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Rollover Equity: An Overview of Tax-Deferred Structures for Founders and Private Equity Firms

11.25.2015

Private equity (PE) firms and other financial buyers continue to provide an important source of capital in the M&A market. After purchasing a business, PE firms usually cannot, or do not want to, provide management themselves and instead normally intend to keep existing management in place. In addition, most PE firms require management to maintain substantial equity in the purchased business to help ensure a profitable operation of the business and, eventually, a profitable exit for the PE firm. Because of this, PE firms frequently encourage or require selling owners (often referred to as "founders") to rollover a portion of their equity in the business.

PE firms prefer or require equity rollovers for a variety of reasons. First, using rollover equity aligns the financial interests of the purchasing PE firm and the founders, while also helping bridge valuation gaps. Second, rollover equity may also be viewed as "cheaper" than paying additional cash, especially if the underlying business was priced using an aggressive enterprise value. Lastly, rollover equity also functions as a form of seller financing, which can be an integral part of the PE firm’s overall financing for the transaction.

From a tax standpoint, the rollover of founders’ equity can be structured as fully taxable or tax deferred to the founders. Founders will likely wish to structure rollover equity transactions on a tax-deferred basis, unless tax rates are expected to rise considerably.

A tax-deferred rollover transaction involves the deferral of taxes on the portion of the founders’ equity rolled over into equity of the buyer’s entity, with the cash portion of the transaction consideration remaining fully taxable. There are several ways to structure tax-free rollover transactions.

The remainder of this article provides a brief overview of techniques that may be available for founders to receive their rollover equity on a tax-deferred basis.

Purchase of ⟨ 100% of the Target Company’s Equity

A relatively simple way to effect a tax-deferred rollover of founders’ equity is for the buyer to purchase less than 100% of the company’s equity directly from the founders. In such a transaction, the founders will not recognize taxable income on the equity they retain and do not sell. However, unless the founders’ entity is taxed as a partnership, this type of transaction will not result in any inside tax basis step-up. This lack of tax basis step-up results in many PE firms avoiding this structure. Moreover, PE buyers are normally ineligible to be shareholders of a subchapter S corporation, so the entity, if taxed as a corporation, will have to be a subchapter C corporation going forward, with the requisite corporate, or "double," tax being paid.

Holding Company Formation

In a holding company formation transaction, the buyer first forms a holding company (Newco), which is generally a corporation. The founders then contribute all of their target company equity or assets to Newco in exchange for Newco equity. The PE firm follows suit by contributing its related business interests and/or cash to Newco. The cash and/or business interests are then distributed to the target company or its founders. If structured correctly, the founders’ contribution is tax-free under IRC § 351, with the exception of the cash "boot" received in the transaction.

A variation of this structure involves the buyer purchasing a controlling share of the founders’ equity and contributing it to Newco. The founders then contribute the remaining target company equity to Newco. As before, this transaction is generally nontaxable to the extent of the rollover portion of the deal under IRC § 351, with the cash paid directly to or distributed to the founders as taxable "boot."

In both of these holding company formation structures, Newco will generally receive a tax basis step-up in the portion of the target company’s equity or assets acquired equal to the amount of taxable cash or "boot" received by the founders.

LLC "Drop-Down" Structure

In an LLC "drop-down" structure, the target company forms a new limited liability company (LLC) subsidiary. Next, the target company contributes assets to its new wholly owned (and disregarded for tax purposes) LLC. Following this "drop-down" of assets, the PE firm buyer either (1) purchases from the target company a majority interest in the LLC’s equity or (2) contributes cash to the LLC in exchange for LLC equity with the cash being immediately distributed up to the target company.

For tax purposes, if properly structured, the PE firm’s purchase of LLC equity will be treated, for tax purposes, as an asset acquisition, with the PE firm buyer being treated as if it purchased an undivided interest in the LLC’s assets. As a result, a new holding period in the purchased assets will commence with the LLC receiving a tax basis step-up in those same assets. In light of the ability to achieve a tax-deferred rollover of the founders’ equity and a step-up in tax basis, along with the flexibility to distribute debt refinancing proceeds and sell the target company’s assets without C corporation "double" tax, the LLC "drop-down" structure is often considered the most tax efficient structure when available.

Tax-Deferred Merger

Another potential structure is a tax-deferred merger. If structured properly, the target company may be merged into a newly formed acquisition subsidiary of PE buyer on a tax-deferred basis. However, the founders must take a substantial portion of their consideration, typically at least 50 percent, in the form of equity of the acquisition subsidiary in order for the acquisition of rollover equity to qualify as a tax-deferred "reorganization." As the parties are denied any tax basis step-up in this structure, such tax-deferred mergers are uncommon in PE firm acquisitions. For more information, please contact a member of our Mergers and Acquisitions team.

by Jeffery R. Schaffart and Zachary M. Rupiper

November 2015

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