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The impact of a secondary transaction on your next 409A valuation is changing

January 6, 2023
Chad Willbur and Jackie Ammon

Private companies need a 409A valuation for tax purposes. They also need a valuation used to calculate stock compensation expense under ASC 718.  For decades, most companies have enlisted a valuations provider to generate a single appraisal to satisfy both 409A and ASC 718 requirements. Consolidating the two helped save time and money.

Now, things are changing. The rapid rise of the market for secondary transactions has caused Carta’s valuations team to question the wisdom of using the same valuation for two different purposes. Carta—the market’s largest provider of valuations—has started advising some companies conducting secondary transactions to use separate valuations for 409A and ASC 718 compliance. This shift in approach is based on two things: existing guidance from the American Institute of Certified Public Accountants (AICPA) that tells appraisers to rely more heavily on implied valuations from secondary transactions for the purposes of ASC 718, and Carta’s belief that the trend of emphasis on secondary deals will continue. 

The price of a recent secondary transaction has always factored into both kinds of valuation appraisals. But treating the two valuations separately can reduce the impact of a secondary deal on a company’s 409A. It removes a major roadblock for companies that might be concerned that a rising 409A valuation would make it harder to attract top talent with stock options. This could significantly impact the private secondary market.

In this post, we’ll examine: 

  • The differences between valuations used for 409A and ASC 718
  • The old model of how a secondary transaction impacts valuation 
  • How and why the model is changing
  • The potential implications of the shift

409A valuations vs. valuations for ASC 718

Both a 409A valuation and a valuation used for ASC 718 assess the value of a company’s common stock. But the regulatory codes that define these two valuations call for appraisers to approach them in different ways. 

Appraisals for 409A

A 409A valuation is used to set the strike price for stock options issued to employees. Appraisers try to determine what a company’s shares would sell for in an ideal market where buyers and sellers possess the same information about a company and its finances—or the fair market value (FMV). To do so, they consider factors such as a company’s current assets, its cash flows, comparable public companies, and the implied valuation from any recent secondary transactions. 

Companies typically want their 409A valuation to be as low as possible while remaining defensible to the IRS. Doing so allows them to issue equity to employees at a lower strike price. For employees who hold stock options, a lower strike price means exercising those options is less expensive. And for both options holders and restricted stock unit (RSU) holders, a lower strike price increases the upside for employees if the value of their equity grows and a liquidity event occurs. 

Appraisals for ASC 718

The guidelines for a valuation used to calculate stock compensation expense under ASC 718—which gives investors an idea of how dilution might affect a company’s earnings in the future as employees exercise their options—are a bit different. Instead of focusing on an ideal market, the Accounting Standards Codification asks appraisers to “maximize the use of relevant observable inputs and minimize the use of unobservable inputs.” In other words, appraisers should rely more on an observed transaction price from any secondary transaction and less on factors such as cash flow models, market comps, or discounts.

Companies use an ASC 718 expense to record stock options or other stock-based compensation on their financial statements to remain compliant with Generally Accepted Accounting Principles. While most companies want their 409A valuation to be low, they’re less concerned with where their ASC 718 expense falls, since it doesn’t impact the price at which they’re able to issue options. It is simply designed to measure the potential impact of dilution.

How secondary transactions impact valuations 

Shareholders in private companies can use secondary transactions to cash in on some of their equity holdings. Tender offers, auctions, and block trades are all examples of private secondaries. The share price in a recent secondary sale is one way to assess a company’s worth. 

These transactions have historically had the same impact on the valuations a company uses for 409A and ASC 718, since companies and appraisers have treated these two valuations the same. But Carta believes that different kinds of secondary transactions should impact 409A and ASC 718 differently, and that impact should depend on the characteristics of the transaction in question. 

Secondary transactions and 409A

When calculating a 409A valuation, appraisers generally give more weight to secondaries that resemble a transaction on a public stock exchange because those sorts of free-market deals are considered the best indication of true value. 

A secondary program will have high impact on a 409A valuation if it involves:

  • A larger percentage of a company’s shares
  • Frequent transactions on a regular schedule
  • Many buyers and sellers
  • Equal access to company information among all parties

A secondary transaction has less of an impact on a 409A valuation if it:

  • Involves a smaller percentage of company shares
  • Is a one-off transaction
  • Includes few buyers and sellers
  • Limits access to company information for some parties

For example, a transaction involving 10% of a company’s cap table, dozens of buyers and sellers, and full financial disclosure to all participants would be weighted more heavily for 409A purposes than a transaction involving 1% of the cap table and just a few buyers and sellers who were not provided up-to-date information from the company. The type of a transaction matters less than the size of the transaction and whether all parties had equal access to information. 

Secondary transactions and ASC 718

When calculating a valuation used for ASC 718, recent guidance from the AICPA and Financial Accounting Standards Board asks appraisers to prioritize some transaction types over others.  

More emphasis is placed on:

  • Prices from one-off bilateral block trades, in which investors buy private shares directly from sellers without company oversight

Less emphasis is placed on:

  • The size of the deal (in terms of the number of shares or the percent of the cap table transacted)
  • Prices from any company-sponsored transactions

To summarize, both approaches emphasize trades that happen on a free market, but they differ when it comes to what constitutes the freest market. The 409A approach is based on the idea that transactions involving many shares, many buyers, and many sellers are the best way to determine an asset’s true value, regardless of whether the company structures the transaction. The ASC 718 approach is based on the idea that the best way to determine a stock’s true value is to consider the price from all transactions that were not company-sponsored, regardless of their size. 

Why the model is changing

A new emphasis on secondary valuations

A decade ago, an implied valuation from a secondary transaction might have accounted for just 5% of an overall 409A and ASC 718 calculation. Since then, the overall market for venture secondaries has expanded, growing from $23 billion in 2011 to $105 billion in 2021. As these transactions became larger, more frequent, and more structured, regulatory bodies concerned with accounting practices (such as the SEC) began to scrutinize the gaps they saw between the valuations companies were using to comply with ASC 718 and the share prices of recent secondary sales. 

In the 2020s, appraisers tried to close that gap by increasing their emphasis on secondary valuations for ASC 718 purposes—and thus for 409A purposes as well, since many companies and service providers still treat the two the same. Today, a recent secondary share price might account for 50% of a valuation used for 409A and ASC 718. This is why Carta believes moving away from using one appraisal for both purposes is correct.

The growing impact of secondary transactions on valuations used for 409A and ASC 718 highlights the differences that have always existed between fair market value and fair value. Carta’s valuation team believes that a sophisticated, multifaceted analysis that weighs multiple factors is still the best approach to 409A, rather than a more simplistic focus on observable inputs. That’s why we now advise companies to treat these two valuation types separately, focusing on a full financial analysis for the purposes of 409A and on observable inputs for ASC 718. 

Fair market value vs. fair value

Say you buy a used car for $10,000. Unbeknownst to you, the car was in a flood. An auto appraiser who knows the vehicle’s full history would say it’s worth closer to $5,000. Which of those figures is the car’s true value? 

This example highlights the key tension between fair market value and fair value. What is the truer value of an asset: The actual amount a buyer paid, or the price that a buyer might pay in a hypothetical fair and free market with equal access to information? 

An independent appraiser can arrive at a valuation that’s far from the price of shares sold in the company’s most recent secondary transaction. That’s because appraisers have much better access to a company’s finances. The secondary market, meanwhile, is quite opaque—particularly the market for direct secondary transactions.

Reasons an appraiser might not weigh a secondary transaction heavily in their valuation estimate include: 

  • A lack of access to a company’s financial information
  • A lack of market-based price discovery
  • A limited number of buyers and sellers

Separating 409A and ASC 718 appraisals allows Carta’s valuations team to continue taking all these variables into account for the purposes of 409A, rather than treating all secondary valuations the same. 

What the changes mean for secondaries

For private companies, separating the 409A valuation from the valuation used for ASC 718 removes a major impediment to conducting secondary transactions: The fear that these deals will lead to a major increase in their 409A. Recent secondary valuations are still a factor in determining 409A. But they don’t have to be a large factor. Companies can work with Carta’s liquidity team to structure secondary transactions to achieve their aims. Carta also provides full 409A and ASC 718 services to cap table customers, whether a company is considering a secondary transaction or not. 

To learn how this shift might impact the market for secondary transactions, reach out to Carta at partners@carta.com

To reach a member of the valuations team, fill out the form below.

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