Retaining Equity vs Rolling Equity

19 Mar Retaining Equity vs Rolling Equity

Shoot The Moon

Retaining Equity vs Rolling Equity

Play Episode Pause Episode

Mute/Unmute Episode Rewind 10 Seconds 1x Fast Forward 10 seconds

00:00 /

RSS Feed

Share

Link

Embed

EPISODE 212

EPISODE TRANSCRIPT

Mike Harvath  00:06 

Hello and welcome to this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters on Bloomington, Minnesota. For those of you that are new to the podcast, revenue rocket is the world’s premier growth strategy and M&A advisor for tech enabled services. Companies. With me today are my partners, Ryan Barnett and Matt Lockhart. Welcome guys, 

Matt Lockhart  00:31 

Hey, hey, I am excited about the topic. I’m not going to steal your thunder, Ryan. I am less excited about the 10 inches of snow that we received in our wonderful headquarter location in in Minnesota here. So let’s get on to the more exciting topic. Ryan, what’s going on? 

Ryan Barnett  00:53 

Not quite spring yet, but maybe it’s around the corner. Man, well, we’ll get there pretty soon. You’ll have to dust off those golf clubs and get out on the course, but today, strap on the skis and get going. Yeah, I’m really excited today about this, this topic. It’s something that we work with a lot of buyers and sellers of it, services, firms, and one of the tools that we see is utilizing equity in some level is part of a transaction. And today we really want to talk about a it’s a nuance, but a distinction of the difference between rolling equity and retaining equity. And as we start to see deal structures contain more equity components, there’s some really interesting options for both, but also both of them with risks. So Mike, Matt, really wanted to pick your brain today on you know, what is the difference between these two? What suitors should look for, what why suitors use this, and why sellers should really consider one or the other. So Mike, why don’t you get us going? And just, can you help define what rolling equity is? And let’s just start with rolling equity, and then we’ll move into retaining equity. So Mike, what’s rolling equity? 

Mike Harvath  02:05 

Yeah so rolling equity is a pretty typical approach used by sponsors or private equity firms when they’re trying to build a business for a future exit. And typically, the program is they look to acquire a company that is a platform fee, assume sort of a greenfield start private equity look to deploy capital. So they look to acquire a majority stake in a platform company, and then ask the sellers to roll the portion that they are not acquiring into the new company structure called Rolling equity. So not atypical for private equity firms to acquire about 70% of the equity for a combination of cash and seller note, in some cases, or all cash and then a follow on percentage. Just in this example, to keep it simple, 30% is rolled into the new CO, or new company, where there are going to go and portend to do additional acquisitions and bring them in to new co with a similar structure. 

Ryan Barnett  03:14 

Okay, So if we start out with rolling equity, what’s going to be retaining equity? 

Mike Harvath  03:21 

Retaining on the other hand, is a situation where it’s much more like finding an investor, pure play investor, where you’re going to likely sell the majority of your equity, but you’ll retain a portion of that equity in your existing business. So in the example I used before, oftentimes there may be a new brand, if you’re rolling equity, there’s going to be, certainly a new corporate structure with management oversight. There’s going to be a roll up, essentially a new bigger company that you’re going to acquire companies in, and you may participate in that to kind of go back to rolling equity as a if you’re a platform in particular as a leader, or even if you’re what’s called a tuck in investment of someone that plays a role in that business, because you’re still have, you know, skin in the game, so to speak. Um, there’s a lot of talk about the second bit of the apple people go then ultimately sell that all up new co to someone else in a in a retaining equity scenario. You have equity that continues on in your business, and you’re part of a like a syndicate. Essentially, you’re part of the business that might share services. You still get distributions paid to you because the new owner owns control of your business because they bought controlling interest, but you’re also an equal partner from, you know, from from that perspective, maybe not equal from an equity perspective, but certainly a player at the table with the same class of equity as the person that made the investment. It. So, you know, there’s different levels of risk that are associated with that. Certainly, if you retain equity, it’s possible for you to get dividends and do other things that are beneficial, just like you do now as an owner. But if you retain equity, you could also get a capital call. Should you need to put money in? And that’s, you know, does occur from time to time, if people are looking to build up a broader structure, oftentimes, people use this analogy around a tent pole. Essentially, there’s shared services and savings and investment capital to build a much broader consortium of companies under the tent, but your company operates more like an individual tent pole that helps hold up the broader tent, and you get to leverage those services and savings of the bigger company, and ultimately, when there’s an exit to be made, participate in the multiple accretion that occurs for a bigger firm. 

Ryan Barnett  06:02 

All right, Mike, I think that’s a great start. If I break down some of the differences there. When you’re rolling equity, I’m hearing that that invested, that the equity it’s it goes into the invested or the acquiring company or the new entity. That happens where retaining equity that’s going to stay in the original business. I heard in both cases, sellers are probably involved, so you’re still likely to be going forward in the firm active in the business, in the role of equity might have less operational control, where, in retaining equity might have more operational control. I heard that there’s some, typically, some time frames associated with our consideration for both role in equity and retaining equity. In some cases, that routine and equity could be indefinite or based in the future buyout terms. So working with the, you know, the right buyers to define that time frame is important. And I heard some risk and reward there too. Mike, it sounded like the in the retaining equity, the risk is for potential capital, for potential just running the business overall is different than rolling equity. Did I get those the definitions just sort of, did I get that summary right? Yeah. 

Mike Harvath  07:20 

I think so absolutely correct, Ryan. I think in particular, rolling equity, if your goal is to ultimately exit the business, maybe before it’s sold again, or that second bite of the apple happens, that’s a better strategy for you, because typically, there’s a corporate structure that would allow you to be simply an investor and more passive in nature as you move forward, we’re in retaining equity pretty hard to do. That certainly could be done. I don’t want to say it’s an impossibility, but it’s a you know, you you have the same class of equity as your investor, and the expectations for your involvement and risk and reward are higher, and you have to be prepared to, you know, face that if you’re going to move into a scenario around retaining equity. 

Ryan Barnett  08:09 

Great, great setup, I appreciate that. Mike, and when we start to think about sellers and you’re going through this decision making, Matt, I’d love to hear kind of the idea, if you’re really talking to an IT services CEO and you’re considering a sale. How do they decide whether rolling equity or retaining equity starts to make sense? You know, what are some key factors you might think about when making that type of decision? 

Matt Lockhart  08:34 

Yeah. I mean, I think that let’s kind of talk about the two sides of the coin here. If one side of the coin is is rolling equity in a larger, new CO, if you will, and or an existing platform. You’re, you’re really assessing the sort of the strength of the buying firm. Oftentimes, these are, you know, private equity backed scenarios, and so, you know, assessing the the wherewithal of the of the buying firm and or their investment partner, their private equity partner, their strategic plan, how big, right? How big are their goals? Obviously, if you are seeing an opportunity where you’re partnering up with a well qualified investment group, potentially partnering up with an existing platform that has strength and and the ability to grow more quickly, as well as the capital reserves the fund to be able to go quickly in in executing additional acquisitions, then you have a real opportunity to gain in that second bite at the apple, as Mike called it, in the future. Be. Because there is a significant multiple arbitrage to be one. And multiple arbitrage is you’re selling, you know, your stake of the business, and selling your business for a certain multiple. As the business grows through acquisition, through organic growth, there’s a natural increase in the multiple in which it will be sold for at a future date. So I think that that you know, assessing that team, assessing that plan, and understanding their past success, understanding their strategic imperatives, etc, etc. Are all super important considerations on the flip side of the coin for the seller themselves. Mike brought up a key point previously, is, what is the timeline? What is your timeline as a seller? How much involvement Do you want to have moving forward if you want to have distinct involvement in the greater New Company, is there an opportunity for you to do so if you want to have more limited involvement, you know, call it continuing to run Your business, or continuing to run a region of the the new CO is there is that opportunity present in with that, with that new partner and or, to your point, if you want to exit more quickly and become an investor, is that scenario parent as well, because those are pretty distinctly different in the context of rolling equity versus retaining equity, as Mike talked about previously. So I think that it’s a consideration of what is the opportunity, what is the opportunity for that second bite at the apple? Who is that partner? But then, you know, super importantly, what are you looking for as a seller? What is the appropriate match for your team, for your organization, which then fits into the cultural and strategic fits that we’ve talked about and to shoot in most podcasts. 

Ryan Barnett  12:25 

Yeah, and Mike Matt, feel free to answer this too. But when we think about these deals, is there a level of control that might be different, or operations in a company that is rolling equity versus retaining equity in I’ll just give it the example. Will things like culture change compare in either scenario differently? So if you’re rolling equity versus retaining equity, the expectation of culture or maybe even the management structure that you’ve built and granted, I definitely know this. It depends question on the buyer. But when you think about these two concept, does one? Is that different typical scenario compared to rolling equity? Mike, one should start with that one? 

Mike Harvath  13:19 

zyeah I mean, I think it certainly can be Ryan. I mean, I think when you think about, you know, what’s implied with a retaining equity scenario is that you have to have sort of an entity to retain, or a way to retain that stock, right, that equity value. So it implies that there’s going to be less change, less disruption, potentially, in that business, meaning the leadership structure would likely stay the same, the brand would stay the same. Your go to market strategy would be the same. But you know synergy, savings and opportunities to leverage Well, if you want to call them sister companies in the Holt CO or in the broader company that has invested in you exist more in an arm’s length sort of relationship. You you would contact one, you would partner with them. You maybe have shared services across all of the companies for back office and marketing. And you know the things where you can get some synergies, but the individual brand and go to market and leadership and sales infrastructure will likely stay the same because you’re a vest, you have a different level of commitment and investment owning equity in that business than you might if you rolled equity. Now this is where the Depend comes in, if you roll equity versus retain equity. Those same things could occur. But what we see more more regularly, is a scenario where there is more integration, there is more synergies. That can be I mean, that’s the positive of the integration, more synergies. That ultimately can be leveraged, and more best practices that can be leveraged if you’re being brought in as a talking to established platform, because likely that platform is bigger, more mature, may have little better leverage against you know, from an expenses, ability to create margin, and you can adopt many of the best practices if you’re integrated into that company as a tuck in, or if you’re a platform in that situation where your role equity, you set the stage for that, and then the tuck ins would tend to follow sort of your lead there. But in that case, you’re typically becoming one organization, even if that integration doesn’t happen immediately, and I don’t think it happens carelessly, I want to be just clear about that that you know, certainly in a role of equity scenario, there’s plenty of great operators out there that are doing it right, but, but most of the most of the time, not all the time, but Most of the time, that model is more about integration and sort of aligning and coalescing around a brand, a single brand, versus retaining equity. That’s that’s not the case. Typically, those businesses run independently. They just have a different sort of investment and capital structure. 

Ryan Barnett  16:20 

It feels like the role in equity has a opportunity to be more cohesive and work as a group together, compared to retaining equity. Could have a chance of you could really shine and have your own independence and be a little bit more responsible for your own contribution. Not sure if that’s dumbing it down too much. But Matt, what do you think? 

Matt Lockhart  16:44 

Yeah, I mean it potentially in context. I mean I think that there’s the opportunity for the same positives in in both scenarios. I think it’s, it is, though, correct? What you said that in retaining equity more of the responsibility is impendent upon the owner in a retained equity scenario to be ensuring that culture is correct, the strategy is correct, etc, etc, because Both scenarios have the opportunity to continue to make additional acquisitions. Both scenarios can be viewed as a platform. It is. It is simply a different investment vehicle as well as you know, sort of who’s responsible for continuing to drive things out. 

Ryan Barnett  17:43 

I think great, great points both, both that, Mike, appreciate it on both of the sides of your In either case, it sounds like the you’re really in a long term relationship with the buyers, and you’re going to be going through something together. It could be. It could be another exit event. Mike, what kind of due diligence do you need to do as a buyer or seller on the buyers and buyers? What you what kind of questions should you expect from that seller to to make sure that we know what the relationship they’re getting into is is credible and great for the ongoing nature of the combined firm. 

Mike Harvath  18:26 

Well, there’s certainly, regardless, if you’re rolling equity or retaining equity, you’re about to enter into a partnership, right? And you need to do appropriate diligence on your future partner or investor to make sure that you can work together and that your your goals are aligned, and more importantly, that you’re you know the expectations around how that equity will be treated, either rolling equity into the new entity or retaining equity. You know what that means and what sort of governance and controls you have over that, and what is your risk for dilution? This is a bigger risk in a rolled equity situation than in a retained equity situation, because ultimately, if you’re retaining equity, there has to be some sort of mechanism for the buyout of that equity in the future, and for all intents and purposes, it can’t really be diluted if you’ve retained equity in your business, and that business continues to operate as a standalone business, other than for shared services and things that you would get from what I called, earlier, the syndicate of companies that are under that that have been, you know, from the investment vehicle we’re enrolled rolled equity. Little different scenario. You know, if there’s another going to be another 10 companies purchase. You know, those companies that are rolling equity, their equity coming from Treasury per se, so you’re not getting. Diluted are. There is no Treasury store of equity for which you would be diluted in that situation. And what is the level of dilution based on the business plan? You want to enter that with an eyes wide open, alignment with your financial partner. You want to understand, you know, who owns equity today, there’s a difference between preferred shares and common shares. Who has preferred shares? Who has common shares? Certainly, that’s also consideration when you sell equity to an investor in a in a retained equity scenario. And there’s a lot of moving parts here. It’s part of you know why there’s advisors, M&A advisors in the market to help you make sense of it all? Because certainly there’s, we’ve seen all kinds of tactics and approaches by companies that both are sponsors, that do approach the market in both ways, with rolled equity or retained equity, and understanding your benefits and and risks associated for that new partnership is pretty critical, understanding that upfront and being clear and having it documented well in your shareholder agreements will be important, and then being able to have aligned interest versus Some unexpected scenario come to be in which you’re surprised later, certainly you don’t want that, and you want to make sure you’re getting good advice and counsel from a qualified M and A advisor as you try to put these things together. 

Ryan Barnett  21:37 

And that was my question. Back to Matt, kind of what things should an advisor? What role should advisor be playing in these, these options and and talking to sellers and walking them through them? 

Matt Lockhart  21:49 

Yeah, well, I mean, I think that this is a step, is providing counsel as to the differences in the opportunities, what it means, as you know, for you as a seller, helping to provide both the strategic as well as the financial you know, diligence on the potential buying parties pertaining to, you know, their plans of rolling, you know, looking for rolled equity versus retained equity. You know, most buyers go into it with a plan or desire for one versus the other. And you know, and then just assessing the you know, the viability you know, of the deal you know, related to that. In addition, as an advisor, we can be creative. Oftentimes, a retained equity plan can be a start for a group. It could be a minority investment by an investment party. You know, that’s an option. So, you know, providing those creative options, but really, certainly making it as clear as possible, as to, you know, the opportunity for the seller, both in the near term and then in the long term, both financially and then professionally, and not just for those people on the cap table, but what it means for the organization as a whole. 

Ryan Barnett  23:25 

Great makes sense, and we’re here to help out with that discussion. Little revenue rocket plug, and we’re also here to hear your future topics. So if there’s something that you want to talk about, please let us know info@revenuerocket.com Mike, I’ll turn it over to you. Matt, feel free to chime into any last thoughts about this topic. 

Mike Harvath  23:47 

Well, I’d weigh in to say, you know, there is a huge amount of capital has flown into the world of it, services, tech enabled services, over the last, oh, I don’t know, five to seven years, we don’t see that trend ending anytime soon. I think the world has been awakened to the tech world anyway, it’s been awakened to the value that IT services, provides, to kind of getting the work done right. You know, if we add some perspective on this. If we, you know, roll a clock back to the late 90s and, you know, we’re all talking about y2k and how systems had to be aligned to, you know, not have the death Knoll ring on 1100, due to y2k the focus was much more on software and systems. I think, you know, since then, and really since the origination of services around tech, probably late 80s and into the 90s, we’ve learned that, you know, the real work happens with, you know, smart people implementing great systems and and that you. The value of that continues to be held in high esteem, and I think, frankly, has been given a huge amount of value, sort of credibility, if you will, by the capital markets weighing in and investing in these types of companies and continuing to fuel consolidation. So, you know, there’s no question that as an owner of an IT services company, you have a lot of choices, as you choose to grow and scale with a partner, as you choose to maybe exit your business, or as you choose to grow through acquisition even, you know, there’s certainly a world of opportunities out there, and we think, you know, this is just one small, very narrow niche consideration when you’re thinking about, you know, working with a capital partner, but there are many others to consider, and certainly would encourage you to, you know, get out there and take a look and and feel your growth through some of these opportunities. 

Matt Lockhart  25:59 

Yeah, I was just going to compliment second that oftentimes sellers are look at the discussion related to equity negatively, and we’ve we see a lot of these opportunities, and we’ve seen the success of the opportunities, and Just out of the gate. Would counsel sellers to be open to the discussions, to be open to learning, and not to go into it sort of with a negative and or guarded perspective, you know, right out of the gate. But hey, great subject. Ryan, 

Ryan Barnett  26:39 

thanks, Matt. Really appreciate the topic and the insight here, and we’d love to work with you on if you’re considering these types of deals, please give us a call, and we’re happy to get more into the specifics with that. I’ll turn over to you, Mike, for to wrap it up. 

Mike Harvath  26:55 

Sounds good. Ryan, sounds good. Matt, so that will tie ribbon on it for this week’s Shoot the Moon podcast, I encourage you to tune in next week when we continue to unpack various topics around mergers and acquisitions and growing your business in the world of tech enabled services with that make it a great week.