24 Apr Understanding Secondary Sales
We frequently field questions from startup executives who are considering selling Common Shares in Secondary Transactions. Exchanges do exist to trade equity securities in private companies are traded, but the most common Secondary Sales of Common Stock we review come in the following forms:
1. Direct sale of Common stock to new investors
2. Direct sale of Common stock held by founders or employees to existing investors
3. Common stock transactions tied to current or subsequent preferred equity financing rounds.
Scenarios 2 and 3 are most common when Companies are attracting the attention of Early Stage investors who want to claim a larger portion of the Company’s Equity than they are able to through purchase of Preferred Shares alone. With the Preferred rights and preferences secured, investors ask Companies to sell Common as well as Preferred Shares at the Preferred Price in order to achieve their target ownership of the Company.
While the prospect of liquidity for Founders and early employees is certainly attractive, this scenario must be carefully considered, as there will be an impact on the Company’s 409a valuation if it is determined that a Market transaction in Common Shares has occurred. This could mean that future options exercise prices will be higher than they should be, and the Company will be challenged to attract and retain top talent.
When we review Secondary Transactions, we seek to determine if the transaction is an indicator of Fair Market Value for the Common Stock. The IRS defined Fair Market Value as follows:
Fair Market Value is the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
The facts and circumstances around the transaction are carefully examined to determine if the fair market elements are in place. We look at whether the transaction was “orderly”, if is any indication the transaction was in a “forced” or liquidation” sale.
There is no clear definition of an “orderly” transaction, but it is reasonable to infer that if the Company or it’s investors participate in the transaction, the transaction was orderly. Contrast this with transactions that may happen outside of the Company’s influence (shares traded by a third party without the Company’s knowledge or input). In most cases, Common shares can’t be sold without Board approval, this it is very rare that a transaction could be considered “disorderly”.
It’s also critical to determine if the Common Stock sold in the transaction is identical to the Common Stock that is the underlying security for Option holders. Frequently, investors will require that a new “Common Stock” security is created with rights and preferences that the class of Common issued to option holders do not enjoy.
When we review Secondary Sales of Common to determine what weight it should have in the final determination of Fair Market Value, we consider the following:
- Timing of transaction data: Was the Common Sale proximate in time to a Preferred Equity Issuance?
- Frequency: Are the multiple instances were Common Stock was sold?
- Volume: How much stock was sold?
- Who bought the Shares:
- Sufficient sophisticated bidders: Was sufficient financial and company information available to the buyers to support a determination of Fair Market Value?
- Did the Company Buy the shares? Were they motivated by factors unrelated to the intrinsic value of Common Stock?
- Who sold the Shares? If it’s the Company or Founders, it can’t be argued that the sellers don’t have full knowledge of the value of the shares.
Investors or Employees that hold Common Shares are typically required to receive Board approval before selling shares, so if the transactions are approved, that’s an endorsement of the transaction valuation and it should have weight. The Board has the best insight into the future value of the Company and also is bound by fiduciary responsibility to the Company to establish the value of the shares.
In the rare case that Employees or Investors sold Common Shares outside the Company’s knowledge, the circumstances and motivation behind the sale would be carefully examined to determine if the transaction can be considered “Orderly”.
When Management agrees to sell Common Stock, and the transaction meets the definition of a FMV transaction it must be given weight.
The information provided here is for educational purposes only and is not intended as tax advice. Oxford Valuation Partners does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Oxford Valuation Partners assumes no responsibility for the tax consequences to any investor of any transaction.