Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Equity Rollover That Cost a Founder 50 Million
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- Lucas: So there's a term in every private equity purchase agreement that gets maybe two minutes of attention at the closing table, but it can quietly wipe out a founder's entire net worth. I'm talking about the equity rollover. Luna: The rollover. Right, where the seller keeps a piece of the business instead of taking all cash. Lucas: Exactly. And in theory, it's a beautiful thing. You align incentives, you get a second bite of the apple when the buyer sells the company in three to five years. But here's the catch. The way that rollover is documented, the conversion mechanics, the waterfall language — it can completely change what that equity is actually worth. Lucas: Today I want to walk through a case from a few years back. A founder of a logistics software company, profitable, about forty million in revenue, sold to a mid-market private equity firm. The deal was structured at a hundred and fifty million enterprise value. The founder rolled over twenty percent of his equity. On paper, that's thirty million dollars of upside. Luna: But it didn't turn out that way. Lucas: It turned out to be worth essentially zero. The buyer sold the company eighteen months later for two hundred million. The founder walked away with nothing from that rollover. Just the cash he'd taken upfront. Luna: That's painful. What happened in that eighteen months? Lucas: Well, the problem wasn't performance. The company grew, margins held up. The problem was the class of equity the founder received. It was structured as preferred stock in the holdco, with a liquidation preference and a preferred return that accrued at eight percent per year. And the rollover was documented as a conversion of that preferred into common at the exit. Luna: So the founder didn't own common shares, he owned preferred that would convert. And the conversion mechanics were the trap. Lucas: Right. The conversion ratio wasn't fixed. It was based on a formula tied to the buyer's internal rate of return. The more the buyer made on its own preferred, the fewer common shares the founder's preferred converted into. By the time the exit happened, the buyer had earned its full preferred return, plus catch-up, plus a chunk of the remaining proceeds. The founder's conversion was diluted down to almost nothing. Luna: So the buyer's upside came first, and the founder's rollover was the residual. Lucas: Exactly. And the founder, understandably, thought he was getting twenty percent of the upside. He didn't read the waterfall clause carefully. He didn't model out what happened if the exit multiple was only slightly above the entry multiple. He just saw twenty percent and signed. Luna: How common is this? I feel like most founders I talk to treat the rollover as a formality. Lucas: It's incredibly common. In most PE deals, the rollover equity is structured as some form of preferred stock precisely so the buyer can control the exit waterfall. And the founder, who's usually focused on the headline price, doesn't spend an hour modeling the rollover. That's a mistake. You should spend as much time on the rollover as you do on the purchase price. Luna: And this is exactly the kind of conversation that makes you pause and think, if only we'd had this conversation earlier. Which, you know, is a good moment to say that if these conversations have moved your work forward in some small way, you can help keep the show ad-free by supporting us at buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash fexingo. Lucas: Yeah, and honestly, even if just one listener avoids a mistake like this because of an episode, that's worth more than a coffee. But the coffee helps too. Luna: It does. Okay, back to the story. So the founder rolled over twenty percent, but effectively got zero. What did he miss specifically? Lucas: Three things. First, the liquidation preference. The preferred had a one-times preference, meaning the buyer gets its original investment back before anyone else sees a dollar. That's standard. But on top of that, there was an eight percent accrued return, and that return compounded. So after eighteen months, the buyer's preferred was worth roughly a hundred and twelve percent of its original investment, just from the accrued return. Luna: And the founder's preferred? Did that also accrue a return? Lucas: It did, but here's the kicker. The founder's preferred had the same eight percent accrued return, but it was subordinated to the buyer's preferred. So the buyer gets paid first. And the founder's preferred was also convertible, but the conversion ratio was reset at exit based on the buyer's internal rate of return. If the buyer hit a certain IRR threshold, the founder's conversion ratio dropped significantly. Luna: So the better the buyer did, the worse the founder did? That seems perverse. Lucas: It's a common structuring technique. The buyer wants to ensure it hits a target return, so it puts in a mechanism that gives it a larger share of the upside if the exit doesn't generate enough to hit that target. In this case, the buyer's target was a two-times return. And at the exit, they got about one point eight times. So the mechanism kicked in, and the founder's conversion was cut dramatically. Luna: And the founder didn't model that. He just assumed his twenty percent would stay twenty percent. Lucas: Right. And to be fair, the buyer's lawyers did disclose the mechanic. It was in the operating agreement, buried on page forty-three. But the founder's lawyer skimmed it, and the founder didn't read it at all. This is a classic case of 'the devil is in the footnotes.' Luna: What should a founder do before signing a rollover agreement? Is there a way to protect against this? Lucas: The first thing is to ask for a fixed conversion ratio. Instead of a formula tied to the buyer's IRR, you want a fixed ratio at the time of signing, or at least a cap on how much the ratio can change. That gives you certainty. The second thing is to negotiate for a 'high-water mark' on the preferred return, or a cap on the liquidation preference, so the buyer's preferred doesn't overhang your equity. Luna: And the third thing? Lucas: Model the downside. Don't just model the happy path where the exit multiple goes up. Model the flat case, the slight-down case, and the case where the exit happens earlier than expected. In this scenario, if the founder had modeled an exit at one point eight times, he would have seen the problem immediately. Luna: It's almost like you need a financial advisor on the sell side, not just a lawyer. Lucas: Absolutely. A good investment banker or a financial advisor who is independent of the buyer can run these models and flag the risks. But many founders skip that to save on fees. That's a false economy when the rollover is worth eight figures. Luna: Have you seen any deals where the rollover was structured fairly? Where the founder actually got what they expected? Lucas: Yes. The best structures I've seen are simple. The founder gets common stock, same class as the PE firm's common, with no liquidation preference, no accrued return, and a simple pro-rata split of the exit proceeds. That's clean and transparent. But PE firms rarely agree to that because they want the downside protection. So the compromise is often a 'parallel' preferred, where the founder's preferred has the same terms as the buyer's, but with no conversion mechanism. The founder participates pro-rata in the exit after the buyer's preference is satisfied, but the founder's preference is also satisfied at the same time. Luna: So it's a pari passu structure, essentially. Lucas: Exactly. That's the term. And that's what you want to ask for. If the buyer says no, then you need to understand exactly what the conversion formula will do in every scenario. Luna: It's a tough negotiation, though. The buyer has more leverage, especially if there are multiple bidders. Lucas: It is, but you'd be surprised. When the founder in our case finally understood what happened, he went back to the buyer and asked for a make-good. The buyer actually agreed to a small cash settlement, not because they had to, but because the founder had a relationship with the management team and they didn't want the bad blood. So sometimes, just asking can get you something. Luna: But the lesson is, ask before you sign, not after. Lucas: Yeah. The best time to negotiate is when you have leverage, which is before the deal closes. Once you've signed, you're just another creditor in the waterfall. Luna: So if you're a founder listening and you're in the middle of a deal right now, what's the one thing you should do this week? Lucas: Pull out your draft operating agreement and find the section on the rollover. Read it. If it mentions a conversion ratio, a waterfall, or a preferred return, flag it and send it to your lawyer with two questions: 'Under what circumstances does my equity get diluted?' and 'What is the worst-case scenario for my rollover?' If your lawyer can't answer those clearly, you need a new lawyer. Luna: That's concrete and actionable. I love that. Lucas: And one more thing. Don't just focus on the price. The price is the headline, but the rollover is where the real money is made or lost in a PE sale. I've seen founders negotiate a five million dollar price bump and then give up twice that in the rollover without realizing it. It's a trade-off that people don't think about. Luna: That's a great point. You're trading price for rollover terms. Lucas: Right. So if the buyer is offering you a lower price but a clean rollover, that might actually be the better deal. It's all about the total package, not just the number on the cover page. Luna: We should probably mention that this is a general discussion, not legal or financial advice. Every deal is different. But the principles are universal. Lucas: Absolutely. And with that, we'll leave you with this. When you're negotiating your next deal, think about the rollover. It's not a formality, it's a second negotiation. Treat it that way.