The private equity buyer wants us to roll over twenty percent of our equity, but their term sheet includes a compounding liquidation preference on their preferred shares. How do we structure our rolled equity to prevent getting wiped out if the business is sold again at a lower valuation?

Question

Tyler Smith · Accepted Answer

Rolling over twenty percent of your equity into the buyer's new entity can yield a massive payout on the second sale, but only if you negotiate the distribution waterfall correctly. Private equity buyers often insert a compounding liquidation preference on their preferred shares, which means they get paid back their entire investment plus a fixed annual interest rate before you receive a single dollar for your rolled common equity.

If the business does not grow as expected or is sold in a down market, this liquidation preference can completely wipe out the value of your rolled shares. To prevent this, you must insist on rolling your equity into the exact same security class as the buyer, which is known as rolling pari passu.

If the buyer refuses and insists on preferred shares, you must negotiate a catch-up provision or limit their liquidation preference to a one-times non-participating return. This ensures that you distribute the sale proceeds proportionally from dollar one.

Do not let the excitement of a high headline enterprise value blind you to the math of the waterfall. Dedicate structured Thinking Time to model various exit scenarios and exit valuations to ensure your rolled equity actually converts into real wealth.