Hi, it’s CJ Gustafson and welcome to Looking for Leverage.

Today’s term: management rollover equity, the portion of your sale proceeds you roll into equity in the business on the other side of a transaction. How do you evaluate what you’re getting?

When I was CFO of a company that was being acquired, one of the last things we had to hammer out was the new employment agreements for the management team.

Different employees were being asked to roll different amounts of their proceeds into the new company. Some were around 10%, generally midlevel managers. Others were closer to 40%, mostly members of the founding team. The percentage depended largely on their role and how important they were to the business going forward.

And then we had to get those employees comfortable with actually taking the stock.

Imagine you’ve spent years working toward a payday. You’re finally close enough to calculate what’s going to hit your bank account. You can smell the money. And now someone is telling you a meaningful chunk of it needs to go right back into another private company. Kind of a bait and switch, but also very much a part of the game.

Naturally, there are some questions.

Part of the confusion is that several things get negotiated at once: your new job, the money you’re taking home from the sale, and the equity you’ll own going forward.

Rollover is money from the sale that you’re putting back into the business. That’s different from a new incentive equity grant you earn by sticking around and hitting targets. And it’s different from “revesting,” where a portion of your sale proceeds becomes subject to a new vesting schedule.

All three can give you a financial reason to stay. But if I’m being asked to reinvest money from shares I already owned, I’m going to have different questions than if you’re offering me additional equity for the next few years of work.

You take part of your proceeds in cash and roll the rest into equity in the business on the other side. Depending on the structure, that can mean exchanging your existing shares for new equity rather than receiving cash and writing a check back (which is generally more tax efficient).

The sponsor gets continued alignment with management. Management gets another bite at the apple. Blah blah blah.

Sounds reasonable.

But if I told you I was buying your stock for $2 million, with the requirement that you put $800,000 into another stock, you’d probably want to know a little about the second stock.

Who wouldn’t?

From the buyer’s perspective, the ask made sense. They were buying a business they needed people to keep running. The people responsible for ongoing technical innovation and important partner relationships were particularly valuable. The buyer wanted them to have real money riding on what happened next.

And there’s another benefit for the buyer: the money you roll is money they don’t have to come up with at closing. They want you invested in the outcome in a way that also helps them pay for the deal.

That’s how we ended up with rollover percentages ranging from roughly 10% to 40%.

But the employee had to believe in the stock they were getting, too. And that changed the conversation - during the sale process we were predominately in the position of answering questions; now we were quizzing the buyer.

We wanted to see the latest 409A valuation. We wanted to understand what security we were receiving and where it sat in the equity stack. And we wanted to see the financial performance of the company we were joining.

That was actually the first time we learned the buyer’s revenue size, growth rate and earnings. They were a private company and had kept those numbers pretty close to the vest throughout the process.

When there is money on the line, especially money you’ve already earned, it deserves more diligence than “these seem like nice people to work for.”

Start with the entry valuation. What enterprise value are you investing at? Subtract the net debt, and what equity value are you getting?

Then look at what that price implies relative to revenue and EBITDA. You’ve probably spent plenty of time defending the valuation of the company you’re selling. Spend some time questioning the valuation of the company you’re buying into.

And understand how the rollover shares are being priced. Seeing a 409A is useful context; you still need to understand the valuation and terms being used for your actual investment.

Next, figure out what you actually own.

A headline ownership percentage doesn’t answer those questions.

If there’s preferred equity ahead of you, you need to understand how much gets paid to that equity before money reaches yours. Otherwise, you can be right about the business growing and wrong about how much of that growth ends up in your pocket.

Ask to see the waterfall. Run a few back of the envelope exit values through it.

Then there’s dilution.

You don’t need to predict every acquisition they’ll make over the next five years. But you should understand how your ownership can change based on how many companies they typically buy per year.

This was my money going into the deal. So what happens to it if I’m no longer working there?

Goodwin flags these repurchase provisions as a point to negotiate, including whether the company can buy the equity back at fair market value or a discount.

Imagine putting $800,000 back into the business, getting fired two years later, and then learning what the documents say about buying you out. I’d rather have that conversation before signing.

In our case, asking these questions forced us to learn a lot more about the company we were joining. That was a good thing.

But it was also my job to help people understand what they were being asked to do with their money.

Let’s say an executive receives $2 million of proceeds in a sale and is required to roll 40%.

Assume the buyer has a $600 million enterprise value and $200 million of net debt at close.

At that valuation, an $800,000 investment represents 0.20% of the equity, assuming the same price per share and ignoring differences in securities, incentive pools and other dilution.

Five years later, the business sells for $1 billion, with net debt down to $100 million.

If the executive still owns 0.20% and all equity participates equally:

$900 million × 0.20% = $1.8 million

The $800,000 rollover becomes $1.8 million, or a 2.25x multiple on invested capital, before taxes.

Great. We would all be so lucky for it to work out that cleanly.

Add a preferred return, dilution from an incentive pool or another round of capital, and the same exit can produce a very different check.

The rollover percentage tells you how much money you’re putting in. You need the rest of the terms to understand what might come back.

You worked hard for the first check. Give the money you’re putting back in the same attention you gave the money coming out.

Wishing you a second bite worth taking,

CJ

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