Solving the transparency barrier in secondary transactions

The last few months have been rough on tech sector company valuations. Valuations of public tech companies plummeted due to out-of-control inflation, increased interest rates, supply chain challenges and the war in Ukraine. Large private companies such as Stripe, Instacart and other unicorns are revising their valuations. The tech sector is seeing significant jobs cutting as companies focus on managing the tough environment and preserving cash to weather the economic winter. Volatility in the markets is leading to significantly reduced M&A activity, while the IPO and SPAC markets have effectively “taken the rest of the year off”. If these trends continue well into 2023, this may result in an early spring for secondary markets.

A decade ago, M&As and IPOs were predominantly the only avenues for private company shareholders to achieve liquidity for their shares. However, in recent years, secondary deals—deals in which investors buy equity stakes from early backers, founders and employees — have gained prominence as they facilitate the path to liquidity, especially as companies stay private for longer. Investors and employees are seeking some or complete liquidity to fund milestones in life such as buying a home, paying a child’s tuition or caring for a parent.

In the absence of a company driven price setting event (financing round price, M&A purchase price or IPO listing price), sellers and buyers need to establish their own transaction price. These liquidity opportunities require significant due diligence and create considerations applicable to a company’s valuation, accounting, tax, regulatory requirements, legal and human resources. Despite being an established market, the information available to buyers and sellers is limited and characterized by a lack of transparency when compared to the market for publicly-traded stock where securities laws, disclosure requirements and investor rights are well understood.

In the case of buyers, who, under U.S. laws must be accredited investors (sophisticated high net-worth individuals and professionally managed funds) – they are assumed to have the experience and resources to evaluate the merits of the deal, despite the challenges of information scarcity and lack of transparency. Sellers on the other hand, and specifically employees, are not normally exposed to the company’s financials, forecasts, and most recent valuation studies. Furthermore, they lack the experience, and resources to conduct an independent valuation study of the company to determine the attractiveness of the deal. As such, their only reference point in pricing the deal is the actual premium offered for their shares over and above the exercise price for their options of the price they paid for their shares. But is the premium offered “fair”? This is often an unknown variable for most sellers.

This gap may lead to an unfair negotiation of secondary liquidity events. We believe that private companies offering secondary liquidity events to their employees need to be aware of the unique challenges that these events introduce and that are often not well understood. Addressing these challenges can only happen if management of private companies increase transparency and information with their employees, thereby creating a win-win path to liquidity in the secondary market. Regularly disclosing 409A valuations with employees can be a good start. 409A valuations are prepared with the goal of estimating common stock / ordinary shares fair market value, i.e. a theoretical effort to guess a proper secondary market price. As more and more companies embrace this transparency, the secondary markets will benefit from consistent and transparent transaction pricing. Increasing trading volumes will amplify price discovery and reduce marketability discounts, thus increasing the value of stock-based compensation for start-up employees while decreasing the cost of private capital.

Avivit Ben-Avi is the Managing Director of AST Private Company Solutions, Inc.