with $7MM in their pocket on the day of original sale, and $2.1MM incremental at an undetermined date in the future when there is a second liquidity event. This results in the seller receiving a total of $9.1MM for their car wash.
The Buyer B comparison makes this crucial point: a seller’s payday in the form of rollover equity is completely and totally dependent on the future success of the resulting company (and the team leading that future company). The seller shares in both the future success (upside) and the future failure (downside) of the company, and the seller has opted to give up value today for a variable future payout.
Buyer C: Higher Purchase Price ? More Money to Seller
Buyer C throws a new wrench into the equation: higher total purchase price. Along with this higher purchase price comes a larger proportion of rollover equity. Buyer C is not offering 10x EBITDA, but rather 11x EBITDA, creating a total purchase price of $11MM. However, the cash portion of compensation on close is $7MM (same as Buyer B), with the remaining now $4MM being in rollover equity.
In this scenario, the resulting company successfully finds a secondary liquidity event where, on a comparable and all-else-equal basis, the resulting company’s value has increased to $13MM (same as the upside scenario for Buyer B). In this scenario, again, as an equity holder in the company, the original seller is a beneficiary of this success. This time, however, the magnitude of the impact on their total payout is increased due to the larger proportion of rollover equity. The seller ends up with a total of $11.7MM ($7MM cash on original sale and an additional $4.7MM at a future date from the rollover equity portion).
This sounds great, but on second look, the natural question arises: Why is the seller only up ~18 percent on their rollover equity portion and not 30 percent? This is a very astute, relevant, and important observation. For now, the short answer is because by purchasing the car wash for more in the beginning, the acquiror has devalued the expansion/profit experienced between when they bought the wash and when they sell the company during the second liquidity event. Remember, the acquiror didn’t pay $10MM like Buyer B. They so generously paid $11MM. So, the company only experienced a $2MM (as opposed to a $3MM) value increase when reaching secondary liquidity at a $13MM sale, which is no longer a ~30 percent increase.
Here, as with the Buyer B downside scenario, the resulting company ends up being sold for $7MM later down the road. Just as positive returns were amplified by the larger proportion of rollover equity compensation in the upside scenario, so is the equity rollover deals can be stellar for both sellers and acquirers.opposite true in this downside scenario here. The “stock is down” again. But this time, the seller owns more stock. The seller’s total end-of-the-day compensation after the secondary liquidity event is $9.5MM ($7MM of upfront cash upon initial sale, and $2.5MM for the rollover equity upon the secondary sale later).
Buyer C is both the most interesting and pertinent. Here we have a buyer who has come to the table with an offer higher than all others. Buyer C is willing to buy the car wash for 11x (aka $11MM) which is a full $1MM higher than everyone else. This may seem flattering, as they are willing to pay the most.
However, there is a very possible future (the downside scenario) where the seller ends up only making a total of $9.5MM. This should be held in stark contrast to the scenario and payout of Buyer A. Buyer A offered you a full $1MM less than Buyer C, but there is a future where, by going with Buyer C’s higher offer, the seller makes less money.
A higher “total purchase price” or “total offer” does not mean that the seller always makes more money.
There are two major points that should be taken away here:
1) Treat rollover equity as an independent additional compensation form and do not equate it with equal cash
2) Do not only focus on “Total Purchase Price”
Rollover Equity Is a Separate Investment
A seller that accepts part of their compensation as rollover equity is essentially investing in a different company. Even if the seller stays onboard in a large capacity, they will no longer be calling all the shots. This introduces an immediate and real aspect and element of uncertainty (both in time and performance) that should not be ignored.
Whether it is a new private equity entrant that is acquiring washes as their first purchase (from which they will presumably build upon through future additional bolt-on acquisitions) or whether the washes are being acquired by a current active player in the space that already owns 20 washes, the seller is not investing in just their washes. The seller is in fact investing in the resulting total company. This cannot be stressed enough. And this is true for better or for worse.
Higher Total Purchase Price ? More Money to the Seller
When a company is bought for a very high value, and the initial seller has part of their payment tied to the buyer’s ability to go and sell it again to someone else for more — this creates uncertainty and risk. The higher the price the company is originally bought for, the harder it is to sell that same company later for even more.
This article has undoubtedly painted equity rollover deals in an overarchingly negative light. This is neither my intent, nor the truth. Many times, these deal structures do succeed in both aligning incentives, and providing additional upside potential to the seller. Please do not walk away from this article with the takeaway belief that all equity rollover deals are bad. Equity rollover deals can be stellar for both sellers and acquirors.
I often receive questions on these deal structures, and I am never worried about the upside being great. When it works, it can work wonderfully, and everyone (especially the seller) truly does win. What is worth talking about is both how to fully understand what these deals are and what to be aware of.
This article was created to hopefully do this: to allow you to understand why private equity and outside acquirors prefer this deal structure, what’s in it for them, and what it means for the sellers. Equity rollover deal structures are the same as any other risk/reward tradeoff; it’s a tradeoff. It is up to the seller to determine whether the tradeoff is one you are willing and wanting to make.
Harry Caruso is the founder of Car Wash Advisory, a leading car wash broker and advisory firm. The firm works with both buyers and sellers to create successful transactions that benefit all parties. Car Wash Advisory operates nationwide with clientele spanning from single owner operators to large institutions. Harry has a background in investment banking, machine learning, capital raising and cross-capital structure investing. Connect with Harry at www.carwashadvisory.com or give him a call at (203)-858-6875.