Secondary Market May Impact 409A Valuations

Greenstein, Rogoff, Olsen & Co.
Posted: 3/23/11

An issue gaining attention with respect to 409A valuations is the fact that many private company shares are increasingly being traded in the secondary market. There is a debate among valuation specialists over how transactions in private company stock impact the value of the company securities for 409A purposes. The AICPA guidelines states that a recent private market transaction in the stock of a company is considered as the most relevant data point in reaching a conclusion of value for 409A purposes.

However, before considering those transactions, a valuation analyst should analyze following issues:

The nature of the stock: Were there preferred stocks or common stocks sold?
Preferred stock transactions are less relevant than common stock transactions since preferred stocks have liquidation preferences and often more rights than common stocks.

Timing: Did the transaction occur close to the valuation date?
A transaction that occurred more than 12 months prior from the valuation date has less impact on the valuation. Material events that occurred after the transaction should be considered since they might have changed the company’s fair market value.

Volume of the transaction: How many buyers and sellers? How many shares?
Small transactions between a few people are less relevant than larger transactions between many participants. It is also important to understand what percentage the transaction represents of the fully diluted equity capitalization of the company.

Available financial information: Was the buyer well informed?
The definition of “Fair market value” assumes that the buyer and the seller have access to an adequate amount of information. Unlike public traded companies, there is often little or no information about companies trading in a private market. If the buyer is a board member with access to regular financial reports or if the buyer proceeds to a full due diligence process, the transaction will have more impact on the 409A valuation than transactions occurring on marketplaces like Sharespost or SecondMarket.

Buyer/seller motivation: Were the parties independent? Was it a strategic investment?
This is probably the toughest question to answer whether the parties were independent and what were their motivations. The definition of “Fair market value” assumes that neither the seller nor the buyer should be compelled to buy or to sell. The prices paid by investors in equity financing transactions may be complicated by considerations beyond investment such as establishing a strategic relationship or providing liquidity to company founders.

Strategic Investments. The buyer may have other business motives for making the investment which are beyond earning an investment return such as building a strategic business relationship, gaining access to information and influence or obtaining a preferential position as a supplier or customer. In this scenario, the price paid may be overstated and the implied value of the company may be misleading.

Liquidity to company founders or key employees. Some Preferred Shareholders or companies buy common stock from founders or key employees to provide them liquidity. As such, the parties are protecting their investment by paying a premium to the founders or key employees, upon whom the future success of the company is highly dependent. Mostly in these cases, the price offered to a select group of shareholders who are considered to be integral to the future success of the Company is not proposed to all of the Common Shareholders. Consequently, the price paid may be overstated as well.

Bundled Transactions. In some instances, the investors complete an equity financing round including a combination of the latest series of preferred stock, an earlier series of preferred stock and common stock at the same price per share. The common stock price may not seem reasonable given the facts and may be overstated.
Based on the factors explained above, a valuation analyst should carefully analyze the nature of the transactions in privately-held companies before considering their impact on 409A valuations.

Qualifications of Business Valuation Analysts:
The management should carefully consider the education, specialization and credential of a business valuation analyst. The dedicated Business Valuation group at Greenstein Rogoff Olsen & Company (GROCO) provides the expertise of a large big four firm with the hands on individualized service of a small local firm with regional prices. We are committed to provide our clients and their advisors with the highest services and support available. Our business valuation analysts are certified as accredited valuation analyst from the National Associate of Certified Valuation Analysts and have work experience with the big four accounting firms. GROCO is a full-service certified public accounting firm, advising and assisting our clients with their accounting, tax, wealth preservation and business valuation needs.

Our business valuations group has preformed hundreds of valuations of privately held corporations and businesses totaling over $3 Billion in appraised values. This experience includes over sixty-five different industries all geographical regions of the US and all stages of enterprise development, with particular emphasis on early stage companies in the Silicon Valley.

For more information contact Alan Olsen, Managing Partner, at aolsen@groco.com.