[author: Neil Beaton]
This article is the first of two that explore a fairly new, but expanding, phenomena in the pricing of privately-held securities: secondary market transactions. In this first article, the development of secondary markets is covered along with a brief overview of how such markets operate. The article then explores the trade-off of the impact of secondary market transactions on fair value or fair market value. In a subsequent article, an empirical analysis of various secondary market transactions before an initial public offering (“IPO”) is provided compared to the pricing of those securities after these companies completed their IPOs.
A Definition and Background
Secondary markets are defined as markets where non-public debt and equity securities are traded either directly on the exchange or by the use of the exchange as an intermediary. Such traded securities include private company stock, restricted securities, auction-rate securities, structured products such as residential mortgage-backed securities, collateralized mortgage bonds and collateralized debt obligations, limited partnership interests and bankruptcy claims. There are over 25,000 secondary market participants managing trillions of dollars of alternative investments, including private company stock. Many of these participants are registered broker-dealers and include such names as Second Markets, SharesPost, GSTrUE, OPUS-5, 144a-Plus and others. Although they have an international reach, most transactions performed by these intermediaries are focused in the U.S.
Secondary markets have grown rapidly in volume, the number of funds and the number of exchanges since 2003. The slowing of initial public offerings and liquidity events for venture-backed companies following the Dot.com bust in 2000 left many investors, including employees holding stock options, without the ability to liquidate their investments. Although they existed well before 2003, these secondary exchanges, and the volume on them, began to grow considerably after 2003. As shown in the following chart, secondary market volume increased steadily from 2003 through 2008 before the great recession negatively impacted investments and related liquidity across all investments.
Although a number of different securities are traded on secondary exchanges, this article focuses on transactions of the common stocks of venture-backed companies on such exchanges. According to the National Venture Capital Association (“NVCA”), IPOs for venture-backed companies essentially disappeared after the Internet meltdown that began in March 2000. As shown in the following graph, there have only been about 50 venture-backed IPOs, on average, since the over 250 annual IPOs in 1999 and 2000.
Furthermore, as shown in the following graph, the median age of a venture-backed company at IPO increased from four years in 1999 to 10 years in both 2008 and 2009 before decreasing modestly in 2010. As a result, the number of venture-backed company exits as a percentage of total deals has remained anemic over the past ten years (see following graph). On the positive side, sophisticated tracking and financial platforms have been created allowing for greater control over private transactions. Because of this confluence of events, secondary markets have sprouted and flourished over the past ten years.
However, challenges remain. IPOs are still considered a superior path to value and liquidity, but the cost to become and remain public has increased and complying with Sarbanes-Oxley has increased potential corporate governance problems, not to mention the plethora of class action lawsuits whenever a public company’s stock has a hiccup. In contrast, on the private side, equity capital is usually restricted for extended periods, and even when allowed to trade in secondary markets, the mechanics of a sale are often cost prohibitive or a only a limited pool of buyers exists. In addition, ex-employees often own common shares in the private companies they left, creating bookkeeping hassles and reporting nightmares, not to mention legal exposure, for such companies. Even existing employees have become disgruntled as they have foregone higher salaries for stock options that, statistically, won’t be liquid for years. Accordingly, secondary markets have stepped in to fill the void created by these circumstances.
Implications of Secondary Markets on Private Company Valuations
From a valuation standpoint, many questions are raised by transactions on secondary markets. Do trades on these secondary markets reflect fair market value (or fair value)? Do the investors buying these securities represent market participants? Can secondary market transactions be considered orderly? To answer these questions, one must look at the structure of the secondary markets. First, they are largely unregulated. Second, investors buying securities on the secondary markets must be “accredited investors” and satisfy such investor criteria before they are allowed to trade. Sellers are often bound by company shareholder agreements and restrictions and other legal requirements. A many private companies have responded to the possibility of having their shares traded on secondary markets by including “right of first refusal” restrictions in their stock option and restricted stock unit plans. Furthermore, and probably the most important aspect of these secondary markets, is the relative dearth of financial information on the companies whose securities trade on such markets. Unlike companies traded on public exchanges, private companies or investors offering securities on secondary markets often only have access to minimal financial data on the companies whose securities they are buying, and many times, the financial data that is available is derived from secondary sources unrelated to the company itself. Thus, by and large, the securities transactions that occur on these exchanges are often done “blind.” Granted, there may be, and often is, public financial information on the latest round of financing closed by the company, but again, that information is limited and obviously doesn’t allow for an independent assessment of the securities’ value.
So, do these trades represent fair market value (or fair value) or not? Of course, the answer is: “It depends.” The process to list such securities on a secondary exchange provides some insight into a possible answer. The first step in the process is a company partnering with a secondary intermediary. Next, the company decides which information is to be released, if any. Often, very little information is released publicly; however, a company may provide a limited approved list of buyers. The share offering is then marketed to specified buyers, with approved information provided to these company-approved buyers. Once the information has been reviewed by the buyer or buyers, an offer, or offers, are made and the trades are settled. Many of these trades are done by auction allowing for some market influence, but again, the number of sellers and buyers is often unknown.
Without complete disclosure of a company’s financial condition and future prospects, it is doubtful buying decisions, let alone selling decisions, can be a considered fully informed and therefore representative of fair value or fair market value. Furthermore, the trades on these exchanges are not regulated in the same way trades on public exchanges are regulated. The companies that do list their securities on these exchanges generally exert a tremendous amount of control over the amount of information that gets disseminated and who can buy or sell such securities. Such control blunts the “market participant” criteria under Accounting Standards Codification Topic 820 (“ASC 820”) Fair Value Measurements and Disclosures..
ASC 820 was adopted by the Financial Accounting Standards Board (“FASB”) on July 1, 2009. It is now the sole source for guidance on how entities should measure and disclose fair value in their financial statements. The definition of fair value in ASC 820 is the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” ASC 820 assumes an “exit price” approach which is important in dealing with secondary market transactions.
Fair value continues to be measured using all assumptions utilized by marketplace participants, including risk assumptions considered by those participants. The measurement of fair value assumes an orderly, hypothetical transaction in the principal market for the asset or liability. However, if the volume and level of market activity for an asset or liability has significantly decreased, and transactions in a particular market are not orderly, ASC 820 provides additional guidance on factors to consider in estimating fair value. Again, another important point in assessing the impact of secondary market transactions.
For illiquid securities where a market may not exist, a fair value approach much be developed based upon a hypothetical market which incorporates assumptions potential market participants would use in purchasing the security. In the secondary markets, an “artificial” market is created wherein shares are exchanged without complete information. An important concept in the secondary markets for early stage companies is that the unit of account is a single share of common stock. Even when a share is exchanged on the market, it may not rise to Level 1 status. ASC 820 outlines a three-level fair value hierarchy. Level 1 consists of the most “observable” market inputs to arrive at fair value (e.g., liquid investments). Level 2 would broadly include assets and liabilities valued using observable inputs other than quoted prices used to value Level 1 securities, while Level 3 consists of the most “unobservable” inputs. ASC 820 emphasizes that valuation techniques used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable inputs. Secondary markets may be considered either a Level 1 input or a Level 2 input.
Observable inputs are inputs based on market data obtained from sources independent of the entity and should not be limited to information that is only available to the entity making the fair value determination or to a small group of users. Observable market inputs should be readily available to participants in that particular market. Of even more importance in the secondary markets is that observable market inputs should include a level of transparency that is reliable and verifiable.
As a result of the financial crisis in 2008, the FASB issued additional fair value measurement guidance in April of 2009 for estimating fair value when the volume and level of activity for an asset or liability has significantly decreased and when a transaction is deemed “not orderly.” This guidance reinforces the notion that fair value is based on orderly transactions under current marketplace assumptions. When current prices are not indicative of orderly market transactions, an appraiser should utilize alternate valuation techniques to estimate fair value under current market conditions.
In order to determine the reasonableness of secondary market transactions, one must consider whether an active and/or orderly market exists. According to ASC 820, an active market is defined as “[a] market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.” Furthermore, an orderly transaction is defined as “[a] transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction.”
ASC 820-10-35-54C expands on the volume criteria for an active market. Some of these criteria are listed as:
There are few recent transactions.
Price quotations are not developed using current information.
Price quotations vary substantially either over time or among market makers (for example, some brokered markets).
There is a significant decline in the activity of, or there is an absence of, a market for new issues (that is, a primary market) for the asset or liability or similar assets or liabilities.
Little information is publicly available (for example, for transactions that take place in a principal-to-principal market).
Based on the foregoing, transactions of many secondary common stock transactions would not qualify as being conducted in an active market. Secondary transactions do not necessarily occur with regularity nor is volume usually very high. In many instances, there are only one or two major buyers although there may be a large number of individual sellers. As noted earlier, price quotations are often set by the intermediary without a lot of current financial data. Transaction activity may also be impacted by external events unrelated to the company’s own fundamental financial underpinnings. For example, if a successful IPO of a similarly-situated company occurs, transaction activity often increases on that information alone.
ASC 820-10-35-54I expands on the orderly transaction criteria including:
There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions.
There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant.
The seller is in or near bankruptcy or receivership (that is, the seller is distressed).
The seller was required to sell to meet regulatory or legal requirements (that is, the seller was forced).
The transaction price is an outlier when compared with other recent transactions for the same or a similar asset or liability.
The operating phrase above is “usual and customary”. When compared to shares traded on public exchanges, secondary transactions often lack “usual and customary” exposure to the market for a period before the measurement date. Secondary transactions lack a lengthy exposure period and, as noted, are not often accompanied by customary financial disclosures that typical investors have available to them in the public markets. Under these circumstances, ASC 820-10-35-54J indicates that little, if any, weight be placed on such transactions when compared to other indications of fair value. This is not to say that secondary transactions are to be ignored; quite the contrary. Rather, they should be considered in the context of the overall valuation assignment.
To summarize, the relevance of transaction prices in the secondary markets on fair value will depend on the specific facts and circumstances of each particular company’s circumstances. The analyst must not lose sight of the fact that valuations of common stock options related to employees often have limited or no access to secondary markets. There is often limited data available on the volume of shares traded on secondary markets and the number of buyers or sellers. A reconciliation, or at least an acknowledgment, of secondary transactions is highly recommended. In Part 2 of this series, an empirical analysis of secondary transactions will be performed to assess the accuracy, or lack thereof, of secondary transactions compared to subsequent share prices of companies that have completed IPOs. As a teaser, the following chart shows the prices of common stock traded on a secondary market before IPO and the share prices of that company’s common stock after IPO. Can you guess the stock?
Neil Beaton is managing director of Alvarez & Marsal Valuation Services where he provides a broad range of valuation and litigation support services. Please see www.alvarezandmarsal.com for a more information.