When shareholders have held a position in a private company for an extended period of time, it is not rare for them to seek liquidity for a portion or all of their position. In many cases companies are happy to facilitate opportunities for their shareholders to receive that liquidity and recognize a return on their time and/or investment. The secondary transactions that happen as a result are often a source of confusion when considering their impact on a company’s valuation.
For example, if a senior software developer at a company sells his common shares at a 10% premium to last year’s venture round, how does this impact the value of the company? The preferred shares? The common shares? Should this transaction be considered a one-off event of little relevance, or should it be heavily relied upon as an indication of value? The answer to all of these questions is that it depends.
All security transactions, no matter how small, need to be analyzed to determine whether they represent an indication of fair value. The International Glossary of Business Valuation Terms defines fair value for ASC 718 and ASC 820 as
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.[1]
If it has been determined that a secondary transaction is a relevant indication of value, the next step is to determine how much weight should be placed on it in a valuation. Consideration should be given to the following:
- The amount of capital that was paid or percentage of company acquired in the transaction—the larger the size of an orderly secondary transaction, the more weight should be placed on it in a valuation.
- The comparability of the transacted security to the asset or liability being measured—the more similar the transacted security is to the asset or liability being measured, the more weight should be placed on it in a valuation.
- The time that has passed from the transaction date to the measurement date—the closer the transaction date is to the measurement date, the more weight should be placed on it in a valuation.
Example 1
Three large common shareholders in a company each sold 50% of their equity for $10 million to two outside sophisticated investors. The transactions occurred one month prior to the measurement date and accounted for approximately 10% of the fully diluted share count. The shareholders were not forced to sell; they simply wanted liquidity for a portion of their position. They marketed their shares to a few parties who had shown interest, and they provided those parties the necessary information to allow them to make an informed decision. There were no other relevant security transactions within the last year.
This secondary transaction complies with all the criteria that would suggest the transaction represents fair value. Additionally, it was a very recent and large transaction on common stock. Therefore, a significant amount of weight should be placed on it in a valuation.
Example 2
This is the same as Example 1, with one notable difference. In this example, the two investors also purchased $20 million of a new series of preferred stock along with the $10 million of common stock in the secondary. The price per share on the preferred transaction was a 20% premium to that of the secondary transaction on common. No other investors participated in the new preferred round or the secondary transaction.
Similar to Example 1, a significant amount of weight should be placed on the secondary transaction in a valuation. However, consideration should also be given to the indication of value from the new preferred round of financing. Given that each investor purchased the same quantity of both preferred and common shares, it may be appropriate to consider both transactions collectively as a single basket, as one $30 million transaction, instead of separately. Note that a basket-of-securities approach works best when each investor purchases both securities. If one investor purchases preferred and another investor purchases common, then the result will be two separate indications of value that will need to be weighted according to which is the better indication of fair value.
Example 3
This is the same as Example 1, with one notable difference. In this example, the buyers in the secondary transaction are existing Series C and Series B preferred shareholders.
This secondary transaction does not satisfy all the criteria associated with an indication of fair value, because it is not a pure arm’s length transaction. Therefore, it is necessary to study how the existing relationship between the parties might impact the value implied by the transaction. It may greatly impact the value if it is a circumstance in which these investors seek to reward the common shareholders for their work at the company by paying a premium in the transaction. This may be done by preferred shareholders in order to protect their existing investment in the company. Therefore, a secondary transaction such as this may have some weight placed on it or none at all, depending on the degree to which it not being arm’s length has impacted the implied value.
Example 4
The last example to consider is when common stock is purchased by an investor or the company itself and then promptly retired or exchanged for another security. Given that the buyer will not ultimately hold the economic rights associated with the common security that was purchased, the price paid will not be indicative of the fair value for common.
Determining the impact of a secondary transaction on the value of a company and its securities can be complicated, but hopefully, following the process laid out in this article will give some direction on how it should be done.
Due to the everchanging and complex nature of valuations surrounding secondary transactions, please consult with your attorney, tax professionals, or auditors. This article is purely informative, and Scalar does not accept any responsibility for action taken based on the content of this article.
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[1] “Fair Market Value,” International Glossary of Business Valuation Terms, National Association of Certified Valuators and Analysts, accessed July 16, 2019, https://www.nacva.com/content.asp?contentid=166.