How do secondary transactions impact your company’s 409A valuation?
This article will discuss the concept of secondary transactions and their impact on 409A valuation.
In general, a secondary stock transaction is a process in which a securities holder proceeds to sell their shares of the company to a third party. Typically, when an investor buys a company’s shares from existing shareholders, it is considered a secondary transaction. While you might have heard about 409A valuation and its relevance for private companies. Well, a 409A valuation is a way to determine the fair market value (FMV) of a stock, as defined by the Internal Revenue Code. But how does secondary transaction work, how can it impact 409A valuation, and what else do you need to know about it? This article will discuss the concept of secondary transactions and their impact on 409A valuation.
Secondary transaction and 409A valuation
A secondary transaction is a sale of the company’s stock to an investor from existing stockholders, such as company employees, founders, and investors. During a secondary stock transaction, the company’s shares are sold in order for the seller to obtain cash, and the company does not have any involvement.
On the other hand, according to the Internal Revenue Code, a 409A valuation is a process in which the fair market value of a stock is determined. As a private company, the shares are not listed on an exchange, and thereby, there are no current market prices. In such a scenario, the fair market value is determined by a qualified 409A appraiser, and the IRS regulations specify how it should be determined.
Understand 409A valuation
To determine the fair market value of a private company’s stock, a 409A valuation is used. 409A valuation is a specific type of fair market value analysis that determines the value of securities that are not traded in public markets. The purpose of 409A valuation is to ascertain the value of the company’s stock, and thereby, with the help of FMV, companies can issue shares to private equity investors, grant equity compensation, calculate tax liabilities, or for other purposes where FMV of share is required. Companies may hire third-party appraisers like Eqvista to accurately determine the FMV of their stock in a streamlined and consistent manner.
Understand secondary transaction
In private companies, the shares are not traded on an exchange. However, when an existing shareholder decides to sell their shares of the company to an investor, the transaction is termed a secondary transaction. The funds from the sale of shares are directly transferred to the seller, and thus, the company does not engage in the process. Typically, it can be referred to as reselling the shares from the company’s shareholder to another person or entity. In general, the deal takes place between the seller and investor, and thus, the secondary stock transaction process is not done by the company but by the existing shareholder.
Types of Secondary Transactions
Well, there are two types of secondary transactions, secondary sales and repurchases. Following are the detailed descriptions for both types of secondary transactions.
- Secondary Sale – Typically, the sale under a secondary transaction is known as a secondary sale. It involves selling a company’s shares from an existing shareholder to a third party. However, many companies restrict secondary sales to third parties without board approval, and thereby, it may also be subject to the rights of the first refusal by the company or by investors.
- Repurchases – When a company first offers stock shares, it is usually known as a repurchase option. For repurchases, the company may buy back the shares from the shareholders who generally own them at a future date. The repurchases are often done within a preset time period, and hence it allows companies to protect their security from competitors.
How does a 409A valuation work?
Under the 409A valuation process, there are various valuation methods that can be applied to determine the fair market value of a company’s stock, such as the asset-based, market-based, income-based approach, or backsolve method. The methods can be applied based on the factors and assumptions that are alternatively relied upon. Generally, financial projections, mathematical calculations, and estimates made by the company and appraiser are used to determine the value of the stock. As a result, the FMV of the stock is determined.
How does secondary transactions work for employees and founders?
Founders of a private company tend to retain ownership of their shares while employees are usually allocated shares as a part of their equity compensation plan. Assuming that founders and employees have a portion of the company’s equity. However, unlike public companies, where shareholders can sell or trade their shares, this is not the case for private companies. In such a scenario, if an employee or founder wishes to sell their shares, they can only do so through a secondary transaction. This might be beneficial for the seller (existing shareholder), however, the company may not be compensated for the transaction.
How does secondary transaction work for VCs?
VCs are a vital part of private companies, and they often choose to provide capital in return for a stake in the company. While if VCs want to invest, they may be unable to do so because the round has been oversubscribed. Thus, in this case, VCs can acquire shares from the company’s existing shareholders through secondary transactions. This allows VCs to participate in the investment round despite the oversubscription. As such, secondary transaction offers high-level liquidity to existing shareholders of the company.
Secondary Transactions vs. Funding Round
Well, the purpose of a secondary transaction is to sell the shares of a company to an investor from the existing shareholders. While a funding round might be similar in nature, as it is designed to deliver capital from investors to the company. The fundamental difference between a secondary transaction and a funding round is that during a funding round, the company itself proceeds with the process of bringing in capital from outside investors.
Whereas in a secondary transaction, no involvement is made by the company, and only existing shareholders sell the shares. In a secondary stock transaction, the funds that result from the transaction are directly transferred to the seller, and on the other hand, in a funding round, the funds are transferred to the company and usually for the purpose of expansion, growth and development. Hence, secondary transactions and funding rounds differ in process, intent, and outcomes.
How does secondary transaction impact 409A valuation?
As a part of a secondary transaction, an existing shareholder is selling shares to an investor. This lends the existing shareholder some liquidity, and the new investor gains access to the company’s equity. As a result of the secondary stock transactions, it definitely has a direct impact on the 409A valuation of the company. However, the impact on 409A valuation can vary depending upon certain circumstances, facts, and factors. Below mentioned are a few factors that might influence the impact of 409A valuation.
Factors that affect the secondary transaction
Here are a few factors that can play a pivotal role, based on which the impact of the secondary transactions can vary:
- Similarities of sold securities – As a matter of fact, secondary transactions frequently involve granting the buyer additional rights and preferences that a common shareholder normally does not have. Suppose a preferred stock was sold in the secondary stock transaction, for instance. In that case, those preferred shares will include liquidation preferences, voting rights, and information privileges that are not available to common shareholders. The impact of the transaction on the 409A valuation is reduced as a result of meld valuation such that the variations from common shares are considerable.
- Buyers and seller’s motivation – Buyers and sellers of secondary transactions may be influenced by their personal goals and desires. Let’s say that the seller desires liquidity and is willing to accept a lower value than the current FMV in order to obtain funds. While the buyer is ready to buy the stock at a higher price than the FMV. As a result, there is an inefficiency in the secondary stock transaction, and irrespective of the FMV, the transaction can go through. Consequently, the impact on 409A valuation is reduced.
- Transaction size – It should be noted that the level of influence depends on the size of the transaction, typically the number of shares and the percentage of ownership involved. Secondary transactions may involve a small number of shares and, likewise, a small portion of ownership, which will have no impact on the 409A valuation. In general, less than 10% of the fully diluted shares of a company have no impact on the 409A valuation.
- Tender offer – Usually, tender offers are made with the objective of achieving sufficient liquidity and removing any uncertainties regarding ownership structure. In private companies, investors or groups of investors acquire shares through tender offers, and hence, existing shareholders are replaced by new shareholders in a secondary transaction. While the impact of 409A valuation depends upon the price and size at which the tender offer is conducted.
- Timing proximity – At the time of execution of the secondary transaction, if in case a material event has occurred, it may have a direct impact on the 409A valuation. Such events include mergers, acquisitions, or consolidations with another company. However, prior to any of these events, if secondary transactions take place, the impact on 409A valuation is very low. As a result, the timing proximity is the most relevant factor that can affect the impact of 409A valuation.
- Information asymmetry – In the case of information asymmetry, the buyer has limited knowledge about the company’s financial position, operations, and capital structure. The impact of information asymmetry on the 409A valuation is reduced to a great extent. On the other hand, the impact becomes more pronounced if the buyer has complete information about the company. As such, in case of a higher degree of knowledge, the buyer will have a better understanding, and thus, this increases the potential to negotiate a better deal.
- Deal structure – The structure of the deal is also vital in determining the impact on 409A valuation. Usually, secondary transactions are less structured, as commonly, and the traction takes place for the purpose of exchanging cash. However, if the traction has additional pricing clauses like a share escrow or an upside share arrangement, the impact on 409A valuation is reduced as it is a structured deal. The transactions that are structured will typically have less or no impact on 409A valuation.
- Company history and plan for the future secondary transaction – Another important fact that determines the impact of secondary transactions on 409A valuation is company history as well as the company’s future plan. If a company is planning to raise funds and expand its interests, the company should not consider secondary stock transactions as they can create uncertainty and instability. As a result, the negotiations can take place in a manner that results in the impact on 409A valuation.
When should companies ignore secondary transactions?
There are various circumstances or reasons that will lead a company to ignore secondary transactions. The Board of Directors should properly strategize and determine the best course of action. Well, if the company has plans to raise funds or a material transaction is expected to occur soon, the company should ignore or typically black out the secondary stock transactions. In addition to this, every quarter or year-end, the company should evaluate, and according to the maturity of the business, the company should ignore secondary transactions. As a result, the company should either ignore or black out the transactions during certain times.
How to reduce risk of secondary transactions on a 409A valuation?
We have seen that the impact on 409A valuation depends on various factors such as the deal structure, timing proximity, transaction size and so on. But how do companies reduce the risk of secondary transactions on a 409A valuation? Well, there is no one-size-fits-all solution. Every company should conduct its own study based on the circumstances and factors that are relevant to the situation. However, the following are a few measures that can be taken to minimize the risk of secondary transactions:
- The size of the transaction should be reduced, thereby, less than 10% of the fully diluted shares of a company will have minimum or no impact on the 409A valuation. Thus, the fewer the shares involved, the less or no impact on 409A valuation.
- The structure of the deal should be designed in such a manner that it will have minimum impact on the 409A valuation. It should be noted that a pricing model such as share escrow or an upside share arrangement will have little or no impact on the 409A valuation.
- The initial transaction can be structured in a loan instead of an outright purchase. This is because as soon as the shares are purchased, this automatically implies an ownership transfer and subsequent impact on 409A valuation.
Why are common shares prices different from 409A in secondary transactions?
A material event that takes place between the previous 409A valuation and the secondary transaction can potentially impact the 409A valuation. In such cases, the price of the common shares may not be consistent with the price of 409A in a secondary transaction. Furthermore, the buyer of a secondary sale may possess various considerations to value the seller’s share including potential dilution, projected returns, cost of capital and so on. It is indeed at the discretion of the buyer to value the seller’s shares, and thus this is where the price discrepancy between common share prices and 409A valuation occurs.
Get a 409A valuation from Eqvista!
As you have read in this article, the impact of secondary transactions on a 409A valuation is not linear, and it depends on various factors. Thus, to avoid any risk or downsides, it is advisable to get your 409A valuation in a timely manner. Are you confused and looking for a reliable and credible partner for your 409A valuation? Well, Eqvista is a leading company that provides comprehensive solutions for 409A valuation and other similar services related to other financial instruments. Let our team of certified professionals do the work for you! Sign up today to avail of our services and get your 409A valuation at a reasonable price!