The Impact of Exchanges on Private Company 409A Valuations

The Concern Over Secondaries and 409A Valuations

Since the earliest days of secondary trading platforms for venture-backed, private companies – e.g., SharesPost, Nasdaq Private Market, etc. - there has been concern about the potential impact of secondary sales on an issuer’s then-current 409A valuation. The nightmare scenario from an issuer’s perspective is each secondary sale rendering the then-current valuation report no longer reliable for purposes of setting the strike price on employee stock options.

Having to get a new 409A report on the heels of each secondary sale would be unwieldy and would negatively impact an issuer’s ability to attract and retain talent due to: (i) generally higher strike prices (making the options less economically attractive relatively speaking), and (ii) extended timeframes for the options to be formally granted by the Board (as typically updated 409As take several weeks to complete).

Factors Suggesting Secondaries May Trigger the Need to Update the 409A Valuation

As a rule of thumb, a new 409A valuation is required if a “material event” occurred following the ‘as of’ date of the last report. Continued reliance on a valuation prepared prior to a material event is not considered reasonable. While there is no bright-line rule as to what constitutes a material event, generally the receipt of a term sheet for a significant financing, M&A or other material, revenue-producing agreement (which was not considered in the existing valuation analysis) would trigger a well-advised board to consider obtaining a new report.

Though there is less clarity as to exactly what type of secondary sales should be deemed a material event, the IRS issued technical guidance in 2018. Factors the IRS indicated that a board should consider for purposes of determining whether a secondary transaction would trigger a new valuation analysis include the following:

1. What were the key objective of the parties to the transaction (to the extent that it can be gleaned from the transaction process)?
2. Is the transaction more of a one-off transaction or part of a consistent, programmatic trading program administered by the company?
3. Are the shares being purchased by (or on behalf of) the company or third-party investors? If third-party investors, are they existing investors in the company or new investors? If new investors, are they sophisticated investors or price-takers?
4. What level of involvement has the company had in the transaction? Did it provide detailed diligence to the investors or otherwise participate in the negotiation, particularly with respect to the price?
5. How many buyers/sellers are involved in the transaction?
6. Whether there is sufficient secondary trading in the issuer’s securities such that the Board should reconsider the discount for lack of marketability applied to the valuation.

In short, secondary sale transactions that do not carry the indicia of arm’s length financing transactions should not, absent other extenuating circumstances, automatically trigger the requirement to obtain an updated valuation.

Guidance Implies Collective Exchanges do Not Trigger Need for New 409A Valuation

The Collective Exchange Fund, founded by industry veterans, enables a shareholder to exchange some of their stock for an interest in a diversified pool of equities and other assets without triggering a capital gain tax. Generally, an exchange into the Exchange Fund is done primarily for the purpose of reducing the exchanger’s financial risk by trading single stock risk for an interest in a diversified portfolio on a tax advantaged basis. For over-concentrated employees of high-risk, private growth companies, this solution can be part of a highly prudent financial plan.

The structure of Collective Liquidity’s equity exchanges and the intent of the parties are clearly distinguishable from the factors mentioned above for the following reasons:

1. Unlike sellers in ordinary secondary transactions, the exchanger is seeking to reduce financial risk through diversification in a tax advantaged manner. Unlike the typical cash buyer, the Exchange Fund is seeking to build a broadly diversified portfolio of 100 leading private growth companies.
2. Each exchange into the fund is negotiated separately at prices that change daily. Collective’s exchanges are not part of a company sponsored liquidity program and, other than to process the transfer of shares, the company does not participate in or otherwise administer the transaction.
3. Other than holding an immaterial percentage of a company’s shares, Collective is not affiliated with the company or its existing investors. Collective does not hold contractual information rights or typically receive more than summary financial information from companies. Collective does not conduct due diligence of a kind typically done by venture capital firms but is instead a price taker leveraging a proprietary algorithm to price its exchanges.
4. Companies are not involved in Collective exchanges (other than to process the share transfers). They do not participate in the negotiation between the fund and the exchanger and do not make suggestions to Collective as to the pricing of transactions.
5. Each exchange into the Exchange Fund is a one-off transaction with a single seller/exchanger. Collective’s pricing changes daily so the pricing used in one exchange will be different than any other.
6. Exchanges into the Collective Exchange Fund do not occur with sufficient regularity, predictability, or frequency to have a material impact on the overall marketability of a private company’s shares.
   

Conclusion

Issuers should feel comfortable that exchanges of shares into the Collective Exchange Fund do not trigger a need to reset the company’s existing 409A valuation. Collective’s one-off exchanges are distinguishable from typical secondary market transactions in that they are not for cash consideration, the seller’s intent is to de-risk their holdings using a tax advantaged wealth management solution, the buyer’s intent is to build a portfolio of 100 private growth companies, the company is not involved and Collective is neither affiliated with the company nor privy to detailed financial information nor conducting substantive due diligence on the company.

IMPORTANT DISCLOSURES

This information relating to the Collective Exchange Fund, LP (the “Fund”) has been prepared solely for informational purposes, is not complete, and does not contain certain material information about the Fund, including important disclosures and risk factors associated with an investment in the Fund, and is subject to change without notice. It does not constitute an offer to buy or sell an interest in the Fund, nor shall there be any sale of a security in any jurisdiction where such solicitation or sale would be unlawful.

The Fund’s limited partnership interest will not be registered with the U.S. Securities Exchange Commission or other regulatory authority. Investors will be required to verify their status as an “Accredited Investor” pursuant to Rule 501 of Regulation D to participate in any offering of the Fund’s limited partnership interests. No securities commission or regulatory authority has recommended or approved any investment or the accuracy or completeness of any of the information or materials provided by or through Collective Liquidity, Inc. or Collective Asset Management, LLC (collectively, “Collective Liquidity”).

Limited partnership interests in the Fund are not insured by the FDIC and are not deposits or other obligations of Collective Liquidity and are not guaranteed by Collective Liquidity. Limited partnership interests in the Fund are subject to investment risks, including possible loss of the principal invested.

Prospective investors should consider the investment objectives, risks, fees and expenses of the Fund carefully before investing in the Fund. This and other important information are contained in the Fund’s Confidential Private Placement Memorandum (“PPM”), which can be obtained by contacting Collective Liquidity.

Investment in the Fund involves substantial risk and any offering may only be made pursuant to the relevant PPM and the relevant subscription application, all of which must be read in their entirety. No offer to purchase securities will be made or accepted prior to receipt by the offeree of these documents and the completion of all appropriate documentation. The Fund intends to primarily invest in securities of private, late-stage, venture-backed growth companies. There are significant potential risks relating to investing in such securities. The Fund is not suitable for investors who cannot bear the risk of loss of all or part of their investment. The Fund is appropriate only for investors who can tolerate a high degree of risk and do not require a liquid investment. The Fund has no history of public trading and investors should not expect to sell limited partnership interests in the Fund. No secondary market exists for the Fund’s limited partnership interests, and none is expected to develop. The Fund has a limited operating history, and its performance is highly dependent upon the expertise and abilities of its manager. There is no assurance that the Fund’s investment objectives will be achieved, and results may vary substantially over time. This is not a complete enumeration of the Fund’s risks. Please read the Fund’s PPM for other risk factors related to the Fund. Although the manager of the Fund will value its portfolio using the Private Market Valuation Algorithm, it can be difficult to obtain financial and other information with respect to private companies, and even where the manager is able to obtain such information, there can be no assurance that it is complete or accurate. Because such valuations are inherently uncertain and may be based on estimates, the manager’s determinations of fair market value may differ materially from the values that would be assessed if a readily available market for these securities existed.

The information contained herein does not constitute a recommendation or advice by Collective Liquidity. You should consult your own tax, legal, accounting, financial or other advisers about the information discussed herein based on your specific risk profile and financial situation, including the suitability of an investment in the Fund, with Collective Liquidity, or any product offered or managed by Collective Liquidity.

Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.