This is a 2010 article describing / predicting the effect of secondary markets on private company stock valuations. With the attractiveness and increasing popularity of marketplaces for pre-IPO stock, there is growing debate over how transactions in private company stock impact the value of company securities for 409A purposes. At the core of these discussions is the question of whether a transaction occurring in a private marketplace is a strong indication of value. In this article we offer guidelines for valuation professionals and company executives to consider when assessing the impact of such secondary transactions on the fair market value of private company stock.

1. THE EFFECT OF SECONDARY MARKET SALES ON
409AVALUATIONS
Bo Brustkern | June 22, 2010
If preferred stock was sold in the transaction, how do
the rights and preferences of the preferred compare
to the common?
Do the shares sold carry with them information rights?
Voting rights?
Rights or restrictions on future sales?
Liquidation preferences?
Have material events occurred since the transaction that
might have altered the company’s fair market value?
How many transactions took place?
Between how many buyers and sellers?
How many shares traded hands?
What percentage of the fully diluted equity capitalization
of the company does that represent?
Was there a balance between supply of shares for sale
and demand from buyers?
1
IRC 409A is a section of the U.S. tax code that applies to stock options. Under 409A, stock options
that have an exercise price less than the fair market value of the underlying stock as of the grant
date could result in adverse tax consequences for the option recipient.
“...it is quite likely
that the valuation
arrived at through
fundamental
analysis will not
be equal to the
price obtained in
secondary
transactions.”
With the attractiveness and increasing popularity of marketplaces for pre-IPO stock,
like SecondMarket, there is growing debate over how transactions in private company
stock impact the value of company securities for 409A purposes.1
At the core of these
discussions is the question of whether a transaction occurring in a private marketplace
is a strong indication of value.In this article we offer guidelines for valuation professionals
and company executives to consider when assessing the impact of such secondary
transactions on the fair market value of private company stock.
Mapping the Course
The potential impacts of private secondary market sales on 409A valuations are, in a
word, complex. Transactions may reflect discounts or premiums for marketability,
liquidity, and/or control, each of which impact the fair market value of private company
stock. Further, purchasers may be willing to pay a premium for access to private
stock they would not otherwise have, thus overpaying vis-à-vis fair market value. Such
overpayments are sometimes referred to as a posturing or access premium, and are
difficult to quantify. Similarly, sellers may be willing to take a lower-than-fair price due
to extenuating financial exigencies. These issues are just the tip of the iceberg. When
Arcstone is engaged to value equity securities where secondary sales have occurred
(or are contemplated), we take a close look at the facts and circumstances surround-
ing the transactions themselves. Some of the factors we consider are
identified below along with their relevance to fair market value.
With increases in similarity, proximity, volume, supply/demand balance,
participants, information quality, information symmetry, and sophistication,
the price obtained in a given transaction is more relevant to fair market
value.
Similarity
Proximity of Timing
Transaction Volume
Supply/Demand Balance

2. Information Symmetry
Sophistication
2
From IRS Revenue Ruling 59-60, which defines fair market value for tax (409A) purposes.
Was the information about the potential risks and
rewards associated with the underlying company
plentiful and of high quality?
Defining Market Efficiency
Together, the above factors help to describe the efficiency of the marketplace at the time of the
transaction and for the specific equity securities in question. When a market is efficient, it can be
stated that the price achieved in a transaction was:
In other words, in an efficient market, the ultimate price more closely approximates fair market value. But
are platforms such as SecondMarket really efficient, or is it better said that they enhance the efficiency of
the market? Currently, we might say they are more efficient than transactions occurring outside the
platform; yet, they do not achieve the efficiency characterized by public securities trading on the NASDAQ
or the NYSE. Thus an argument could be made that the prices achieved in secondary market transactions
are not reliable indicators of fair market value for 409A purposes. However, each transaction is executed
under different circumstances, so no broad-based rule of thumb may reasonably be applied.
As secondary market transactions begin to more profoundly exhibit the qualities of an efficient market,such
transactions will be more readily viewed as indicative of fair market value. Put simply, we hold that increases
in similarity, proximity, volume, supply/demand balance, participants, information quality, information symme-
try, and sophistication increase the relevance of the price obtained in a given transaction to fair market value.
Careful Consideration Required
For the foreseeable future, valuation analysts must closely analyze transactions to understand the essence
of how and why they transpired – before opining on their impact on fair market value. Companies involved
in significant secondary market activity should consider actively incorporating such activity in their periodic
409A valuation updates. Even so, for the reasons stated above, it is quite likely that the valuation arrived at
through fundamental analysis will not be equal to the price obtained in secondary transactions.
the price at which the property would change hands between a willing buyer and a willing seller
when the former is not under any compulsion to buy and the latter is not under any compulsion
to sell, both parties having reasonable knowledge of relevant facts.2
Bo Brustkern is Founder and Managing Director of Arcstone Partners, a nationally recognized
business valuation boutique. Mr. Brustkern is an executive committee member of the Fair Value Forum
based in Silicon Valley and is a member of the Appraisal Issues Task Force based in Herndon,Virginia.
Prior to founding Arcstone, Mr. Brustkern was a venture capital and private equity investor for over
seven years. He earned an MBA from the Anderson School at UCLA, where he was a Deutchsman
Venture Fellow, and a BA from Dartmouth College.
be considered institutional-grade due diligence?
posturing, or other motives)?
Was such information equally available to both buyers
and sellers?
Do the buyers and sellers have sufficient expertise
and/or guidance to accurately value the equity
securities?
Are they professional investors?
Were they advised prior to the transaction?
What are the possible motivations beyond achieving a
purchase at fair market value (e.g., capital foothold,
Could the analysis conducted prior to the transaction
Information Quality