This article is a continuation of the article titled “Transitioning ‘Tails’: A Veterinarian’s Journey” that was published in Issue Number 9 (2024) regarding a veterinarian’s exit strategy, and is the fifth and final in a continuing series that guide the reader through the sale process.
This installment will briefly address the equity documents issued in connection by a consolidator or private equity (“PE”) backed buyer.
If you choose to sell to a PE-backed buyer or consolidator, there is a great likelihood that a portion of the purchase price will be in some form of equity. From the buyer perspective, this is important for two main reasons: first, equity incentivizes the seller and aligns their interest with the buyer (as the seller will have “skin in the game” to maximize production and increase the value of such equity) and, second, to lower the cash portion of the purchase price (as the purchase price will be paid in both cash and equity, the buyer can spend less cash at closing and preserve liquidity for other acquisitions or operational investments).
The most common equity issuance is either in the form of “Top-Co rollover equity” or a joint venture.
TopCo Rollover Equity
TopCo rollover equity is when a seller reinvests a portion of the purchase price into the buyer, or more commonly, into the buyer’s parent company (“TopCo”). TopCo rollover equity is attractive to a seller because rollover equity is tax deferred (meaning taxes are only owed when the equity is sold). The cash price of your sale is taxed as a capital gain (upon the sale). Equity is also attractive because there is a chance the value of the TopCo equity increases exponentially, depending on the success of the business.
It is important to understand that when you are presented with an opportunity to re-invest your proceeds in rollover equity that there is little room for negotiation of the equity documents (as each seller will sign identical paperwork) and you are bound by the terms of the TopCo entity’s governing documents (such as an operating agreement or partnership agreement) which includes, among other things, restrictions on equity transfer (i.e., you cannot sell or transfer the equity unless consent to sell or transfer is received), there are no, or very limited, voting or management rights, and there are additional restrictive covenants (which likely survive beyond your employment term). If you are presented with a TopCo rollover option, it is important to consider these factors as your investment is “locked” in until there is an “exit” event such as a recapitalization (i.e., a sale or refinancing) and you cannot sell the equity to get cash. Also, as there is a chance for the value of the rollover equity to increase, there is also a risk that the value of the equity decreases.
It is also important to consider what happens to your rollover equity after your employment term ends. Each PE buyer is different – some buyback your TopCo equity (and possibly for a discount), while others let you keep your equity if you are not a “bad leaver.”
JV Equity
As the market shifts, many PE consolidators are now offering a “joint venture model” (or a “JV”).
A new JV buyer entity will be formed where the PE consolidator will own a majority of the equity interests and the seller will own the remainder. The JV will enter into a contract with a professional entity that owns the clinical assets (depending on the state jurisdiction). Similar to TopCo equity, this model aligns the seller’s interest with that of the buyer going-forward–the value of the seller’s equity in the JV is directly tied to the performance of the JV (the better the performance, the higher the value).
Similar to TopCo equity, the JV entity’s governing documents will contain restrictions on equity transfer (as the PE company generally does not want to bring on new partners into an existing JV), restrictive covenants, and will likely contain a management fee that is paid to the private equity company off the top of the JV’s revenue.
Given that the seller will have a minority interest in the JV, it is unlikely that the seller will have management or voting rights. However, certain items should require the seller’s approval in a JV. For example, there should be a provision in the equity document that allows you to, at a minimum, participate in the sale of any equity interests (this is a tag along right) or require the minority equity holder’s consent to amend the governing documents.
Equity in a PE–backed transaction can represent a significant opportunity for long-term financial gain, but it is not without risk. Sellers must balance the potential upside against the illiquidity, lack of control, and possibility of losing value. A thorough review of the equity terms—alongside careful consideration of your own risk tolerance and liquidity needs—is essential before committing.
Jeremy M. Musella is an attorney at Forchelli Deegan Terrana LLP in Uniondale, NY. He is a member of the firm’s Corporate and M&A and Veterinary practice groups. Questions about purchase agreements? Contact Jeremy at jmusella@forchellilaw.com or (516) 812-6330.