A private equity buyer requires us to roll twenty percent of our equity into their new platform, but their operating agreement creates preferred units with an eight percent hurdle ahead of our common units. How do we evaluate whether this rollover equity is real value or an illusion?

Question

Tyler Smith · Accepted Answer

Rollover equity is marketed by private equity sponsors as a second bite at the apple, giving the founder upside in the next recapitalization. However, if your rolled equity takes the form of junior common units sitting behind a wall of senior preferred units carrying an eight percent compounding annual distribution hurdle, your actual payout in five years might be zero.

In this capital structure, the private equity firm pays itself an eight percent compounded return on its preferred equity before a single dollar flows to the common equity holders. If the platform company exits in five years at a modest gain, the accumulated preferred return and senior bank debt consume all the liquidity proceeds. The sponsor makes a profit, the lenders get repaid, and the rolled equity you counted toward your purchase price gets wiped out.

To evaluate and protect the value of your rollover equity, demand the following terms:

- Pari passu equity alignment, requiring your rollover equity to hold the exact same class, liquidation preference, and distribution rights as the sponsor's primary equity contribution.
- Mandatory pro-rata tag-along rights that allow you to participate in any subsequent partial or full sale of the company on identical valuation terms.
- Drag-along floors requiring that you cannot be forced into an exit that returns less than the original agreed-upon value of your rolled shares.
- Information rights granting your team quarterly financial statements and board-level updates.

Never treat rollover equity as guaranteed consideration. Price the cash at close to cover your acceptable baseline, and treat junior rollover shares as speculative equity.