Rollover Equity: Why Your 20% Might Pay You Nothing

Rollover equity sounds simple. A private equity firm buys your company, you keep 20% of the new company, and you expect 20% of whatever it sells for next time. That is partnership math, and in a private equity deal it is often wrong. Owning 20% and being paid 20% are two different things, and the gap between them is usually settled in a few lines of the letter of intent.

Rolling part of your price into the buyer’s company is mainly a private equity structure. Strategic buyers usually want all of the shares. When Morrison Park Advisors reviewed 13 recent Canadian rollover deals in 2024, over half of the buyers were private equity firms, most of them based in the United States (Dentons, via Mondaq). If a financial buyer is at your door, expect the question.

Who Gets Paid First

When the business is sold again, the money comes out in a fixed order. People call it the payment waterfall.

• Debt first. The buyer usually funds part of the price with bank debt, and the lenders are repaid before any shareholder sees a dollar.
• Preferred shares next. Many sponsors put their own money in as preferred shares or shareholder loans, which are paid back before common shares.
• Common shares last. This is often where the owner’s rolled stake sits.

Your 20% is 20% of whatever reaches the bottom. If the sponsor holds a different class of share from you, it may not even be 20% of that.

How much a preference hurts depends on its terms. A non-participating preference lets the buyer take its money back or its percentage, whichever is larger, but not both. In a good exit it costs you little. A participating preference lets the buyer take its money back first and then its percentage of what is left. That costs you in every scenario.

One Deal, Two Versions Of 20%

Say your business sells for $20 million. The buyer funds it with $10 million of bank debt and $8 million of its own money, and you roll $2 million. Equity is $10 million, so you own 20%.

Now compare two versions of that 20%. In the first, everyone holds the same shares, and equity is split 80/20. In the second, the buyer’s $8 million is a participating preferred share: it is paid back first, and what is left is split 80/20. Assume the $10 million of debt is still owed when the company is sold again.

Look at the flat case, where the company sells for exactly what the buyer paid. On the same footing, you get your $2 million back. With the buyer paid first, you get $400,000 and lose 80% of what you rolled. In the bad case the type of share makes no difference. The debt takes everything, and no one’s equity is worth anything.

It can be worse. Sponsor preferred shares and shareholder loans often carry a fixed return that accrues each year until it is paid (Altss). If the buyer’s $8 million accrues 8% a year, compounding, then after four years the buyer is owed about $10.9 million before common shares see a dollar. In the flat $20 million sale, equity is $10 million. You get nothing. Same business, same price, same 20%.

A non-participating preference would change most of this. In the flat and strong cases the buyer would simply take its 80%, and you would receive the same $2 million and $5 million as if you held the same shares. That is why the exact words in the term sheet matter.

Your percentage means nothing until you know where your shares sit in line.

What To Ask For, And When

The better ask is not that the buyer drop its preferred shares. It is that you get the same strip: if the sponsor holds preferred and common shares, you hold preferred and common in the same proportion, at the same price per unit. US deal lawyers describe this as close to the norm in private equity rollovers (Lathrop GPM). It puts you on equal footing without asking the buyer to change its structure.

Then ask for a short list of protections.

• Tag-along rights, so you can sell alongside the sponsor, on the same terms, when it sells.
• Limits on the drag-along, so you can only be made to sell on the same terms and price per share as the sponsor.
• Pre-emptive rights, so you can keep your percentage when new shares are issued.
• Information rights, at least regular financial statements.
• Limits on fees and other payments to the sponsor, which come out ahead of you.
• Consent rights, so the waterfall cannot be changed against you later.

Mind the tax as well. In Canada, the rolled portion can often be exchanged for the buyer’s shares on a tax-deferred basis under section 85 of the Income Tax Act. Structured badly, the rolled value can be taxable at closing, with no cash from it to pay the tax. Have your tax advisor design it before the terms are set, alongside the rest of your capital gains planning.

Timing matters most. Ask at the letter of intent, before the lawyers paper the deal. Once a term is in the LOI, the buyer treats it as agreed, and reopening it costs goodwill you will need later. Your lawyer documents the deal you negotiated. Negotiating the waterfall is not their job. It is the same lesson as answering an unsolicited offer and choosing between a share sale and an asset sale: the terms that matter most are set early.

We read the fine print before owners sign. If a private equity term sheet is on your desk, or you expect one, Book a call.

This is general information, not legal or tax advice. Speak to your lawyer and tax advisor about your deal.