IVCA Feature: ‘Structuring and Negotiating Rollover Equity,’ an Overview of the Sept. 13th IVCA Education Luncheon
One of the prime benefits that the IVCA provides, are the luncheons that feature a topic or issue that affects venture capital and/or private equity. It was PE in the spotlight for “Structuring and Negotiating Rollover Equity,” which gave investors a deeper understanding of how to best structure rollover equity to minimize tax issues. The September 13th, 2016 event featured Saul Rudo of Katten Muchin Rosenman LLP with an assist by Steve Jarmel of Periscope Equity. The event was sponsored by Katten Muchin Rosenman LLP.
Saul Rudo is the national head of Katten’s Tax Planning practice and is a member of the firm’s Board of Directors and Executive Committee. Steve Jarmel, founder of Periscope Equity, added context from the transaction side of the topic.
Saul discussed the key questions that must be asked in deciding the details of rollover equity.
Some of the key questions when considering rollover equity include:
  • Percent of Target equity or assets rolled over?
  • Percent of “New” Entity owned by Rollover Members?
  • Mandatory capital contributions for growth or add-ons?
  • Pre-emptive rights for additional security issuances? If so, include a pay-to-play provision?
  • Liquidation preference for Buyer? Senior or secondary liquidation preference for Rollover Members?
  • Incentive equity for Rollover Members?
  • Tax Distributions? The Buyer has extra amortization deductions.
  • Board membership for Rollover Members (until diluted)?
  • Consent rights for Rollover Members?
  • Investment opportunities?
  • Tag-along rights?
  • Redemption of Rollover Units for competition, retirement, or otherwise?
  • Rights to financial and other information?
The presentation can be found HERE.
The following provides high level notes on selecting a structure for the transaction.
Depending on the assets of the Target LLC, the Sellers may recognize both capital gains and ordinary income (i.e., depreciation or amortization recapture).
The Buyer will want the Target LLC to make a Code §754 election if there is appreciation in the Target LLC’s assets (and may increase the purchase price as a result of such election).
The Sellers will likely be subject to state income tax on sale of LLC interests, based on their residence.
Even if the Target LLC was formed before 1993, there should not be anti-churning issues.
Debt financing at the LLC level may cause part of the acquisition to be taxed as a redemption or other distribution, which would generate a tax basis adjustment inside the partnership which would likely be shared by the partners (rather than the tax basis adjustment generated by an equity purchase, which belongs to the purchaser).
A buyer PE firm may use a blocker corporation or an AIV to hold the Target LLC interests.
Retention of the LLC structure provides a single level of tax for rollover and some AIV investors (i.e., increase in tax basis of equity for share of after-tax earnings and potential increased purchase price on future sale of the business).
The LLC Holdco allows for the issuance of profits interests to management and other key employees.
The operating agreement of an LLC will contain the substantive provisions otherwise contained in a shareholder’s agreement, articles of incorporation, and bylaws of a corporation in a single document.
The LLC Holdco will allow the parties to more easily split proceeds on a sale and account for escrows and shareholder representative amounts.
The LLC Holdco provides an additional liability shield for the owners.
The LLC Holdco allows for add-ons to be held in a brother-sister corporate subsidiary which can be sold separately without corporate tax.
The Sellers should recognize capital gains on the stock sale or redemption, with the previously discussed caveat that a portion of the redemption may be taxed as a dividend.
Many states will tax the Sellers on their gain if they are residents there, but some, such as Florida or Nevada, will not.
There are no anti-churning concerns because any intangible assets would be held inside the corporation, and the transaction is a stock sale.
Depending on the assets contributed to the Target LLC, the Sellers may recognize both capital gains and ordinary income. The Buyer may provide a gross-up to account for the extra taxes compared to a stock sale (including additional state income taxes).
The Buyer will be treated as purchasing a pro rata share of the assets of the Target and contributing such assets to the Target LLC in exchange for its Class A Units.
The Sellers will likely be subject to state income tax on their flow-through share of the gain from the S corporation’s sale of LLC interests/deemed asset sale, based on their residence and perhaps based on where the S corporation conducts business.
If the business began before 1993, there may be anti-churning concerns if the Buyer purchases less than 80% of the outstanding equity. Any LLC interests redeemed in Step 2, Alternative B, should likely not be counted in determining if Buyer has purchased at least 80% of the outstanding equity, which means that if the redemption represents a significant portion of the overall acquisition, the Buyer may end up “purchasing” less than 80% of the outstanding equity.
If the LLC is established as a partnership at least one day before the transaction, query whether the anti-churning issue can be avoided as in the LLC structure previously discussed.
For more information regarding this presentation, contact Saul Rudo at www.KattenLaw.com