The expression “You can’t have your cake and eat it too” is a common figure of speech that has been in use since the 1500’s. It essentially illustrates the concept of trade-offs – that is, one cannot both eat their cake and also retain possession of it – once the cake is eaten, it is gone. I think most of us have felt the desire to achieve two attractive outcomes that both can’t occur simultaneously.
Companies that sponsor, or are involved in, secondary transactions of their common stock may relate to this expression. In the hundreds of valuations I perform each year, one of the most common questions I am asked is how a secondary sale will impact a company’s fair market value valuation performed to comply with Internal Revenue Code (“IRC”) section 409a (“409a”). Typically, a valuation performed for 409a compliance purposes is meant to ascertain true fair market value and does not take into consideration the various reasons entities may pay a premium in a secondary transaction. At the same time, executives and management would like to understandably get as healthy of a price for their shares as possible in a secondary transaction, which may be higher than true fair market value. If a secondary transaction happens at a high price-per-share, does that pull the 409a value for the company up? Is there a way to get a high sales price for shares in a secondary transaction while also keeping the 409a value lower?
Because a secondary transaction technically meets the definition of fair market value, which is defined as “the price at which an asset 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”, it is always something that will need to at least be considered in a valuation analysis. However, the extent to which it needs to be weighted, or if it even needs to be weighted at all, depends greatly on the facts and circumstances related to the transaction. The following matrix, while not comprehensive, illustrates some of the factors that my firm considers when making this decision:
As can be seen in this matrix, there are a number of factors and considerations for each factor. No one factor would ultimately decide whether or not a secondary transaction will need to be weighted in a valuation for 409a purposes. Rather, we look wholistically at all factors for each transaction and make a judgment call on whether or not it would be appropriate to weight the transaction, and if so, what weighting it should receive.
In returning to the original question of this article, is it possible to have your cake and eat it too? As it relates to secondary transactions, the answer is, it depends (I know, this seems to always be the answer). However, if most factors in the matrix above are at the “not likely to be weighted” end of the spectrum, it may be possible to both get a high sales price for shares while also keeping the 409a value lower.
Note: In this blog post we focus purely on fair market value impacts of secondary transactions. Also critical are the tax implications for selling shareholders and even the company (depending on the structure of the proposed transaction and the level of involvement of the company). These should be considered and discussed with competent tax advisors.