Executive Summary: The article explores the impact of a tender offer on the 409A Fair Market Value (FMV) and the criteria used to assess whether it is considered a material event. A tender offer is a type of secondary sale or purchase of securities, typically common stock, made by an investor, group of investors, or a third party. If the tender offer is deemed a material event, the existing 409A FMV report may become outdated and require an updated report. In order to determine if the tender offer is an arm’s length transaction between unrelated parties, a comprehensive analysis of the offer and surrounding circumstances must be conducted. This analysis should consider several key factors, such as related parties, pricing, process, motivations, and conditions.
A tender offer is a purchase offer made by a buyer (a shareholder, a group of shareholders, an investor, a group of investors, another company, the company itself, etc.) to purchase a certain number of shares of a company’s stock, or the stock of another company, from its existing shareholders. In the context of a private company, a tender offering is usually considered a structured liquidity event that typically allows (some) existing shareholders to sell their shares and liquidate the holdings while the company is private without having to wait for the company to go public or any merger/acquisition scenario.
The Internal Revenue Code (IRC) section 409A provides guidance on the valuation of securities for specific purposes, including determining the fair market value of a private company’s common stock for the exercise price of stock options and the valuation of restricted stock units (RSUs). In accordance with section 409A, the fair market value of common stock is determined based on the price at which the stock would be sold in an arm’s-length transaction between unrelated parties.
To meet the requirements of section 409A, companies usually hire a qualified independent appraiser to estimate the 409A fair market value of their securities. The appraiser’s value is presented in the form of a report, commonly referred to as the 409A fair market value (409A FMV). The conclusions in the 409A FMV report are valid for either 12 months from the valuation date of the report or until there is a material change, such as changes in financial performance, market conditions, business prospects, primary securities issuances, or secondary sales of the company’s securities.
A secondary sale of securities refers to the sale of securities that have been previously issued by the company and is not part of a primary offering directly from the company. A tender offer is a form of secondary sale or purchase of securities, typically a company’s common stock, made by an investor or group of investors, a third party, or, less commonly, the company itself. In early-stage venture-backed enterprises, tender offers are often made at a premium over the market value (usually the original issue price of the latest preferred stock) and for a fixed number of shares, allowing existing shareholders to sell some or all of their illiquid shares. The consummated tender offer is a secondary transaction in the company’s common stock, usually priced at the per-share value of the latest preferred stock. If the tender offer meets the criteria for an arm’s-length transaction between unrelated parties, it may indicate the fair market value of the securities being sold in the tender.
After a consummated tender offer, if the company has hired an independent appraiser to estimate its 409A FMV, the tender is likely to be considered a material change, causing the 409A FMV assessment to become outdated. Many events at both the macro and micro levels qualify as material changes, but secondary sales of the company’s securities that are subject to 409A FMV determinations are typically considered material events by most analysts.
So, if a tender offer is a material event and the old 409A FMV report needs to be updated, how does it impact the previous 409A fair market value conclusion? The analysis depends on whether the securities sold in the tender offer were (i) sold in an arm’s length transaction (ii) between unrelated parties.
To determine if a tender offer for private company securities is conducted in an arm’s length transaction between unrelated market participants, a thorough analysis of the offer and the circumstances surrounding it must be performed. This analysis should take into account several key factors, including:
Related Parties: When the tender offer does not involve new buyers, investors, or shareholders, the parties involved are effectively related, and the transaction may not reflect an arm’s length value.
Pricing: An arm’s length transaction occurs when the parties involved are acting in their own self-interest and are not influenced by any relationship or obligation to each other. In the context of a tender offer, this means that the offer price should be based on the fair market value of the securities being offered and not artificially inflated or deflated due to a special relationship between the parties.
Process: The more robust the tender offer process (such as robust negotiation between the buyers and sellers regarding terms, conditions, pricing, etc.), the more likely the tender is arm’s length. The task force believes that more weight should generally be given to transactions that involve robust negotiations, such as if certain investors are increasing or decreasing their percentage ownership or if the round is at a different price than the previous round.
Pricing: In an arm’s length transaction, the parties act in their own self-interest and are not influenced by any relationship or obligation to each other. In the context of a tender offer, this means that the offer price should be based on the fair market value of the securities being offered, rather than being artificially inflated or deflated due to a special relationship between the parties.
Motivations: It is important to examine the motivations of both the buyer(s) and seller(s). For instance, if the buyer(s) seeks to take control of the company or to acquire a substantial stake, it may suggest that the transaction is not arm’s length. Similarly, if the seller(s) wants to attract a specific investor by allowing them to purchase an ownership level that would otherwise not be attainable, due to other shareholders avoiding dilution, it may indicate that the transaction is not arm’s length.
Orderly Transaction: An orderly transaction is one that is exposed to the market for a period of time before the measurement date to allow for customary marketing activities. It should not be a forced transaction, such as a forced liquidation or distress sale. If the evidence suggests the transaction is not orderly, then little weight should be placed on the transaction price compared to other indications of fair value.
Frequency, Scope, and Volume: When evaluating these transactions, other factors to consider include whether the transaction is a one-time event or repeated, and whether it is only open to a few common stockholders (such as the founders or senior executives) or is a broader tender offer. If the transaction is part of a repeatable exit market for employees or other shareholders who are not forced to sell, it generally provides a strong indication of fair value.
Comparisons: To determine if the offer price is fair, it may be useful to compare the offer to similar transactions in the market or to use quantitative valuation methods to estimate the value of the securities being sold.
Documentation: Lastly, it is crucial to review any documentation related to the tender offer, including any agreements or contracts, to guarantee that they are consistent with an arm’s length transaction. This includes examining any provisions that may give the investor group an unfair advantage or that may suggest the transaction is not completely independent.
Accordingly, determining whether a tender offer impacts an existing 409A analysis requires a fact-intensive inquiry. If the tender offer is considered a material event, a company’s legal counsel will likely recommend obtaining a new 409A FMV report. However, not all tender offers will have an impact on 409A FMV conclusions. If the tender offer is an arm’s length transaction between unrelated market participants, the 409A FMV of the company’s securities may be impacted. To avoid any risk or tax penalties, it is advisable to promptly obtain a 409A valuation during a tender offer, as a careful assessment of its relevance and potential impact must be performed.
If the tender offer is not an arm’s length transaction or conducted between related parties, the 409A FMV of the company’s securities may not be affected. However, if a large group of shareholders suddenly have the opportunity to sell stock all at once, it would likely have a material impact. In some cases, a tender offer for a private company’s common stock may provide a reasonable indication of the common stock’s 409A fair market value. However, it is important to note that a tender offer is just one factor that the IRS may consider when determining the fair market value of a private company’s common stock. Other factors, such as the company’s financial performance and the value of its assets, may also be taken into consideration.
The impact of secondary transactions, including tender offerings, on a 409A valuation is not linear and depends on various factors such as the price and size at which the tender offer is conducted. Careful assessment of the relevance and potential impact of any secondary offering is required. To avoid any risks or tax penalties, it is advisable to promptly obtain your 409A valuation during a tender offering.
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The outcome of a tender offer can have a significant impact on the validity of an existing 409A FMV report, and it is important for companies to carefully consider the key factors that determine if a tender is an arm’s length transaction between unrelated parties. Eton is here to help navigate you through the complexities of this analysis. Our team will work with you to ensure that your company’s financial reporting is compliant and that your IRC 409A FMV report accurately reflects the fair market value of your common stock
Our team will work with you to ensure that your company’s financial reporting is compliant and that your IRC 409A FMV report accurately reflects the fair market value of your common stock and any impact to it from a preferred stock financing. Join the industry leaders who have already experienced the advantages of Eton’s exceptional client service and valuation expertise. Contact Eton Venture Services today.