Secondary market liquidity and fair market value

This article was coauthored by Andres Trujillo, CartaX.

The secondary market for private stock offers companies the opportunity to unlock the value of equity for their shareholders, whether founders, employees, or early investors. By making private company equity liquid before the company goes public, shareholders can realize the value of their assets as a company grows.

The secondary market for private stock functions quite differently from the public stock market. With no centralized market infrastructure, matching supply and demand comes with risk, overhead, and a myriad of limitations including transfer restrictions, little to no price transparency, less efficient price discovery, extended settlement cycles (upwards of two to four weeks), and high administrative and operational burdens on companies. As more and more capital is piling into the most attractive companies later and later into their lifecycle, the typical catalysts for going public are diminishing. This means that for early employees and investors, the time to exit is extending and as a result, pre-exit liquidity is increasingly important. Yet, its forms have remained largely unchanged for decades.

Today, private market secondaries take two forms:

1. Structured liquidity programs, such as tender offers (company buybacks or third-party transactions), block sales, auctions, options repricing/RSUs
2. Direct stock transactions, which are supply driven events that are initiated by a broker or a company’s network of current and former employee stockholders 

Tender offers are the most common type of issuer-approved secondary. These are issuer-sponsored, episodic events initiated by the company, with one or multiple goals in mind like cleaning up the cap table of former employees and early investors, mitigating share dilution in connection with a large fundraising round, or supporting employee retention and talent acquisition goals in a highly competitive environment.

Since 2017, Carta has been partnering with companies seeking liquidity, delivering a solution that simplifies the execution of tender offers and company repurchases. Carta is leading the next evolution in private market liquidity with the launch of CartaX in the first quarter of 2021. With CartaX, issuers will be able to create a permissioned marketplace for their equity, offering them the ability to set transaction configurations, including transaction frequency, eligible participants, and eligible securities, while maintaining visibility over price formation throughout the liquidity event. As companies consider offering liquidity through CartaX on the path to IPO, they need to understand their company’s valuation and the potential positive and negative implications of a secondary stock transaction to that valuation.

Since 2016, the Carta Valuation Team has completed over 19,000 valuations for tax compliance under IRC 409A and financial reporting purposes under ASC 718. The team has assessed a wide array of companies, varying from very early-stage businesses to late-stage pre-IPO companies. In 2020, our team expects to complete over 9,000 valuations, including over 1,200 companies with $50M or greater in total revenue, over 900 customers that are currently audited, and over 300 customers that are being audited by Big 4 accounting firms this year. 

Surprisingly, the most frequent question asked to the Carta Valuation Team is not related to the sophistication of the calculations in our models or how we assess the risk of a business we’re assessing, but rather how secondary stock transactions impact the value of their equity under IRC 409A and ASC 718. In the past two years, the Carta Valuation Team has assessed 400+ secondary stock transactions, ranging from the most basic tender offers to direct stock transactions to distressed stock sales, using guidance from the AICPA.¹  

One type of secondary transaction offered on CartaX is the Carta Cross, a proprietary auction-based transaction that can recur monthly, quarterly, or annually at the issuer’s discretion. The Carta Cross is designed for efficient auction-driven price discovery, allowing an issuer’s equity holders to sell to investors permissioned by the issuer to participate in the auction. 

The valuation work completed by 409A analysts in advance of a tender offer, auction, or other secondary transaction takes certain transaction characteristics into consideration. These characteristics are evaluated against the company for which they are completing the valuation; the analyst will then apply a weighting to the characteristics based on company-specific data. To understand the potential impact of company-controllable factors on this weighting, we’ve assigned them by level, split between high and medium impact:

Higher impact transaction characteristic levers

• Recurring auctions – Less frequent Carta Cross transactions indicate lower weighting
• Restrictions on who can sell – Increased buyer and seller restrictions (i.e., share class, role, tenure) indicate lower weighting
• Purpose of the auction – If the primary purpose of the auction was to provide liquidity for employees to improve recruiting and retention or for other non-economic reasons,  indicate lower weightings
• Exit timeline – If the availability of CartaX auctions has delayed the clients plans for an exit, indicate lower weightings

Medium impact transaction characteristic levers 

• Size of the auction – Fewer shares transacted as a % of the total capitalization indicate lower weighting
• Buy side engagement – More participants in the auction indicate higher weighting
• Access to company disclosures – Limited access to company information indicates lower weighting

Summary of transaction characteristic levers and impacts

Now that we have an understanding of the levers and their influence on weightings, let’s look at examples of heavily weighted vs. lightly weighted transactions: 

Examples of transactions

Heavily weighted: Meetly loves CartaX and wants to take full advantage of the platform in advance of their planned IPO in two years. The company has set up quarterly recurring auctions in which any shareholder is allowed to participate. Their most recent auction had over 100 buyers and sellers, with more than 10% of all shares outstanding being transacted.

Lightly weighted: Meetly is planning to complete an IPO in three years, in part to provide liquidity to early employees. These employees, however, need liquidity sooner than three years, so Meetly has a one-off auction open only to these early employees. Employees sell some of their shares, which make up less than 2% of all shares outstanding, and Meetly decides to delay their IPO timeline to four years.

As issuers consider programmatic liquidity for their equity holders on CartaX, we recognize that they may have questions about valuation and disclosures. The Carta Cross features symmetric disclosure in the context of the auction and standardized documents (approved by the issuer) and the CartaX team can refer issuers to the Carta Valuations team for expert advice on evaluating the impact of a Carta Cross on an issuer’s valuation. Each company’s transaction structure on CartaX may have unique characteristics leading to varying effects of the transactions on a company’s 409A valuation; however, the benefits of a CartaX listing, such as employee recruitment and retention, more competitive price discovery, and scalable liquidity, can outweigh any potential 409A valuation impact. 

As companies evaluate listing on CartaX, the Carta Valuations team is available to consult on 409A valuations while the CartaX team is available to consult on all aspects of the listing process and auction mechanics. Contact listings@cartacapitalmarkets.com to learn more about listing on CartaX.

 ¹American Institute of CPAs. The AICPA has published guidelines specifically for 409A valuations, entitled Valuation of Privately Held Company Equity Securities Issued as Compensation – Accounting and Valuation Guide as well as a Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies – Accounting and Valuation Guide—two valuable guides we leveraged when developing our framework.

© 2021 Carta Capital Markets, LLC (“CCMX”). All Rights Reserved. CCMX Member FINRA/SIPC. CCMX undertakes no obligation to update content herein. No business, investment, tax, or legal advice is provided by CCMX. Potential investors are advised to conduct their own due diligence and consult with their tax, legal, and financial advisors with respect to any investment. All securities involve risk and may result in partial or total loss. Investments in private securities are speculative, illiquid, and involve a high degree of risk, including the possible loss of the entire investment. There is no guarantee that a private company will conduct an initial public offering or provide an alternative exit strategy for invested capital. Images are illustrative and may differ from application experience.