Over the course of the last few years, particularly since 2021, there has been a shift in healthcare M&A transaction structures to include a greater proportion of rollover equity (particularly in private-equity-backed transactions) and earnouts. These vehicles shift risk and economics to post-acquisition. This trend has necessitated more thorough due diligence in evaluating such components, as their ultimate value can significantly impact the total consideration received by sellers. This article addresses some of the due diligence and legal considerations to address when evaluating transactions with rollover equity and/or earnout components.
Rollover equity refers to structures wherein sellers agree to reinvest a portion of their ownership stake in the acquiring company as opposed to taking cash proceeds from the transaction. Some structures are still referred to as rollover even if the sellers instead reinvest in a regional or national entity. Rollover equity has continued to grow in prominence, particularly in middle market and lower middle market transactions, increasing from 46% of transactions in 2020 to 57% in 2023. While data is scarce by definition for private market transactions, it is safe to assume that rollover equity has increased in popularity to help bridge the gap between buyer and seller expectations by shifting a portion of the “headline” valuation into non-cash consideration and also creating more economic alignment post-transaction. This rollover equity has also been touted as an opportunity for significant upside potential, as the seller’s ownership in the post-acquisition company has historically appreciated significantly in value in many instances.
As rollover equity has become a fixture in more transactions, and the relative amount of reinvested capital has increased, it becomes more critical to evaluate the rollover investment during the diligence phase of a transaction. Because these investments are by definition closely held, there is typically low visibility into the valuation of the rollover equity investment. Suppose, for example, that a business equally owned by two founders is evaluating an offer to be acquired for $10 million, $5 million of which is to be reinvested in the acquiring entity. Eventually, the $5 million reinvestment amount is converted into the number of shares or units in the acquiring entity. How do the sellers know if the $5 million reinvestment is fairly represented by 5,000 shares, for example? Only a valuation analysis of the acquiring entity’s equity will truly answer the question. And, in this example, because 50% of the purchase price is allocated to rollover equity, the economic feasibility of the transaction hinges upon the rollover equity investment. Further, any anticipated appreciation in rollover equity value, and related exit paths, must be carefully considered.
The appreciation potential of rollover equity represents both opportunity and risk for sellers. The true/final economic value of a transaction with rollover equity can only be fully assessed when the rollover equity is eventually liquidated, typically in a “second bite at the apple” scenario. It is also important to note that many transactions involving a “second bite at the apple” will require a portion of the initial rollover investment to be rolled into the new transaction. Thus, sellers are not typically fully liquidating their investment. To illustrate how significantly the appreciation or depreciation of rollover equity can impact total transaction value, consider several scenarios based on a hypothetical transaction.
Consider a transaction where a private equity firm acquires a healthcare IT company for $40 million. The seller agrees to roll over 25% ($10 million) of the proceeds into the new entity, receiving $30 million in cash at closing. The deal is structured with a debt-to-equity ratio of 1:1, meaning $20 million of the purchase price is funded through debt, with $20 million in equity ($10 million from the private equity firm and $10 million from the seller’s rollover).
In this case, the seller’s $10 million rollover represents 50% of the total equity in the post-acquisition entity, despite being only 25% of the total transaction value. This leveraged structure amplifies both the potential returns and risks associated with the rollover equity.
Following are three potential outcomes after a five-year holding period:
Under this scenario, the new entity thrives under private equity ownership, and the company is sold for $120 million after five years. After the $20 million in debt is repaid (assuming no additional debt was taken on), $100 million in equity value remains. The seller’s 50% equity stake is now worth $50 million (a $40 million increase in value from the initial rollover).
In this scenario, the rollover equity appreciation is equal to the total transaction’s initial value. Said differently, the seller gained as much from the rollover equity appreciation as they did in the initial sale.
In this scenario, the company experiences lackluster performance, and the company is sold for $60 million after five years. After the $20 million debt is repaid, $40 million in equity value remains. The seller’s 50% stake is now worth $20 million.
Importantly, under this scenario, the seller still notices an economic gain even though the total equity value of the enterprise is flat over the next five years. This is because the seller and buyer invested an equal amount of equity at the original transaction date and because the initial acquisition was funded partially through debt. Just by paying off the acquisition debt, there is economic return to the shareholders.
In this scenario, assume that the company is sold for just $30 million after five years. After repaying the $20 million debt, only $10 million in equity value remains. The seller’s 50% stake is now worth $5 million.
Under this underperformance scenario, while the total value of the company decreased $10 million, the sellers only experienced a $5 million loss because the sellers received $30 million in cash up front and because the acquisition was financed by debt and equity from both buyer and seller.
These scenarios demonstrate how dramatically the ultimate transaction value can vary based on post-acquisition performance and the appreciation or depreciation of rollover equity. In the strong growth scenario, the seller realizes twice the headline transaction value, while in the underperformance scenario, the seller receives less than the original transaction price despite taking 75% in cash at closing.
Many factors can influence the value of rollover equity in a merger and acquisition context. It is crucial to develop a strong understanding of the value drivers of rollover equity when assessing acquisition offers from a seller’s perspective.
The capital structure of the acquiring entity dramatically affects the risk-return profile of rollover equity. Higher leverage magnifies equity returns in successful outcomes but also magnifies losses on the downside. In the example above, the 1:1 debt-to-equity ratio meant that the seller’s $10 million investment represented 50% of the equity. If the leverage had been 2:1 ($26.7 million debt, $13.3 million equity), the same $10 million rollover would represent approximately 75% of the equity, further amplifying both potential gains and losses. The use of leverage has generally decreased in mergers and acquisitions since interest rates started to increase in 2022, as the cost of borrowing eliminated some of the benefits of applying high amounts of leverage to a transaction. Further, the “growth at all costs” or “growth as a strategy” paradigms have been increasingly questioned by investors.
The seller’s ability to protect their rollover equity depends largely on negotiated governance rights. Sellers should perform careful due diligence by asking buyers for information around the following:
These are key factors in reviewing acquisition offers, as the absence of many investor protections can decrease the value of rollover equity. Often, these provisions are included in the governance documents of the rollover investment entity, which makes essential the careful review of these agreements prior to closing.
The timeline and mechanism for liquidating rollover equity is crucial to its ultimate value. In other words, a lack of mechanisms to liquidate rollover equity investments greatly decreases the value of rollover equity. Private equity firms typically have defined investment horizons (four to seven years), but this does not guarantee an exit for the rollover equity investors. Clear documentation of liquidity options—whether through a tag-along right in a future sale, put options after certain time periods, or redemption provisions—provides important protection for sellers. Without defined exit mechanisms, rollover equity may remain illiquid indefinitely, substantially reducing its practical value. Again, these exit provisions should be included in the governance documents of the rollover investment entity.
Rollover equity can provide significant tax advantages when properly structured, as it may qualify for tax-deferred treatment. Unlike cash proceeds, which trigger immediate capital gains tax, properly structured rollover equity can defer taxation until the equity is ultimately sold. This tax deferral creates additional value by allowing the full pre-tax amount to appreciate before any taxation occurs.
The specific legal structure of the acquiring entity (corporation, partnership, LLC) and the form of the rollover (stock-for-stock, assets-for-stock) will determine the tax treatment. To achieve tax deferral, the transaction must typically qualify as a tax-free reorganization under Section 368 of the Internal Revenue Code or meet other specific requirements.
Performing due diligence on these items will significantly impact the after-tax proceeds of a transaction, the key output that should be solved for.
When evaluating rollover equity, sellers must conduct thorough due diligence on the acquiring entity, in a similar magnitude to the level of due diligence typically performed on the selling entity. This includes but is not limited to:
Depending on how the rollover equity is structured, there may be incentives for the seller to refer business to the rollover investment entity (or its affiliated operating entities) in order to increase its value. Such referrals could violate state and federal healthcare laws that prohibit physicians and other healthcare providers from being compensated for their referrals, including the federal Anti-Kickback Statute (AKS) and Stark Law. In these situations, it is essential for any referral relationship to be structured in a manner that is compliant with relevant safe harbors and exceptions. For further discussion on these referral-related concerns, please see the Legal Issues section of Critical Factors Affecting Earnouts, below.
Also, in recent years, the FTC and DOJ have both expressed concerns whether certain roll-up strategies violate antitrust laws due to increased market concentration. There is concern that industry consolidation results in fewer companies controlling a significant portion of the relevant market. This can lead to higher prices and reduced access to care for patients. While these concerns are not unique to the healthcare industry, they should be considered as part of any transaction which includes a rollover component.
Finally, any rollover equity offering must be structured in a manner that is compliant with applicable corporate practice of medicine (CPOM) laws, which place restrictions on non-professional (i.e., licensed physicians and other providers) ownership of healthcare entities. As part of the initial due diligence, transaction parties and their advisors should review applicable state law to determine whether the governing state recognizes CPOM restrictions and, if so, how best to structure the transaction to ensure that the post-closing ownership, at both the operating and investment levels, complies with such legal requirements.
Rollover equity has become increasingly commonplace in middle market and lower middle market M&A transactions. The economic return that sellers ultimately receive from a transaction is only knowable after the outcomes of the rollover equity component are fully realized, which may take years after the initial transaction. Further, the so-called “second bite at the apple” can meaningfully impact the total proceeds to sellers. Because of this, thorough due diligence needs to be undertaken by sellers to fully understand the potential outcomes of their reinvestment in an acquiring entity, along with the related legal issues, as buyers and sellers transition from adversarial parties to business partners.
Like rollover equity, earnouts have become increasingly common in some corners of healthcare transactions, particularly with financial investors such as private equity firms and family offices. Also, like rollover equity, earnouts shift a portion of the transaction’s value towards future operations and events. Finally, like rollover equity, earnouts have been used as a tool to bridge valuation gaps between buyers and sellers. However, earnouts must be carefully evaluated through proper transaction structuring and governance provisions to be effective while avoiding issues and distractions, including legal complications, after the transaction has closed.
Earnouts are contractual arrangements where a portion of the purchase price is contingent on the acquired business or sellers individually meeting specific financial or operational targets post-closing. They function as risk allocation mechanisms that place a portion of the transaction’s value contingent on future performance. Earnouts have continued to grow in prominence, particularly in middle market transactions, with data showing an increase from approximately 20% of deals in 2018–2019 to about 37% in 2023.
Data on the usage of earnouts is hard to come by for private market transactions. However, it is safe to say that earnouts become more popular in times of market uncertainty and when acquisition financing terms are more restrictive. In addition, earnout structures can and have become increasingly complicated, with nonlinear payout features and structures affecting different classes of shareholders in different ways.
The design of an earnout arrangement substantially impacts both the likelihood of achievement and the ultimate value received by sellers. As with rollover equity, the true economic value of a transaction with an earnout can only be fully assessed once the earnout period concludes and all contingent payments are determined. To illustrate how significantly the achievement or non-achievement of earnouts can impact total transaction value, consider several scenarios based on a hypothetical transaction.
Consider a transaction where a private equity backed strategic buyer acquires a behavioral healthcare services provider for a headline price of $50 million. The deal is structured with $35 million paid at closing and a potential earnout of $15 million over three years ($5 million per year) contingent on achieving specified earnings before interest, taxes, depreciation, and amortization (EBITDA) targets. The earnout is triggered if the business achieves EBITDA of at least $8 million in each year, with full payment if EBITDA reaches $10 million or more.
Because 30% of the transaction’s total value is only realized if the earnout payments are fully received, the economic viability of the transaction hinges on the ability to and likelihood of achieving the specified EBITDA targets.
Following are three potential outcomes during the three-year earnout period:
Under this scenario, the business achieves EBITDA of $11 million, $12 million, and $13 million in years one, two, and three, respectively. As a result, the seller receives the full earnout amount of $5 million in each year.
In this scenario, the business achieves EBITDA of $7 million, $8 million, and $11 million in years one, two, and three, respectively. Based on the earnout structure, the seller receives $0 in year one (below $8 million threshold), $4 million in year two (80% of full target of $10 million), and $5 million in year three (above target).
In this scenario, the business achieves EBITDA of $6 million, $7 million, and $7.5 million in years one, two, and three, respectively. All three years fall below the $8 million EBITDA threshold, resulting in no earnout payments.
One important realization regarding certain earnout structures is that it may take several years to fully adjudicate the earnout. Businesses typically experience some level of momentum in operations across years, and thus, the first year of performance post-acquisition can oftentimes set the stage for performance and earnout achievement in future years.
Several factors significantly impact the likelihood of earnout achievement and the ultimate value received by sellers, each requiring careful consideration during transaction structuring and negotiation:
The structure of the earnout itself is oftentimes the topic of intense negotiations, as it can have a significant impact on the likelihood of the sellers achieving the full headline transaction value. Examples of considerations include:
The specific financial or operational metrics used to measure earnout achievement dramatically affect both the probability of payment and alignment of incentives. Buyers typically prefer metrics further down the income statement (EBITDA, net income) as these reflect profitability, while sellers often favor top-line metrics like revenue which are less susceptible to buyer-controlled expenses. The choice of metric should reflect both the value drivers of the business and areas where sellers believe they have competitive advantages.
The cornerstone of successful earnout structures is precise definition of the performance metrics and calculation methodology. This includes:
The importance of these elements is difficult to overstate.
The allocation of control prerogatives during the earnout period represents one of the most critical and potentially contentious aspects of earnout negotiations. Without adequate protections, sellers may find their earnout prospects diminished by decisions entirely within the buyer’s control. Example key considerations include:
The Delaware Court of Chancery has addressed numerous cases highlighting the importance of clearly delineating control over business decisions that impact earnout achievement. Without explicit contractual protections, courts generally defer to the buyer’s business judgment unless the seller can demonstrate bad faith or actions specifically intended to evade earnout obligations. Therefore, when representing the seller, it is important that the purchase agreement include provisions that limit the buyer's sole discretion in operating the business during the earnout period. Preferably, these provisions allow the seller to maintain some level of oversight over post-closing operations and/or ensure the buyer's business decision-making process is consistent with pre-closing operations.
The timeline for earnout measurement and payment significantly impacts both value and risk. Longer earnout periods increase uncertainty for sellers but also may allow for recovery from short-term setbacks. The payment structure—whether in equal annual installments, escalating targets, or cumulative goals—also affects the risk-reward profile for sellers.
For example, a structure with separate annual targets offers sellers multiple independent opportunities for achievement. A structure with a cumulative goal over the entire earnout period magnifies uncertainty but may also shorten the earnout’s effective period. Some earnouts incorporate “netting” provisions where underperformance in one period must be recovered before additional earnout payments are triggered.
Earnouts create significant tax and accounting complexities for both buyers and sellers. For tax purposes, sellers must determine whether to recognize contingent payments under the installment method or report the estimated fair value immediately. The specific earnout structure affects eligibility for capital gains treatment and the timing of tax obligations. For buyers, earnouts create additional complexity in purchase price allocation, goodwill determination, and subsequent operations reported on the income statement.
As with rollover equity, earnouts have the potential to incentivize referrals as a means to achieve target revenues. This is particularly a concern if the seller is a physician or physician-controlled entity that is in position to refer or generate business for the buyer. If any such referrals are intended to increase revenues such that the seller meets the earnout threshold, this could trigger a violation of the AKS, assuming federal healthcare business is part of the transaction. Fortunately, there are safe harbors, like the sale of practice safe harbor, which can potentially protect referral relationships in the context of an earnout arrangement and therefore should be carefully scrutinized as the parties structure their transaction.
In addition, the Stark Law could be implicated if any of the seller's referrals include designated health services (DHS). In some instances, the isolated transaction exception might apply to insulate the referral arrangement though this can be challenging if the payment mechanism is not set in advance (which is often not the case with earnout amounts). If the isolated transaction exception does not apply, other exceptions like the fair market value exception can also be considered. In certain instances, no exceptions will apply, resulting in the parties having to reconsider the use of an earnout payment in the transaction. This may include restructuring the payments to be based on objective measures not related to referrals, including cost reductions, operational improvements, and the addition of new business through expanded contracts or service lines.
As a final note, some states have developed laws similar to the AKS and Stark Law, which should also be analyzed when considering the use of an earnout provision. In addition, state CPOM and fee-splitting laws should also be considered when analyzing the payout of earnout funds.
Earnouts have become a common tool to bridge valuation gaps between buyers and sellers. However, a transaction’s total value may be jeopardized if the earnout arrangement is not structured properly, is ambiguous in any way, is based on metrics that are not reasonably achievable, and do not include protections and covenants to align incentives post-transaction. Proper diligence can alleviate problems several years in the future and also improve the success of the earnout.
Rollover equity and earnouts both have increased in prevalence in recent years. Both shift economic value to after a merger or acquisition, and both can potentially take years to be fully realized. Only then can a seller understand the true economic outcome of a transaction. Rollover equity and earnouts have become a significant component of lower middle market and middle market transactions. As such, due diligence on these items has become a critical element of negotiations and deliberations during transaction proceedings. As seen in the examples above, the overall outcome of a transaction hinges on the outcome of future performance. There are also many aspects of rollover equity and earnouts that should be carefully examined, including the potential legal issues arising out of these contingent payments.
