The New Normal: Secondaries and the 409A Valuation Process
Times have changed in the burgeoning private secondary market. We are increasingly asked by companies: what are the effects of a secondary transaction on our 409A valuation? It is an important question because the 409A valuation is used to determine the fair market value of the company’s common stock when issuing stock options or other deferred compensation. In other words, the 409A valuation is used as the strike price of stock options granted to employees, setting a base upon which profits are treated as capital gains by the IRS. The short yet unsatisfying answer to the question regarding the impact of secondary transactions is there is not one answer. In the valuation and audit community, the only consensus about dealing with secondaries is that it continues to be a rapidly evolving gray area.
Secondaries were once largely ignored in 409A valuations by companies, valuation firms and auditors. In recent years, however, increased SEC scrutiny on 409A valuations prompted the American Institute of CPAs (AICPA) to create guidelines that specifically recognize secondary transactions, released in an entirely new chapter in the 2012 update of the Valuation of Privately Held Company Equity Securities Issued as Compensation. This new chapter flagged the importance of secondary transactions and outlined some of the key factors which determine the significance of a secondary transaction in the 409A valuation. Specifically, the guide mentions that the activity level of the secondary market and the circumstances of each transaction, including the orderliness (e.g. seller in distress), timing, number of bidders and information available to bidders, should be considered.
While specific weights are not given by the AICPA guide, the guide makes it clear that secondaries must not be ignored. According to Bharat Kanodia, Associate Director at Ipreo, “Up until 2012, the use of secondary transactions in 409A valuation was entirely at the discretion of the company. Companies must now place some weight on secondary transactions in the 409A valuation.” Based on our conversations with valuation experts, in practice companies are considering a range of weights, from as low as 1-5% to as a high as 100%, depending on the profile of the company and transaction circumstances. For example, a “one-off” secondary transaction in the equity of a younger startup company occurring at or near the time of a major round of financing may be given a nominal weight in the 409A. Conversely, multiple arms-length secondary transactions in the equity of a pre-IPO company may be used as the primary determinant of the 409A valuation.
While no two secondary transactions are alike, and the actual circumstances will be different in each case, based on our experience there are certain alternatives a company may want to consider when permitting secondary sales that will be less cumbersome in the 409A valuation process:
Work with a third party secondary buyer: Many companies are including secondary sales in financing rounds. Between rounds, a company may want to consider a third party. Based on our conversations with valuation experts, if the company or insiders are buying shares, the assumption is that common stock transactions reflect fair market value. In particular, it would be suspect for an investor and board member who approves the 409A valuation to engage in secondary transactions at a substantially different valuation. However, a secondary transaction completed by a third party buyer lacking complete information is a less relevant indicator of fair market value.
Be careful with secondary exchanges: The AICPA guide states that companies should closely watch the “pattern of trades” on a secondary exchange. If the transactions involve many investors and sellers, and pricing is within a reasonably narrow band, those trades will be viewed as an indication of fair market value.
Work with a single secondary counterparty: Even if multiple secondary transactions take place over time, secondary sales to a single buyer may be considered one data point in a 409A valuation. The transaction price will certainly be considered more definitive if it results from a broader auction process involving multiple bids by sophisticated parties.
Offer liquidity first to founders or other key employees: According to Matt Tillotson, Principal at Scalar Valuations, founder or key employee share sales are in some cases considered “a form of compensation which creates an alignment of timeline and interest before an exit.” On the other hand, a broader liquidity program in which a share price is offered to all employees will likely be a better indicator of fair market value. Note that if it appears that a founder or key employee is receiving an offer above the fair market value, it is prudent for the seller(s) to recognize some portion of the sale as ordinary taxable income.
Redeem or exchange common shares for preferred shares: If common shares sold in a secondary transaction are simultaneously redeemed by the company and reissued as preferred shares with the same economic rights and privileges as previously issued preferred stock, the transaction price is unlikely to be pegged at face value in the 409A. Instead, the secondary is another data point similar to the pricing of a new preferred round of financing, by which the 409A price will be determined using the back-solve method.
It is critical that companies work with independent valuation experts, tax experts and auditors to derive a rigorous 409A valuation. As the secondary market for private companies flourishes, there is a strong argument for using secondary transaction prices in conducting and supporting the 409A. While secondary transactions add yet another tool to consider when conducting the 409A valuation, we believe the benefits of employee liquidity significantly outweigh the potential costs of administration. Liquidity programs have been shown to be highly effective for employee recruitment, retention and motivation (See our article, Employee liquidity – good for private companies?), which is exactly the kind of competitive advantage promising startups need to find the best talent.