Company Valuation: Do Secondary Market Transactions Help Assess Value?
Frank, Rimerman + Co. LLP – Business Valuation
Private companies and individuals often engage Frank, Rimerman to assess the value of a company and its individual ownership interests. Because these firms are not traded on public markets, we generally think about private company value based on hypothetical transactions, rather than real market events. But with the recent rise in the number of online secondary market transactions involving private company stock, we’ve had to consider what role, if any, these transactions should play in assessing value.
Company Valuation
As fundamental valuation experts, most of our assignments involve determining the value of a share of a private company’s equity security (usually common stock), which is not sold on a public market. Because these companies and individuals are using this assessed value to comply with tax or financial reporting requirements, the premise of value is, by definition, based on what a hypothetical willing buyer and seller are likely to do.
However, there are times when real transactions—such as a recent equity financing or third-party sale of stock—allow us to step out of a hypothetical world in determining the value of an enterprise or equity security. Recently, a growing number of observable third-party sales are taking place on online exchange sites that facilitate the trade of private company stock.
The Rise of The Secondary Marketplace
This secondary marketplace has matured from a conceptual idea to live marketplaces boasting more than $1.7 billion in stock transactions completed since 2008.i Currently, the two biggest players in this growing space are SharesPost and SecondMarket. For sellers of private company stock, these marketplaces allow shareholders to gain liquidity without waiting for a merger or public offering. For buyers of private company stock, these marketplaces may be the only way to purchase stock in a private company. By facilitating private company stock trades, these exchange sites can significantly benefit both buyers and sellers. The question is, do these transactions provide evidence of value in a fundamental valuation assignment and, if so, what is the strength of that evidence?
Factors Considered in Secondary Market Transactions
In determining how much weight to give secondary market transactions in company and per share valuations, we consider the following factors:
- Timing of the Transaction. Although public companies with significant floats of stock trade thousands of times every day, private company stock rarely trades. And, when those transactions do occur, they may or may not happen on a date that is close to the date a fundamental valuation is required (known as a “valuation date”). In assessing the relevance of these transactions as an indicator of value, a transaction that occurs more than three to six months prior to a valuation date is often considered stale. This timeframe can be much shorter if material events have occurred at the company or in the marketplace between the transaction date and the valuation date.
- Size of the Transaction. Most stock transactions on exchange sites involve significant blocks of stock with transaction prices well into the millions of dollars. For example, SecondMarket claims it has completed “550 private stock transactions, amounting to nearly $700 million completed since 2008,”ii which equates to an average transaction size of $1.27 million. In determining the relevance of these (and other third-party) transactions, we will attempt to dig into the facts, if we can find them, to determine the circumstances surrounding the sale. In most of our engagements, we value single shares of stock or relatively small holdings. Therefore, sales of larger blocks of stock are not particularly helpful to our valuation analysis.
- Whether Parties Had Reasonable Knowledge of All Relevant Facts. We generally will not know whether, and to what degree, parties to exchange site transactions had knowledge of all (or even any) of the relevant facts about the company or its ownership structure. Public companies are required to make regular SEC filings that provide investors with information about the company, its operations, profitability, and strategic plan. No such standard materials are publically available for private companies. Without this kind of disclosure, a prospective buyer must rely on information obtained through personal connections, calls to the company, the company’s website, or the Internet. Some of these exchange sites provide investors with independent equity research that can be used to help make an informed decision. However, even if the company sponsors these reports on behalf of its investors or discloses confidential financial information to the research analyst, the level of detail will usually lack the transparency of information available on publicly traded companies. If we believe a transaction was done without reasonable knowledge of the relevant facts, we will discount the value of the transaction as an indicator of company value.
- Parties’ Intent. It is almost impossible to determine what may have motivated a buyer or seller to enter into a transaction and establish a transaction price. Buyers or sellers may have motivations that have little to do with the economics of the subject stock. For example, a seller may need cash due to financial situations (such as being close to bankruptcy) or personal situations (such as being involved in divorce). Similarly, a buyer may be motivated by non-economic goals—for example, desiring information rights. In evaluating the evidentiary value of these transactions, we attempt to determine what circumstances may have influenced the parties’ behavior or affected the pricing, such as a stock transaction that is part of a bundled exchange (a conditional sale of stock as part of a financing relationship, for example).
- Liquidity to Founders. Founders often sell common stock as part of a new round of equity financing at price that is at or near the price paid for preferred stock. We generally do not consider this common stock price to indicate fair market value because in many (if not all) of these cases, the common stock is available only to founders allowing them to “take money off the table.”
There is no particular formula for weighing the above factors. In arriving at a valuation conclusion we consider the circumstances surrounding any recent secondary market transaction, the company’s financial picture, and the fundamental and hypothetical methods for determining value. On balance, however, we find that online secondary market transactions are of minimal assistance in determining a company’s value.
Summary
While our opinion is our own, we believe that our observations correspond to those of many people in the valuation community here in Silicon Valley. Because private company transactions lack information transparency and often take place under circumstances that do not represent the broader marketplace, they are impaired as a valuable indicator of Fair Market Value. As a result, most fundamental valuations are based on hypothetical methods rather than third-party transactions within or outside of these online secondary markets.
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i https://www.secondmarket.com/private-company and https://forgeglobal.com/?utm_term=sharespost_