Learn everything you need to know about section 409A of the internal revenue code. From what is a 409A valuation to 409A methodologies and process.
This presentation is meant for educational purposes only. Carta does not provide legal, financial or tax advice of any kind, and nothing in this presentation constitutes such advice. If you have any questions with respect to your own legal, financial or tax matters, please consult a professional adviser.
In 2017, it’s widely known that companies are staying private longer. From Palantir declaring that it will never go public to Airbnb raising billions of dollars from large private equity firms. When staying private, companies need to create liquidity for early employees and investors, who don’t want all their wealth tied up in a single asset.
Enter the private tender offer – an increasingly important vehicle for CEOs and CFOs who want to keep employees and investors happy.
So, what is a tender offer, how do you structure a successful tender and what are some common pitfalls? All of this and more will be covered in the FAQ below:
Secondaries and buybacks are simply types of tender offers. A secondary is when investors buy shares from employees (or early investors) and a buyback is when the company itself buys the shares.
However, more recently, the term tender offer has become synonymous for when a company organizes and runs its own secondary rather, than allowing a secondary to take place ad hoc through brokers.
In the past, the secondary market was a bit like the wild west — happening through back channels and oftentimes creating distractions for a company’s own fundraising strategy. Today, more companies are using a Right of First Refusal (ROFR) or a no-sell clause and running their own tender offers on a regular basis to better manage the process.
A) The number one reason companies do tender offers is to allow employees and early investors to cash out. Maybe they want to buy a car or put a down payment on a house. Selling their shares in a tender will give them a lump sum of money quickly.
B) Another common reason for a company to make a tender offer is to accommodate investor demand without diluting your current investors. If new investors want to become a part of a fast-growing company or if an existing investor wants to increase their ownership, a company can run a tender offer rather than issuing new shares and causing dilution.
C) Finally, a company will run a tender offer if they want to clean up and take control of their cap table. If there are former employees or investors who are no longer invested in the company, it would be beneficial to remove them as partial owners. Through a tender offer they can get rid of their shares to new investors who are engaged and excited about your business.
- Discuss if your company has the time, resources and interest to run a tender. Also make sure you have a 409A compliant valuation.
- Find buyer or raise the funds to do a buy back.
- Determine who participates and what are the parameters. Most tender offers have a provision that states if the buyer does not get at least X amount of shares the entire tender is voided and no one buys or sells anything.
- Draft and review tender documents with lawyers
- Get board approval of the buyer and the size of the tender offer.
- Invite people, usually employees, to participate. Provide at least 20 business days for employees to decide if to take part. This usually consists of meetings to inform and education employees on how to sell their shares and the tax consequences.
- Allow time for employees to exercise and sell shares, during this time gather funds to purchase and subsequently sell their shares.
- Close tender window, the buyer has increased their ownership and employees get a lump sum of cash.
4. Why would a company buy back its own stock?
Buybacks are less common than secondaries and are done when a company is flush with cash and wants less outstanding shares. A buyback allows a company to clean up their cap table and gives businesses more shares to distribute in the future to new investors, executive hires, and more.
When performing a buyback it has the opposite effect of dilution. The shares “disappear” giving the remaining stakeholders a higher percentage ownership than they had prior.
The price of a tender is set by what the market is willing to pay. If a hot company is sought after by multiple investors this will drive the price up.
There are a number of indicators that help guide this process, including what price investors paid during previous equity rounds and how much the company has grown since then.
Investors will pay a discount if they are buying common shares from employees rather than preferred shares from investors. While it is far from a rule, a 20% discount for common shares is normal; however, if the company appears close to an IPO then this discount might be lower.
Tender offer costs can vary incredibly. It is also difficult to be sure the costs because of the lack of transparency in private markets. However, there are many factors that can influence the cost of running a tender for a company.
- Broker dealer or intermediaries: They can charge for finders fee, placement fees, transfer fees, etc.
- Lawyers: Both the company and buyer can lawyer up and sometimes the company will have to pick up the tab.
- Tax advisors: Taxing can be so complicated that companies will bring in a specialist.
- International exchanges: If the buyer is international this will drive up the complexity and the cost.
Finally, the size of the tender is probably the most important factor in the cost. The larger the tender and the more money changing hands increases the complexity. There are more people participating in the tender and that will drastically impact the cost.
Software tools, like Carta, are working to reduce the cost of running a tender offer, making them more feasible for smaller companies. When all stakeholders are in one central location it is easy to share documents and track who has signed them. In software, the cap table is a live document that gets updated automatically whenever an employee exercises or sells an option. These perks not only make the tender easier to run but also decrease the cost by limiting amount of time spent having to use and pay lawyers.
First, it costs money.
It not only costs the company’s money to organize the tender but a buyback will directly cost the company money on their balance sheet to buy the shares. While secondaries do not directly cost money, the company will not make money from running the tender either.
Second, it can be hard to manage.
It is a difficult to decide which employees will be allowed to take part. Tenders can be complicated to explain to employees. There is also always the concern that if early employees sell off a lot of their equity they will not have the same incentive to stay with the company.
However, the positives often outweigh the negatives for a company. The challenges and costs associated with tenders are why they are done by mostly C stage and later companies.
Tender offers will always affect the 409A valuation. How much depends on three factors: frequency, size (i.e. how many shares are being bought and sold), and the sophistication of the buyer.
Frequency: As a company does more tender offers, the 409A valuation will start to inch towards the higher tender offer price. Common private shares are discounted because they lack liquidity. It is difficult, if not sometimes impossible, to sell them because there isn’t a market. This makes the shares less valuable and less expensive. If a private company is frequently running tender offers, then they are creating their own market for those shares. The discount on common shares decided by the 409A will decrease as the company runs more tenders. The overall 409A valuation price will therefore increases.
Size: As more shares are bought and sold in a tender, the more impact it will the 409A valuation. Similar to frequency, the more shares bought in a tender offer increases the liquidity and therefore the value
Sophistication of the buyer: The more experienced and qualified the investor leading the tender offer, the more impact it will have on a 409A valuation. Investors choose prices based off industry experience and detailed knowledge of the company. These factors make the tender offer price credible and therefore have a larger impact on 409A valuations.
One of the most common questions we get is, “should I accept a tender offer?” That is a personal decision for you and your family. If you need the money or have been dreaming of buying something expensive then maybe you should sell off some shares for cash.
There is always an element of risk involved if you decide to sell you shares in a tender. The price of the shares could go up. The company might do another tender in a few years and offer more for the shares. However, the company could decrease in value and you would have lost your chance. Think about your goals, what amount of risk you are comfortable with, and make your decision from there.
Private companies have much more control over their tender offers. They can dictate who gets to participate in them and how much they can buy.
When a public company runs a tender offer, they announce their intention to buy shares to the entire marketplace, not just to employees.
Public companies have very different reasons to run tenders than private companies. In public companies, investors and employees can go to the public market to buy and sell shares, unlike private companies.
There are three main reason public companies run tender offers.
A) If they want to convert back to a private company, they will propose an under market value price to buy all their shares back.
B) If an investor offers a tender on shares of a public company, they might be trying to pull a hostile takeover without the company’s knowledge. They will offer a lower price to buy a controlling percentage of shares.
C) Companies will buy back their own stock if they feel their share price is too low. This artificially increases demand, causing the stock price to rise.
Tender offers become more common as companies mature. It has been reported that Uber, Airbnb and Palantir have all run tender offers. SpaceX, Tanium, Docusign and Pinterest have also been reported selling private shares through secondary markets.