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Three tips for valuations related to secondary sales

05 September, 2017

Sundar Ramamurthy
TMT Deals Principal, PwC US
Lucas Collins
Deals Director, PwC US

Liquidity is a hot topic for executives at private companies who are looking for ways to liquidate holdings in order to access cash in the near term. While the secondary market is a known entity for private company equity sales, it comes with a lack of transparency and perplexing intricacies that could have a big impact on the company and its shareholders.

Because of this complexity, we recently released a paper titled, Private Company Liquidity: CEO and CFO Considerations: A Guide to Secondary Transactions. It provides a deep dive into several key factors for secondary transactions, including valuation, accounting and tax considerations.

Valuation is a priority

Valuation is typically one of the first questions management will address related to the secondary transactions. In addition to performing regular ongoing valuations for tax and financial reporting purposes, companies might want to perform a valuation to create a liquidity program to provide an exit for employees or raise money in the primary market from VCs.

As it gets closer to an IPO, a company’s stock will generally continue to trend up (as shown on the timeline below). Secondary sales influence the valuations around 409A and that’s why it is critical for management to estimate the fair value of options correctly, especially when the company is nearing an IPO date. You don’t want to create a difference between the 409A and ASC 718 valuation, which could occur if auditors do not agree with your fair value assessment.

Three tips for secondary sales valuations

Here are three key considerations when placing a weighting on secondary sales:

  1. What’s my motivation? – There are several reasons why secondary transactions occur. It could be a mechanism to provide key founders and employees liquidity in advance of an IPO. Or it could be a more systematic re-purchase by the company to provide an exit for employees and limit the number of new shareholders. Or there might be small investors speculating and buying shares from employees based on recent news. The motivation of the buyer/seller will often determine the relevance of a secondary sale on the fair market value of the stock, which is the standard of value for 409A.
  2. Size matters – Larger transactions tend to carry more weighting as they naturally carry more diligence and access to company data. Similarly, a higher number of trades by multiple independent third parties would likely provide greater support for fair value.
  3. Timing is everything – Valuation timing is typically based on growth rate, so quarterly valuations are common for strong growth companies. Timing is particularly important for companies close to an IPO. First because stock price tends to ramp up fairly quickly in the months preceding the event and second because there tends to be a rise in secondary sales around this time. As companies issue options and perform a 409A valuation, a secondary sale that happened six months earlier may no longer be indicative of the current value. The weighting placed on secondary sales should be balanced based on the closeness of the sale to the valuation date.