Compliance, Fundraising

Secondary Transactions

By Dan Eyman

November 26, 2018

A question often associated with a secondary transaction is how the sale will impact the value of the company’s shares for 409A purposes and the company’s ability to offer low-priced options to its employees. Meld Valuation takes the position that secondary sales are just one data point we consider in the 409A appraisal process along with other valuation methodologies. The circumstances surrounding a secondary transaction are important factors that we consider when deciding first if the transaction is arms- length in nature and secondly how much weight to place on a secondary sale in determining the impact on your 409A valuation. We consider multiple factors of a secondary transaction when determining whether its arms-length and its impact on a 409A valuation.

We consider the following factors pertinent:

Seller and Buyer Motivation

There are frequently extenuating circumstances surrounding a secondary transaction that mitigate its impact on a company’s 409A valuation. For example, a seller may be facing external financial difficulties that make them willing to take a lower-than-fair market price. On the other hand, a purchaser may be willing to pay a premium to gain access to a privately held stock that they would not otherwise have. Because of these mitigating circumstances, we frequently conclude that the secondary transaction does not fit the definition of an efficient market transaction and minimize its impact on a company’s 409A valuation.

Similarity of Securities Sold

Secondary transactions often involve granting the buyer additional rights and preferences which a common shareholder does not typically have. For example, if preferred stock was sold in the transaction, those preferred shares frequently include liquidation preferences, voting rights and information privileges that are not granted to common shareholders. Meld Valuation considers those differences from common shares to be material, and as a result minimize the transaction’s effect on the 409A valuation.

Transaction volume

Meld Valuation also considers the size of a transaction when determining its impact on a company’s 409A valuation. Transactions for a small number of shares, and particularly for small ownership percentages, typically have minimal or no impact on a company’s 409A valuation. While there is no fixed rule for what size a secondary transaction must be before it impacts a company’s 409A valuation, we place little to no emphasis on a secondary transaction that is for less than 10% of a company’s fully diluted shares.

Information asymmetry

Secondary transactions frequently occur where the buyer has only limited access to company information, and as a result their impact on the company’s 409A valuation tends to be minimized.

Proximity of timing

We also consider material events that may have occurred since the execution of a secondary sale. When a secondary transaction occurs a substantial time before such events, its impact on the company’s 409A valuation is minimal.

Deal structure

Meld Valuation also considers whether a secondary transaction involved just the exchange of cash for the securities or whether it included additional pricing provisions such as an upside share arrangement or share escrow. Structured transactions tend to have less of an impact on a company’s 409A valuation.

How can I eliminate or reduce the impact of a secondary share sale on 409A valuation?

While there are no set rules on how to minimize a secondary transactions impact on a company’s 409A valuation, if price must be disclosed, certain types of deals are less likely to have an effect. A secondary sale is less likely to change a company’s 409A valuation if:

  • It is for smaller volumes of shares (<10%)
  • Transaction frequency
  • The company is not directly involved in repurchasing the shares (such as through a preferred investment in the company)
  • The seller or buyer can demonstrate extenuating circumstances to the sale (for example, a unique financial situation for the seller or if only one buyer was allowed to enter into negotiations for the purchase)
  • The transaction involves structured pricing mechanisms such as an upside share or escrow
  • The initial transaction is done through a loan structure instead of an outright purchase.

Are there situations when a company should discourage secondary transactions?

Yes. Boards of directors may wish to impose black-out periods on sales of employee stock during certain periods of time – particularly during periods where the company is fundraising or executing or discussing material transactions. Depending upon the maturity of the company, it may also be prudent to black out trading around quarter or year end. These guidelines need not be as stringent as public companies but are good business practice and prevent incentives from becoming misaligned between the company and its employees.

Shouldn’t the price for my common be the same as the last round?

The price of any stock depends on many factors. Private, venture-backed companies typically have one or several classes of preferred stock in addition to common stock. Such preferred stock carries with it rights and privileges not typically afforded to common stock. For example, a preferred stock will likely have liquidation preference rights that give it a senior claim to any proceeds distributed to shareholders upon a liquidation or change of control. Common shares, without such preferences, will not receive any proceeds from such liquidation or change of control until the liquidation preference provisions of the preferred stock are met. In some cases, this may ultimately render the common stock worthless.

That said, there can be other cases where a common share is worth the same as or more than a preferred share particularly if the last round was done several years earlier and the company has grown meaningfully. Secondary firms advise sellers against simply assuming that the price of a common share today is equal to the last round price. Instead, secondary firms take a market value-based approach to pricing any given equity security taking into account the terms associated with the security, information that they are provided, and dynamics of the sale process.

Why isn’t the price for my common shares the same as the 409A valuation of the company?

A company’s 409A valuation is one data point in the valuation process, but there are many factors that can cause the current valuation to be higher or lower than the last 409A price. In most dynamically changing industries, a material event, either positive or negative, can happen between the last 409A valuation and a secondary sale that dramatically affects the valuation of the company.

In addition, secondary buyers have to weigh several other considerations when they value a seller’s shares, such as the need for future financings and the potential future dilution, differences in opinion as to the appropriate timing and magnitude of a liquidity event, as well as their own cost of capital and target returns profile. Finally, 409A valuations are based on a host of financial analyses. Secondary buyers may have valuation procedures and sensitivities for deploying their own capital that are very different from the analyses provided by Meld Valuation.


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