For many entrepreneurs who have built a successful business from the ground up, the dream exit often involves selling to a deep-pocketed private equity firm. These firms frequently encourage or require the current owners to "roll over" a portion of their equity into the newly acquired company. A rollover typically allows sellers to retain a percentage interest in their business or reinvest their proceeds into a private equity platform in a tax-efficient manner.
While this can be an enticing opportunity to capitalize on future growth by taking a “second bite at the apple,” there are several key differences that sellers should be aware of that might change the incentive structure they have grown accustomed to in running their own founder-owned business.
1. You Will No Longer Be the Boss. One of the biggest and more obvious adjustments for any founder selling their business is transitioning from being the top decision-maker to becoming an employee and minority investor. Private equity buyers may defer to you on day-to-day matters, but they will be pulling the strings on all major financial decisions. While you may retain some leadership role, you will have to get comfortable deferring to the new bosses on most if not all major business decisions. Furthermore, although it is not the norm, certain private equity sponsors may tie repurchase rights on your rollover equity to your continued employment with the company, further hamstringing your leverage over any decision making.
2. M&A Will Become a Key Growth Strategy. A key part of any private equity strategy is acquiring related companies through M&A activity. While this is a great tool to grow your equity stake quickly, most founders come from a background where they are much more cautious about acquisitions. Private equity may be less risk-averse, and this means rollover management will be spending a lot more time on activities that may be new to them – sourcing deals, selling the potential partners, participating in due diligence with potential targets, negotiating transactions and discussing legal risks with lawyers. Then, in the event of a successful acquisition or series of acquisitions, sellers often find themselves drinking from the proverbial fire hose with all the integration activity that is required to bring together multiple business systems and cultures.
3. Get Used to Operating With Leverage. Any private equity firm’s investment thesis relies heavily on using debt financing to turbocharge growth and returns to their equity investors (including the rollover sellers!). As a result, the company you helped build will likely be saddled with a much higher debt load post-acquisition. This leverage can provide a powerful tool for expansion and will juice your returns assuming strong growth during the holding period. On the other hand, this also means there will be intense pressure to hit cash flow and profitability targets to service those loans. An unexpected earnings miss could put the business in a precarious position.
4. The Focus Will Shift to Short-Term Growth. The private equity ownership model is founded on a relatively short investment horizon of three to seven years before flipping the company. This dramatically compresses the timeframe for achieving an exit compared to your previously long-term outlook as an owner-operator. Expect leadership's emphasis to shift heavily toward immediately maximizing short-term growth, profitability, cash flow and making the company look as attractive as possible for a future sale. Strategies that may have paid off down the road could get deprioritized.
While a private equity rollover can certainly mint a lot of wealth for founders, it is crucial to head in with a clear-eyed understanding of how different this next chapter will be. Most private equity sponsors I have encountered and represented are entirely sincere and transparent about continuing to allow management to operate the business. Nevertheless, it is important to be aware of the sometimes dramatic shift of incentives that are at play in a highly leveraged business tasked with quickly returning capital to outside equity investors. Aligning expectations around losing control, operating with debt, and prioritizing short-term results over a long-term vision can help ensure you still find the deal palatable when you cash out again down the line.