The Impact of Exchanges on Private Company 409A Valuations
Summary analysis finding that tax-deferred exchanges do not trigger the need for a new 409A valuation
The Concern Over Secondaries and 409A Valuations
Since the earliest days of secondary trading platforms for venture-backed, private companies – e.g., SharesPost, Nasdaq Private Market, etc. - there has been concern about the potential impact of secondary sales on an issuer’s then-current 409A valuation. The nightmare scenario from an issuer’s perspective is each secondary sale rendering the then-current valuation report no longer reliable for purposes of setting the strike price on employee stock options.
Having to get a new 409A report on the heels of each secondary sale would be unwieldy and would negatively impact an issuer’s ability to attract and retain talent due to: (i) generally higher strike prices (making the options less economically attractive relatively speaking), and (ii) extended timeframes for the options to be formally granted by the Board (as typically updated 409As take several weeks to complete).
Factors Suggesting Secondaries May Trigger the Need to Update the 409A Valuation
As a rule of thumb, a new 409A valuation is required if a “material event” occurred following the ‘as of’ date of the last report. Continued reliance on a valuation prepared prior to a material event is not considered reasonable. While there is no bright-line rule as to what constitutes a material event, generally the receipt of a term sheet for a significant financing, M&A or other material, revenue-producing agreement (which was not considered in the existing valuation analysis) would trigger a well-advised board to consider obtaining a new report.
Though there is less clarity as to exactly what type of secondary sales should be deemed a material event, the IRS issued technical guidance in 2018. Factors the IRS indicated that a board should consider for purposes of determining whether a secondary transaction would trigger a new valuation analysis include the following:
- What were the key objective of the parties to the transaction (to the extent that it can be gleaned from the transaction process)?
- Is the transaction more of a one-off transaction or part of a consistent, programmatic trading program administered by the company?
- Are the shares being purchased by (or on behalf of) the company or third-party investors? If third-party investors, are they existing investors in the company or new investors? If new investors, are they sophisticated investors or price-takers?
- What level of involvement has the company had in the transaction? Did it provide detailed diligence to the investors or otherwise participate in the negotiation, particularly with respect to the price?
- How many buyers/sellers are involved in the transaction?
- Whether there is sufficient secondary trading in the issuer’s securities such that the Board should reconsider the discount for lack of marketability applied to the valuation.
In short, secondary sale transactions that do not carry the indicia of arm’s length financing transactions should not, absent other extenuating circumstances, automatically trigger the requirement to obtain an updated valuation.
Guidance Implies Collective Exchanges do Not Trigger Need for New 409A Valuation
The Collective Exchange Fund, founded by industry veterans, enables a shareholder to exchange some of their stock for an interest in a diversified pool of equities and other assets without triggering a capital gain tax. Generally, an exchange into the Exchange Fund is done primarily for the purpose of reducing the exchanger’s financial risk by trading single stock risk for an interest in a diversified portfolio on a tax advantaged basis. For over-concentrated employees of high-risk, private growth companies, this solution can be part of a highly prudent financial plan.
The structure of Collective Liquidity’s equity exchanges and the intent of the parties are clearly distinguishable from the factors mentioned above for the following reasons:
- Unlike sellers in ordinary secondary transactions, the exchanger is seeking to reduce financial risk through diversification in a tax advantaged manner. Unlike the typical cash buyer, the Exchange Fund is seeking to build a broadly diversified portfolio of 100 leading private growth companies.
- Each exchange into the fund is negotiated separately at prices that change daily. Collective’s exchanges are not part of a company sponsored liquidity program and, other than to process the transfer of shares, the company does not participate in or otherwise administer the transaction.
- Other than holding an immaterial percentage of a company’s shares, Collective is not affiliated with the company or its existing investors. Collective does not hold contractual information rights or typically receive more than summary financial information from companies. Collective does not conduct due diligence of a kind typically done by venture capital firms but is instead a price taker leveraging a proprietary algorithm to price its exchanges.
- Companies are not involved in Collective exchanges (other than to process the share transfers). They do not participate in the negotiation between the fund and the exchanger and do not make suggestions to Collective as to the pricing of transactions.
- Each exchange into the Exchange Fund is a one-off transaction with a single seller/exchanger. Collective’s pricing changes daily so the pricing used in one exchange will be different than any other.
- Exchanges into the Collective Exchange Fund do not occur with sufficient regularity, predictability, or frequency to have a material impact on the overall marketability of a private company’s shares.
Issuers should feel comfortable that exchanges of shares into the Collective Exchange Fund do not trigger a need to reset the company’s existing 409A valuation. Collective’s one-off exchanges are distinguishable from typical secondary market transactions in that they are not for cash consideration, the seller’s intent is to de-risk their holdings using a tax advantaged wealth management solution, the buyer’s intent is to build a portfolio of 100 private growth companies, the company is not involved and Collective is neither affiliated with the company nor privy to detailed financial information nor conducting substantive due diligence on the company.