The Second Bite

The owner across the table had just heard the structure for the first time. Cash for 80% of his company at close, and the remaining 20% rolled into equity of the new company, riding alongside mine. He sat with it for a moment, then said the thing every owner says, in one form or another. Why would I leave a fifth of my money in a business I just sold you?

It is the right question, and it deserves a real answer, because rollover equity has quietly become standard in lower middle market deals. Most owners meet the concept for the first time at a term sheet, under time pressure, explained by the party who benefits from their confusion. I would rather explain it here, in the open, with the math on the table, including the versions where the owner should say no.

The Arithmetic of the Second Check

Start with a simple case. A business sells for $15M of enterprise value. The owner takes $12M in cash and rolls $3M into the new company's equity. The buyer finances the deal with $6M of debt, so the total equity behind the business is $9M, and the owner's $3M is a third of it.

Now run the hold. Say earnings grow from $3M to $4.5M over 5 or 6 years, the debt amortizes down, and the business sells again at the same 5x multiple it traded at the first time. The second sale brings $22.5M. Pay off what remains of the debt, and the equity pool is worth something in the range of $19.5M. The owner's third is worth roughly $6.5M. His $3M became $6.5M while he was mostly retired, and that is with no multiple expansion at all, just growth and debt paydown doing quiet work.

That is the second bite, and the leverage math is why it can compound faster than the business itself grows. The owner's rollover sits behind the debt, so every dollar of paydown and every dollar of growth accrues disproportionately to the equity. The same mechanism that makes buyouts work for buyers works for the seller who stays in the equity.

I use round numbers because the principle survives any set of them, and I resist quoting outcomes as though they were promises. Growth can stall. Multiples can compress. A second bite is a bet, and the honest framing is that the seller is choosing to stay a partial investor in a levered company. Some should. Some absolutely should not.

Where the Trap Doors Are

Everything above assumed the owner rolled into the same class of equity as the buyer. That assumption is the entire game, and it is the first thing I would check if I were a seller, because not every structure works that way.

In some deals, the sponsor's capital comes in as preferred equity with a stated return that must be paid before common equity sees anything, and the seller's rollover lands in the common. On paper the seller owns a third of the company. In the waterfall, that third starts collecting only after the preferred has taken its coupon, year after year, compounding. If the exit is strong, everyone wins and nobody notices. If the exit is average, the preferred eats most of the pie, and the seller's second bite turns out to be mostly air. The structure was disclosed, technically, on page 40 of documents nobody walked him through.

Management fees do a smaller version of the same work. A sponsor pulling a fee off the top every year is draining value out of the company the seller now co-owns. Reasonable fees for real work are fair. What matters is that the seller knows the number and sees it in the model.

Taxes deserve their own sentence, because they change the arithmetic meaningfully. In a properly built structure, the rolled portion is usually tax deferred, meaning the owner pays capital gains now only on the 80% he cashed and lets the full, undiminished 20% ride until the second sale. Rolled dollars work at full strength while cashed dollars work at their after-tax weight. Whether a specific structure earns that treatment is a question for the seller's own CPA, asked early, and any buyer unwilling to spend an hour with that CPA is volunteering information.

So the questions an owner should ask are few and blunt. Is my equity the same class as yours? Show me the waterfall at a good exit, a flat exit, and a bad one. What fees come out along the way? What are my rights if you sell, refinance, or raise more capital? Any buyer who has built an honest structure can answer all 4 in 20 minutes with a whiteboard. Evasion on any of them is your answer.

If a buyer will not draw you a picture of where your rollover sits in the capital stack, you have already learned where it sits.

Paul W. Swaney III

Why Buyers Want It, Honestly Stated

I should be straight about my side of the trade. I want sellers to roll equity, and my reasons are entirely self-interested. A rollover shrinks the check I have to write and the debt I have to raise. It keeps the owner's knowledge, relationships, and reputation attached to the outcome through the transition, which is exactly when a business built around one person is most fragile. And it is the strongest diligence signal that exists. An owner eager to keep 20% of his own company is telling me the earnings are real. An owner who wants every nickel in cash at close is telling me something too.

Because those benefits run to me, the burden of a fair structure also runs to me. That is the trade. I get the alignment; the seller gets same-class equity and a waterfall he can explain to his own accountant without calling me.

The Kitchen Table Test

As a fundless sponsor, I cannot hide a structure inside a fund's paperwork even if I wanted to. There is no blind pool, no annual meeting where the numbers blur together. Each deal stands alone, the seller sits in the same equity I do, and my economics are visible on a single page. When the second sale comes, we are paid out of the same waterfall, in the same order. I built it that way because I have to look these owners in the eye at close, and in a market this size, for years afterward.

Here is the test I offer every seller weighing a rollover, and it costs nothing. Take the structure home and explain it at your own kitchen table. Where your money goes in, where it sits, who gets paid first, what you get in the bad case. If you can explain it, the structure is probably honest. If you cannot, the problem is the structure, and no second bite is worth it.

The first check buys your company. The second one is the referendum on who you sold it to.

Paul Swaney is the founder of Swaney Group Capital, a fundless sponsor focused in the lower middle market. LeverUp® is published weekly. More if I have something else to say.