With the attractiveness and increasing popularity of marketplaces for pre-IPO stock, like SecondMarket, there is growing debate over how transactions in private company stock impact the value of company securities for 409A purposes. At the core of these discussions is the question of whether a transaction occurring in a private marketplace is a strong indication of value. In this article we offer guidelines for valuation professionals and company executives to consider when assessing the impact of such secondary
transactions on the fair market value of private company stock.
Mapping the Course
The potential impacts of private secondary market sales on 409A valuations are, in a word, complex. Transactions may reflect discounts or premiums for marketability, liquidity, and/or control, each of which impact the fair market value of private company stock. Fur ther, purchasers may be willing to pay a premium for access to private stock they would not otherwise have, thus overpaying vis-à-vis fair market value. Such
overpayments are sometimes referred to as a posturing or access premium, and are difficult to quantify.
Similarly, sellers may be willing to take a lower-than-fair price due to extenuating financial exigencies. These issues are just the tip of the iceberg. When Arcstone is engaged to value equity securities where secondary sales have occurred (or are contemplated), we take a close look at the facts and circumstances surrounding the transactions themselves. Some of the factors we consider are identified below along with their relevance to fair market value:
- If preferred stock was sold in the transaction, how do
the rights and preferences of the preferred compare
to the common?
- Do the shares sold carry with them information rights?
- Voting rights?
- Rights or restrictions on future sales?
- Liquidation preferences?
Proximity of Timing:
- Have material events occurred since the transaction that might have altered the company’s fair market value?
- How many transactions took place?
- Between how many buyers and sellers?
- How many shares traded hands?
- What percentage of the fully diluted equity capitalization
of the company does that represent?
- Was there a balance between supply of shares for sale and demand from buyers?
Defining Market Efficiency
Together, the above factors help to describe the efficiency of the marketplace at the time of the transaction and for the specific equity securities in question. When a market is efficient, it can be stated that the price achieved in a transaction was: In other words, in an efficient market, the ultimate price more closely approximates fair market value. But are platforms such as SecondMarket really efficient, or is it better said that they enhance the efficiency of the market? Currently, we might say they are more efficient than transactions occurring outside the platform; yet, they do not achieve the efficiency characterized by public securities trading on the NASDAQ or the NYSE. Thus an argument could be made that the prices achieved in secondary market transactions are not reliable indicators of fair market value for 409A purposes. However, each transaction is executed under different circumstances, so no broad-based rule of thumb may reasonably be applied.
As secondary market transactions begin to more profoundly exhibit the qualities of an efficient market, such transactions will be more readily viewed as indicative of fair market value. Put simply, we hold that increases in similarity, proximity, volume, supply/demand balance, participants, information quality, information symmetry, and sophistication increase the relevance of the price obtained in a given transaction to fair market value.
Careful Consideration Required
For the foreseeable future, valuation analysts must closely analyze transactions to understand the essence of how and why they transpired – before opining on their impact on fair market value. Companies involved in significant secondary market activity should consider actively incorporating such activity in their periodic 409A valuation updates. Even so, for the reasons stated above, it is quite likely that the valuation arrived at
through fundamental analysis will not be equal to the price obtained in secondary transactions.
Bo Brustkern is Founder and Managing Director of Arcstone Par tners, a nationally recognized business valuation boutique. Mr. Brustkern is an executive committee member of the Fair Value Forum based in Silicon Valley and is a member of the Appraisal Issues Task Force based in Herndon, Virginia. Prior to founding Arcstone, Mr. Brustkern was a venture capital and private equity investor for over seven years. He earned an MBA from the Anderson School at UCLA, where he was a Deutchsman Venture Fellow, and a BA from Dar tmouth College.