How does founder liquidity impact the 409a price?
I regularly receive phone calls from entrepreneurs, who are in discussions with investors, asking how an early partial cash-out will impact the price of common stock in their next common stock valuation (think 409a valuation). Oft times, the institutional venture capitalist (VC) is willing to either purchase founder common stock directly from the entrepreneur(s) (“Secondary Purchase”) or allow the company to use proceeds from the simultaneous preferred stock investment to redeem the shares from the entrepreneur(s) (“Redemption”). In both structures, there are some considerations to understand how I would evaluate the impact, if any, the Secondary Purchase or Redemption would have on the price of common stock in the next 409a valuation. While this list is not an exhaustive, I hope it does provide some insight into how I would evaluate the impact on a common stock valuation.
How Large is(are) the Early Liquidity Transaction(s)?
The greater the number of shares of common stock that exchange hands, the more likely it will have a material impact on the capitalization table and therefore will influence the price of common stock in the next 409a valuation. Conversely, if the number of common shares transacted is small in comparison to the simultaneous preferred stock investment and to the total cap table, then there is a strong argument that the transaction is not material.
The next question one may logically ask is, “what constitutes small”? It’s tough to provide a definitive guideline. Certainly, less than 1% of the total cap table is small. If the number of shares transacted represents 2% to 4% of the total cap table, then I think that is small, but is bordering on “large”. Anything greater than 5% is certainly large.
How Many are Participating in the Transaction(s)?
If all common stock holders are given the opportunity to participate in the Secondary Purchase or Redemption (i.e. through a broad marketed offering such as a tender offer), then the price transacted could have an impact on the price of common stock concluded in the new common stock valuation. Conversely, if the Secondary Purchase or Redemption is limited to a few individuals, then that indicates that the Redemption or Purchase may have been influenced by personal situations, de-risking, a requirement to get the deal done or some other qualitative, strategic reason that was not necessarily tied to the price.
Is this an On-going Liquidity Program or One-Off Transaction?
Is the Secondary Purchase or Redemption part of an on-going liquidity program or is this a one-time event with no plans to have another Secondary Purchase or Redemption in the future? If it is part of an on-going liquidity program to employees, option holders, investors and other shareholders, then that signals to me that this transaction should strongly be considered in the 409a valuation as it relates to the price conclusion and / or the marketability discount. If the Secondary Purchase or Redemption is one-off in nature, meaning that it was negotiated as part of the preferred stock investment, then that means to me that this Secondary Purchase or Redemption was more closely tied to the preferred stock investment and would have less influence on the 409a valuation common stock price.
How Was Price Determined and How Does it Compare to the Most Recent Preferred Equity Financing?
This is the elephant in the room. At what price should common stock be purchased in a secondary transaction or redeemed by the company? I have seen prices at exactly the same as the contemporaneous preferred equity price and I have seen common stock transactions at the value concluded in the next 409a valuation. If the transacted price is at the same price as the preferred stock investment, then how can one argue that a security with preferred liquidation rights and preferred dividend rights hold the same economic value as common stock that does not hold those same rights? If they were valued the same, then an investor wouldn’t require those additional economic rights. Furthermore, many preferred securities contain features that common stock securities do not possess such as right of first refusal (ROFR), right of first offer (ROFO), anti-dilution, veto rights and more. To me, if the price of common stock in the Secondary Purchase or Redemption is the same or close to the price of the simultaneously transacted preferred stock price, then that signals that the buyer overpaid for common stock for strategic reasons.
In evaluating Secondary Purchases and Redemptions in the context of early liquidity to founders, I have found that the price of common stock is typically 80% to 100% of the most recent price of preferred stock. In many of the 409a valuations that I perform on early-stage, high-growth companies, and that I have seen from competitors, the common stock value is at 25% to 60% of the most recent round of preferred stock. So clearly, investors or the company are overpaying for common stock and therefore that overpayment needs to be understood in context of the 409a valuation.
Who are the Parties to the Transaction(s) and What Information do they Possess?
The last attribute I evaluate is understanding the parties to the Secondary Purchase or Redemption and what information they possess at the time of the transaction. Those who possess “insider information” because the buyers and sellers are members of the board of directors, are key executives or have a view on the company that a typical investor may not have, would clearly pay a different price then those who do not have such information. Likewise, those that do have access to minimal or zero information (such as some employees) and / or who do not possess the skills to evaluate the pricing of the Secondary Purchase or Redemption may be willing to buy or sell at a value that a party would transact had they had a reasonable data set and had skills to evaluate their holdings. As such, one factor of how much of the Secondary Purchase or Redemption is considered in the 409a valuation will depend upon the parties and the level of information they have at the time of the transaction.
As you can see, there are many factors to consider when determining if a contemplated Secondary Purchase or Redemption should influence the value of common stock in the next 409a valuation. While this area is not clear-cut, I am hopeful that this article can provide some framework for you to understand how we would analyze those transactions.