Secondary Market Transactions and Their Impact on 409A Valuation

1. Secondary Market Transactions and Their Impact on 409A Valuation The startup ecosystem thrives on access to capital and talent, but another equally important factor fuels its growth: equity. For many companies, stock options are not just a compensation tool but a way of aligning employees’ incentives with long-term business success. A key element in this equation is the 409a valuation, which determines the fair market value of a company’s common stock. While valuation dynamics often revolve around primary fundraising rounds, secondary market transactions have increasingly become part of the conversation. When employees, early investors, or founders sell existing shares to new investors, these transactions can significantly influence how fair market value is determined. For companies navigating equity management, it’s crucial to understand how secondary transactions intersect with 409a valuations. What Are Secondary Market Transactions? Secondary market transactions occur when existing shareholders—such as employees, early investors, or advisors—sell their shares to external buyers. Unlike primary financings, where the company issues new stock and raises capital, secondary deals simply transfer ownership of already issued shares. These transactions can happen for a variety of reasons:  Employees may want liquidity before a liquidity event, such as an IPO or acquisition.  Early investors might exit partially to lock in gains.  New investors may seek ownership in a growing company even if the business is not currently raising capital. The rise of secondary platforms has made these deals more common, especially as private companies stay private longer. However, the presence of secondary transactions raises important questions for valuation professionals tasked with determining a company’s common stock value for compliance purposes. Why Secondary Transactions Matter in 409A Valuation? The central purpose of a 409a valuation is to establish the fair market value (FMV) of common stock for setting strike prices on stock options. Since the IRS requires that these valuations be defensible and reflect market realities, secondary market activity cannot be ignored. Here’s why secondary transactions often draw attention in this context:  Pricing Signal: If investors are willing to purchase common or preferred shares at a certain price, it may signal a higher market value than previously established.

2.  Liquidity Data Point: Secondary transactions reveal demand and liquidity for shares in the absence of a public market.  Regulatory Scrutiny: The IRS may view significant secondary activity as a data point when assessing whether a company’s 409a valuation is reasonable.  Alignment with Fair Market Value: Ignoring material secondary transactions could put a company at risk of having its valuation challenged later. Factors That Influence How Secondary Transactions Affect 409A Not every secondary sale automatically impacts valuation. Professionals analyzing these events weigh several factors:  Size of the Transaction: A large volume of shares sold may indicate broader market consensus, while isolated sales may carry less weight.  Buyer Type: Purchases by institutional investors or sophisticated buyers may be more influential than those by friends, family, or small retail buyers.  Stock Class: Preferred stock trades at a premium compared to common stock due to liquidation preferences, dividends, and other rights. Adjustments must be made to bridge the difference between preferred and common stock pricing.  Company Stage: A late-stage company nearing IPO may see a stronger correlation between secondary pricing and common stock FMV than an early- stage startup.  Motivation Behind the Sale: Distress sales (for personal liquidity needs) may not reflect true market value, while arms-length transactions often carry more weight. These nuances ensure that secondary sales are not viewed in isolation but as part of a broader valuation framework. IRS Perspective on Secondary Transactions The IRS expects companies to consider all relevant market data when conducting a 409a valuation. Secondary sales are specifically noted as a factor that can affect FMV. However, IRS guidance also acknowledges that not all secondary trades are equally reliable indicators. If secondary transactions are substantial, frequent, and conducted at arm’s length, valuation providers may give them greater weight. Conversely, if transactions are small, infrequent, or involve related parties, they may be discounted. Ultimately, valuation experts must document why and how they incorporated—or chose not to incorporate—secondary market pricing into the analysis. This defensibility is central to maintaining IRS compliance and avoiding penalties. Benefits of Considering Secondary Transactions in Valuation

3. When handled correctly, incorporating secondary market data into a 409a valuation can provide several benefits:  Market-Reflective Pricing: Ensures valuations are aligned with real investor behavior.  Audit Defensibility: Reduces the risk of IRS challenges by showing thorough consideration of market data.  Employee Confidence: Enhances trust in the fairness of stock option pricing.  Strategic Insight: Offers the company insight into how outsiders perceive its worth. Challenges and Risks While valuable, secondary transactions also pose challenges:  Overvaluation Risk: Relying too heavily on one-off transactions could inflate valuations and lead to compliance concerns.  Complex Adjustments: Converting preferred stock prices into an implied common stock value requires sophisticated modeling.  Market Distortions: Urgent sales or limited buyers can create skewed pricing signals.  Communication with Employees: If employees see secondary shares trading at higher prices than their option strike price, it can lead to confusion without proper context. Balancing Secondary Data with Other Valuation Approaches A robust 409a valuation doesn’t rely solely on secondary sales. Instead, valuation experts typically blend multiple approaches, such as:  Income Approach: Forecasting future cash flows and discounting them back to present value.  Market Approach: Comparing valuation multiples of comparable companies or transactions.  Asset-Based Approach: Reviewing the company’s net asset value, typically more relevant for early-stage or asset-heavy businesses. Secondary transactions often serve as an additional check against these methods rather than the sole determinant of value. When Secondary Transactions Carry Greater Weight Secondary data can be particularly impactful in certain circumstances:  Multiple, consistent trades over a period of time.  Transactions involving sophisticated institutional investors.

4.  Pricing close to a recent primary fundraising round.  A company nearing IPO or acquisition, where valuations are more closely scrutinized. In such cases, valuation providers often give secondary transactions significant weight in adjusting the FMV of common stock. Practical Implications for Startups and Their Teams For startups, awareness of secondary transactions is more than an accounting exercise—it affects people. Employees care deeply about the strike price of their options, and discrepancies between perceived value and FMV can cause frustration. Founders and finance leaders should:  Communicate openly with employees about how valuations are determined.  Work with independent providers who can objectively assess secondary data.  Reassess valuations after material secondary transactions to ensure compliance.  Document decision-making thoroughly to withstand IRS or audit scrutiny. These steps help align the company’s equity strategy with compliance and employee morale. The Role of Independent Valuation Providers Given the complexity of secondary transactions, most companies rely on independent valuation firms to conduct their 409a valuation. Independent experts bring:  Experience in weighing different transaction types.  The ability to make adjustments between stock classes.  Knowledge of IRS requirements and audit defensibility.  Objectivity that internal teams may lack. This independence ensures valuations withstand scrutiny while keeping employee equity programs on solid footing. Why Choose 409.ai? At 409.ai, we specialize in delivering accurate and defensible 409a valuations tailored to the realities of startups and growth-stage companies. Our approach factors in not just financial models but also the complexities of secondary transactions, market dynamics, and company-specific considerations. By working with us, you gain:  Independent, IRS-compliant valuations.  Insightful analysis of how secondary activity impacts FMV.

5.  Clear communication to help leadership teams and employees understand equity value.  Reliable support to ensure your stock option program remains fair, transparent, and defensible. Secondary market transactions can complicate the valuation landscape, but with the right expertise, they can also provide meaningful signals about a company’s worth. At 409.ai, we make sure those signals are interpreted with accuracy and clarity.