Fair Value Update: The Impact of New Guidelines on Secondary Transactions
The updated guidance in Chapter 8 of the American Institute of Certified Public Accountants (AICPA) – “Accounting and Valuation Guide: Valuation of Privately-Held-Company Equity Securities Issued as Compensation,” outlines a framework for using primary and secondary transactions in company securities to assess their impact on estimating the fair value of equity frequently used for 409a valuations and ASC 718 for stock-based compensation. According to the guidance, a primary transaction is defined as the original issuance of an equity interest or debt instrument by a privately held company directly to an investor, excluding public offerings. These transactions can involve both existing and new investors.
A secondary transaction involves the purchase or sale of an equity interest or debt instrument that is subsequent to the original issuance. These transactions can occur privately between parties or through a secondary exchange. Unlike public market transactions, the securities involved in secondary transactions are not public, typically involving accredited investors, and the issuers are not subject to public company reporting requirements. Additionally, purchases of equity interests or debt instruments by the company or its related parties from employees are also considered secondary transactions under this guidance.
Companies conduct secondary transactions involving equity securities tied to compensation awards through various methods, such as company repurchases, investor tender offers, company-facilitated deals, direct shareholder transactions, and secondary marketplaces.
What Is Fair Value?
Per FASB ASC 820, fair value (FV) is defined as the price that would be received in an orderly transaction between market participants in the principal or most advantageous market at the measurement date. AICPA defines the principal market as the market with the greatest volume and level of activity for the asset or liability being measured at fair value.
How Prices of These Secondary Transactions Interact With Fair Value
In performing a 409a valuation, if a secondary transaction for an identical security occurs in the principal market on the measurement date, and no other elements are involved, the transaction price will represent the security’s fair value. In this scenario, a 100% weightage should be applied to the fair value of the respective security. ASC 820-10-20 defines a principal market as “the market with the greatest volume and level of activity for the asset or liability.” However, “market” is not defined in FASB ASC 820, so a one-off or transaction that included other factors (e.g., intent to compensate) might not be the principal market.
When a secondary transaction for a security is observable but not conducted in an active principal market, applying a 100% weightage is not appropriate. Instead, adjustments to the observable price should be made based on the following conditions:
- If evidence indicates that the transaction is not in the active principal market, place little, if any, weight on the value indicated by the transaction price. Use other approaches or methods for estimating the fair value of the securities.
- If there is insufficient information to conclude whether the transaction is conducted in an active principal market, adjust the transaction price for differences in the features of the security, the characteristics of the market, or the timing, as applicable, as well as for any other elements of the transaction. Then consider the adjusted transaction price when estimating fair value. The section below explains how much weight to place on such transactions.
In summary, it is appropriate for the valuation to consider all relevant indications of value, maximize the use of observable inputs, and make reasonable judgments to estimate the price at which the security (or the underlying security) would transact in an active principal market.
Assessing the Relevance and Weighting of the Secondary Market Transactions
Factors impacting the relevance and weighting of secondary market transactions include:
- Multiple observable transactions within a relevant time frame: If transaction prices are consistent and changes in pricing align with developments at the company or market changes, a higher weightage should be applied. Conversely, if transaction prices are inconsistent and changes in pricing do not align with company developments or market changes, a lower weightage should be applied.
- Information asymmetry: This could be defined as a scenario wherein, the buyers and sellers lacked certain relevant information that market participants in the principal market would typically consider, in such scenarios a lower weightage should be applied.
However, in cases where the buyer and seller had access to information similar to other participants in the principal market, a higher weightage should be applied. - Significance of transaction:If the sale represents a substantive transaction in terms of volume or capital, a higher weightage should be applied. Conversely, if the transaction was de minimis to both parties, a lower weightage should be applied.
- Principal market: This market is considered the most relevant for determining fair value because it typically provides the best price due to its higher transaction volume. If the sale occurred in the principal market, a higher weightage should be applied. Conversely, a lower weightage should be applied if the sale did not occur in the principal market.
- Form of transaction: If the transaction was standalone and specifically for capital gain purposes, with no intent to compensate, a higher weightage should be applied. Conversely, if the transaction involved other arrangements and an intent to compensate, a lower weightage should be applied.
- Proximity of the transaction and the measurement date: If the transaction was recent and there have been no significant changes in the company or market since the transaction, a higher weightage should be applied. Conversely, if there have been significant changes in the company or market between the transaction and the measurement date, a lower weightage should be applied.
- Other relevant recent transactions besides secondary transaction: If another relevant recent transaction has an observable price and can reliably quantify the security under consideration, weight may be applied to this transaction. Additionally, if it is possible to calibrate to the original transaction price and then adjust for market and company-specific changes between the transaction and the measurement date, more weight should be applied for this indication.
However, if there is a significant difference between the securities issued and the underlying stock-based compensation, or if there is a significant difference in the information available to both parties, lower weight should be applied to this indication. - Degree of confidence in the unobservable input: A lower weighting should be considered for secondaries in cases where the company is mature, with predictable cash flows, or the company has sufficient data and processes in place to prepare a reliable forecast.
However, if the company is early stage, still doing research and development, yet to have product revenue, or does not have sufficient data to build robust forecast, lower weightage should be applied to other value indicators.
Key Takeaways
As previously discussed, when conducting a 409a valuation, the weight given to secondary transaction prices versus other fair value indicators will depend on the specific facts and circumstances. However, we may observe a higher weightage on secondary transaction prices compared to previous practices because of this updated guidance. In general, this revision in the guidance offers more precise valuations when secondary transactions have taken place in the recent past, typically resulting in higher per share values.
Authors: Uday Singh | [email protected] and Gaurav Kumar | [email protected]