Rolled Equity - Actual Mechanics
Can someone help me understand the actual mechanics behind rolled equity in an LBO? I have modeled this several times for sources & uses and returns analysis for LBOs, but I'm not 100% clear on the actual mechanics. Assuming an LBO with a 20% management equity roll, are either of the below correct or is it something different that happens?
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Sponsor capitalizes 80% of NewCo's (sponsor created acquisition company) equity and management capitalizes the other 20%, then NewCo buys 100% of the target equity?
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Sponsor capitalizes 100% of NewCo's equity, then NewCo acquires 80% of the target's equity, with management retaining the other 20% of target's equity. In this scenario, management would directly own 20% of target equity and would have no direct interest in NewCo.
Would really appreciate a detailed walk of what actually happens to clarify my understanding on a deeper level.
Thank you!
Either of the above is possible. The driver of rollover mechanics is almost always tax. We aim to get management a tax free rollover (otherwise it’s dry income or their purchasing power on an after tax basis is much lower).
Tax lawyers will tell us what is possible to get pre-tax roll. It will depend on where the management ownership sits pre-LBO and whether the target is an LLC or a C-Corp.
The other consideration is where the option plan will sit and whether there is co-invest. Sometimes folks prefer a “clean” co-invest box and have management, both rollover and options, consolidated at the same level. The latter can make rollover at exit cleaner.
Thanks DealTech, much appreciated. On the tax point, more I thought about it, it seems like option #1 would trigger a taxable event for management. Does that eliminate option #1 in most cases? Thinking that for option #2, management could exchange their target equity stake for NewCo equity if needed and retain their basis / not trigger a taxable event.
On your point around C-Corp vs LLC treatment, do you have any insight on what each legal entity type means for purposes of structuring the equity roll mechanics? No worries if that is a little too in the weeds or handled by lawyers.
Thanks again.
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