Source: https://www.teknosassociates.com/three-common-stock-transactions-that-may-affect-your-irc-409a-valuation/
Timestamp: 2019-04-24 10:05:13+00:00

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In the past, common stockholders had to wait for a company to complete an IPO or to be acquired in order to sell their shares. But as the market continues to evolve, new sources of liquidity have emerged for common stockholders, including purchases by venture capital firms or sales on secondary exchanges.
Today, with these new paths to liquidity, it is not uncommon for founders and other employees to have an opportunity to sell some of their common stock much earlier in the life of a company. While this is great for the individuals who obtain liquidity, it can have an undesired effect on the value at which the company prices its stock options because of tax and accounting regulations.
So, when does a common stock sale have a direct effect on a company’s IRC §409A valuation? Let’s consider several different scenarios: a direct sale of common stock as part of a preferred stock financing, a direct sale of common stock to an outsider in a one-time transaction, and indirect sales of common stock through a secondary market in multiple transactions. In each case, we will share the guidance from the AICPA’s recently updated Value of Privately-Held-Company Equity Securities Issued as Compensation (the Valuation Guide) and from Teknos’ own experience in producing hundreds of these valuation reports every year.
As most of our readers know, tax regulation (IRC §409A) requires that a company set the strike price of its stock options at or above the fair market value of the shares of common stock into which the options are exercisable. If the common stock is undervalued and the strike price is set too low, there are substantial tax penalties applied to both the option recipient and the issuing company. The solution to this is to obtain periodic independent appraisals (commonly called IRC §409A valuation reports) and follow the valuation guidance in them. See our previous articles: Why Is Our Stock Option Price So High? and Think That the IRS Doesn’t Care About IRC §409A? Think Again.
And, as many of our readers also know, an accounting standard (FASB ASC 820 fka FAS 157) requires that a valuation report consider the valuation implications of any transaction in the securities of the company being valued. In fact, the accounting standard requires that the appraiser consider giving precedence to a value based on a stock transaction over a value derived by any other method. This means that a preferred stock financing or a common stock sale often – although not always—must trump a discounted cash flow analysis or a comparison to public companies or any other approach used to estimate value.
In some later stage financings, investors offer to purchase common stock in addition to the preferred stock in which they are investing. The investors may do this because they want to own a larger percentage of the company, but the company or its existing investors are unwilling to accept more dilution and/or add more liquidation preferences. Or the investors may do this because some of the founders have expressed a desire for liquidity.
The Valuation Guide states that “these situations require careful analysis of the negotiation dynamics to understand the investor motivations and the implications for the fair value of the common stock.” In particular, as appraisers we are required to examine whether the investor had strategic reasons to pay up for the common stock (e.g. to reach an ownership target or some other goal) or the company had strategic reasons to accept the transaction (e.g. the founders “still exert influence over the company” and accepted a deal that is dilutive to the other shareholders to obtain liquidity for themselves).
We need to consider the relative prices and proportions of preferred stock and common stock in the total deal. Was the common stock purchased at a discount to the preferred stock price? Was the common stock 2% or 25% of the total deal? The transaction will be reviewed in entirety, but often the larger the difference between the common stock and preferred stock prices and the lower the amount of common stock in the total deal, the less influence that the common stock transactions will have on the IRC §409A value.
But what about an outsider who is not purchasing common stock as a part of a preferred stock investment? That investor has not had the benefit of a usual and customary due diligence review. Once again the Valuation Guide directs us to inquire into the facts and circumstances of the transaction to determine whether the common stock transaction is a reliable source of value information.
Were the buyer and seller independent of one another and the company? Were the buyer and seller willing? And were the buyer and seller informed about the company?
In our valuation work, we see transactions in which the seller was forced to sell; for example, because of divorce or unemployment or a need to repay a loan. And in our work we also see transactions in which the buyer or the seller (or both) knew little about the company’s financial condition and prospects; for example the seller has not worked at the company for more than a year or is very junior or the buyer has seen only the company’s website or unsupported news stories.
In these and other cases, we are not required to place much – or even any – weight on the transactions. However, we are expected to note the transactions in our valuation report. And, as with common stock transactions which are part of a preferred stock financing, we need to examine whether the common stock sale was a one-time event or repeated and whether it was open to only a few common stockholders or to a broad cross-section of employees. Repeated or broad common stock purchases may “provide a strong indication of fair value” or, at the very least, may provide an argument against using a large discount for lack of marketability.
In the last decade a number of secondary markets have sprung up to trade the securities of privately-held companies. These include: SecondMarket, SharesPost, OPUS-5, 144a-Plus, and others. Even NASDAQ has jumped in, announcing the formation of a joint-venture with SharesPost. Along with an increase in the number of exchanges, there have been parallel increases in the number of investors participating, in the number of company securities being traded, and in the sheer volume of shares transacted.
There was a considerable amount of press attention paid to secondary market trading in the common stock of Facebook before its IPO: Fortune reported that there were transactions between $42 and $44 per share in April 2012; the IPO was priced in May at $38 per share; the price subsequently fell to $27 per share a week later and $17 per share in September.
FASB ASC 820 defines an “orderly transaction” as one “that assumes exposure to the market for a period … to allow for marketing activities that are usual and customary for transactions involving such assets.” In a preferred stock financing, that usually means that the venture capital investors had an opportunity to discuss the company’s plans with management and to perform a due diligence review.
Facts which indicate that a transaction was not orderly include the sort of forced sales we discussed earlier, plus sales for which there was not adequate “market exposure” (not enough time to allow for marketing activities) or sales in which the asset was marketed to only a single buyer. The fact that a transaction price is an “outlier when compared with other recent transactions” also may indicate that it was not orderly.
The Valuation Guide directs us to place more weight on orderly transactions and little weight on transactions that are not orderly. The amount of weight is to vary with: the volume of the transaction, the comparability of the asset, and the proximity of the date of the transaction.
In particular, the Valuation Guide recommends that we consider: the timing of the transaction data (often there is a lengthy delay because the company and/or existing investors are given time to exercise a right of first refusal); whether the secondary market has a large enough pool of accredited buyers; the amount of financial information available to the seller and the buyer; holding, hedging, and transaction costs; and the pattern of trades.
The pattern of trades can be relevant in this analysis. The Valuation Guide distinguishes between transactions involving “only one or two investors who want to acquire a certain percentage ownership” and transactions involving “many investors and many sellers, and the pattern of bidding reflects a reasonably low disparity between the lowest and highest bids among the winning bidders.” The former may not reflect a “repeatable price,” but the latter may.
As with direct purchases of common stock, repeated common stock purchases on a secondary exchange may “provide a strong indication of fair value” or, at the very least, may provide an argument for reducing the discount for lack of marketability.
Common stock transactions in privately-held companies are happening more often and for larger sums than ever before. Some of these transactions can have an effect on the valuation for compliance with IRC §409A and financial reporting under FASB ASC 718.
Whether a common stock transaction has an effect on the value of common stock depends on the facts and circumstances surrounding it. Transactions involving related parties, transactions involving strategic factors, transactions involving financial hardship, and transactions involving limited financial information may not have much effect on IRC §409A value. However, other factors such as repeated transactions or transactions involving a broad range of buyers and/or sellers can have a counterbalancing effect. In any case, all transactions in common stock should be disclosed to the valuation firm and will have to be considered in its analysis.
It is worth noting that a transaction in common stock may require that the company immediately change the strike price it uses when issuing stock options. Under ordinary circumstances, IRC §409A allows a company to rely on a valuation report until the earlier of 12 months from the valuation date or a material change at the company. However, a common stock transaction may be information that would “materially affect the value of the corporation” and stock options issued afterward may be priced too low – potentially putting these new option recipients at risk for federal and state penalties and putting the company at risk for payroll tax liabilities and cheap stock accounting charges.
It is a good practice to discuss any common stock transaction with Teknos before it occurs in order to understand its implications on IRC §409A compliance – or, if that is not possible, then at least discuss the common stock transaction after it occurs, but before continuing to use a valuation from a report that predates the stock transaction.
Teknos Associates provides valuation and advisory services for emerging growth companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards to deliver relevant and timely valuation reports and fairness opinions.
Special Note: From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services. However, nothing in this communication may be taken to represent the official position or policy of the IRS. The opinions expressed herein are those only of Teknos Associates.
IRS Circular 230 Disclaimer: Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.
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