As VC-backed companies mature, they may not be ready for an IPO or a sale, but private secondary transactions on common stock are a way to get some liquidity for the founders prior to an exit.
Any secondary transaction with the Company’s common stock should be carefully evaluated to determine the relevance and the potential impact on the common stock price for 409A Valuation purposes. The AICPA guide: Valuation of Privately-Held-Company Equity Securities Issued as Compensation establishes a clear set of rules regarding this issue.
The challenge with secondary transactions is that they are often at prices much higher than the previously established price based on the 409A Valuation. This occurs because the founder is trying to get liquidity and the investor is working with them to provide this liquidity; therefore, the price sometimes does not reflect true Fair Market Value, which is the Standard of Value used for option grants under 409A. When it is clear that the transaction was not at Fair Market Value, this higher price does not reset the price of the option grants under 409A. However, not structuring the secondary transaction correctly may result in the resetting of the option grant price at a much higher level, negatively impacting all option recipients who were not even involved in the secondary transaction.
Factors that are considered when looking at secondary transactions include the following:
- Timing of the transaction
- Tender offer
- Repeatable transaction
- Orderly transaction, i.e. sufficient time and information was used by the investors to make their investment decision
Additional factors may include the size of the transaction and the independence of the person buying the stock. Once each of the factors are evaluated, a weighting is placed on the transaction price as well as on the price determined via the typical 409A valuation. The weighting is a judgement call but documentation of all relevant factors is required. And sometimes all of the conditions are met, which means more weighting or even a 100% of the final weighting will be put on the secondary transaction price.
If the founders would like to get liquidity prior to an exit and avoid creating a potentially negative impact on the Company’s 409A valuation, one solution could be the issuance of Series FF preferred stock at the time of incorporation. We will discuss the Series FF preferred stock solution in Part 2 of this article series.
If you would like to discuss secondary transactions and their impact on 409A Valuations, please contact Jeff Faust, CVA, Director of Valuation Services at firstname.lastname@example.org / 408-377-8700 x232 or Irina Plevako, CFA, CVA, Manager of Valuation Services at email@example.com / 408-377-8700 x233.