Traditionally, founders and employees with stock options in early-stage companies had to wait until their companies were sold or went public in an initial public offering (IPO) to liquidate their equity interests. Occasionally, a founder might find a buyer for his / her shares, but that was the exception rather than the rule.
After the Internet bubble burst in early 2000, the timeline for founder and liquidity through IPO and / or sale increased considerably. Today, however, the purchase and sale of private company equity securities through secondary market transactions has become a popular mechanism for founders and employees in venture-backed and early-stage companies to obtain liquidity and diversification. Moreover, in 2009, the introduction of secondary exchanges for the sale of shares in privately-held companies has created an entirely new avenue for liquidity.
In 2013, the American Institute of Certified Public Accountants issued the practice aid Valuation of Privately-Held-Company Equity Securities Issued as Compensation (the AICPA Practice Aid), which recommends that valuation specialists (Specialist) incorporate secondary transactions into their analyses, provided the transaction meets certain criteria that would result in an indication of fair value.
Broadly defined, a secondary market transaction is any purchase or sale, other than the original issuance, of an equity interest in a privately-held company. These transactions are appealing to company insiders because they provide a liquidity mechanism for an otherwise illiquid security. For the Specialist, however, secondary market transactions increase the complexity of valuations performed for tax (IRC 409A) and financial reporting (ASC 718) purposes.
The Relevance of a Transaction
When valuing private company equity-interest transactions, all classes of equity securities must be evaluated. Consideration of a transaction, however, does not automatically mean that the value indication is relevant. Facts, circumstances and the Specialist’s judgment will dictate the relevance of the transaction and the weight, if any, to be applied.
This article focuses on two distinct categories of secondary market transactions: 1) private transactions and 2) secondary exchange transactions by company founders and employees.
Before discussing transaction scenarios, however, it is helpful to understand the motivation of employees and founders selling their shares. In Alvarez & Marsal (A&M)’s experience, the circumstances surrounding typical secondary market transactions include, but are not limited to:
- Founder(s) looking to sell after years of un(der)-compensated effort to build the business
- Financial needs (buying a home, getting married or divorced)
- Former employees with vested shares looking to divest
- Current employees with vested shares riding the liquidity wave
No matter the reason for the sale, founders and employees will be faced with a restricted pool of buyers and a web of internal and external restrictions on sale. State and federal laws not only restrict the manner and number of shares that can be sold; they also place restrictions on individuals or entities who can buy such shares. In the U.S., buyers of privately-held equities must be accredited investors with specifically defined financial and sophistication requirements.
Notwithstanding the litany of regulatory restrictions on the sale of private company equity, demand is stronger than ever as investors seek out privately-held securities in an effort to generate superior returns. Given the risk, and the restrictions surrounding private company equity investment, A&M most frequently sees the following buyers transacting in secondary markets:
- The company
- Existing preferred equity investors
- New preferred equity investors
- Company directors
- Other company shareholders
- Unrelated qualified investors
Given the diversity of investor goals, a review of the facts and circumstances surrounding the transaction must be performed when determining the relevance of the transaction. Key considerations include:
- The nature of the transaction (i.e., was it orderly)
- Timing of the transaction in relation to other transactions involving company securities
- Information available to buyers and sellers
- Transaction size, frequency and market access
- The stage of the company’s development
- The degree to which motivations other than investment returns may have influenced the transaction
The premise of an orderly transaction is included in both generally accepted accounting principles (GAAP) and tax definitions of value. Distressed sales and forced liquidations are not typically indicative of orderly transactions. They are not robust indicators of fair value because they are consummated under circumstances which do not allow the seller to freely negotiate or adequately seek the best price for the asset. An orderly transaction assumes no duress and exposure to the market for a reasonable period of time to allow for usual and customary marketing activities. Circumstances that indicate that a transaction is not orderly may include one or more of the following:
- Inadequate exposure (time) on the market
- Limited exposure to buyers (single or few buyers contacted)
- Bankruptcy or distress of the seller
- Regulatory or legal requirements force sale
- Whipsaw transaction prices over a short period of time
- Transaction price is an outlier when compared to other recent transactions
If a transaction is orderly, the Specialist should consider giving some weight to the transaction. However, when determining how much weight to apply, the Specialist must also consider the following factors:
When did the transaction occur? Was it a contemporaneous transaction (i.e., proximate to the valuation date) or did the transaction close months or years ago? When assessing the relevance of a secondary market transaction, timing is a particularly important consideration. Value is not static; and for early stage companies, it can be extremely volatile. Values change over time as information and expectations about assets, industries, economies and other conditions change. Accordingly, the further removed a secondary market transaction is from the applicable date of valuation, the less relevant the implied value becomes.
Private companies do not have the same disclosure requirements as public companies; and, as a result, the information necessary for investors to accurately assess the financial condition of a private company may not be available. If a secondary market transaction occurs, and either the buyer or the seller is not aware of facts that would be relevant to a reasonable investor’s determination of price, the indication of value from the transaction may not be an appropriate measure of value.
When considering the nature of a transaction, size matters. A purchase of a few shares of common equity is a low-risk transaction that says little about the parties’ sophistication, access to information, or analyses performed. Large transactions, on the other hand, are usually more indicative of sophistication, access to company data and material due diligence by a buyer. Barring other strategic motives, which will be discussed below, a large transaction, if contemporaneous to the applicable date of valuation, offers a more robust indication of value than smaller transactions.
Transaction Frequency / Market Access
The best indications of value for a security come from quoted prices in active markets. For private companies, however, equity transactions do not occur on public exchanges in large volumes. However, this is changing. Over the last few years, secondary exchange sites such as SharesPost’s NASDAQ Private Market or Second Market have evolved into popular trading platforms for interests in private companies.
Transactions on private company trading platforms provide recent comparable transaction data. However, the weight to be applied to these transactions remains an area of uncertainty. Transactions on private company trading platforms do not subject companies to public company regulation and disclosure. Companies trading on these platforms control the flow of information; and without regulation, the potential for asymmetric knowledge between buyers and sellers is significant.
Further, due to the limited number of transactions, these sites may act more like auctions – where the last, highest price, is more influential of future exchange prices than the company’s economic fundamentals. Furthermore, where supply is artificially restricted by contract, regulation, or other factors, the price of a single share of equity will often exhibit artificially high pricing premiums due to an artificially-imposed scarcity.
Notwithstanding the limitations of private company equity trading platforms, when a transaction is orderly, the Specialist should consider giving it some weight in the valuation of private company equity securities.
Transaction motivation is a key issue to be addressed when evaluating the relevance of a secondary market transaction. Specifically, what were the motivations of the buyer and the seller? Were there strategic reasons for the parties to consummate the sale or investment? Was there a relationship between the buyer and seller? Was the transaction a mechanism by an existing shareholder to consolidate ownership, or is it a way to compensate management for years of under-compensated effort spent building the business? Ultimately, the answer to these questions, will affect the relevant weight, if any, applied to such transactions in the valuation of private company equity securities.
Given the consistency of the guidance in the AICPA Practice Aid and the clear focus of SEC commentary, newly public companies and private companies must be ready to identify and give consideration to secondary-market transactions; and where transactions are material and relevant, values must be incorporated into management and the Specialist’s valuation of equity securities.
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