Not an Art: Pricing of Securities on the Secondary Market
How to Price Securities on the Secondary Market
Buyers of private company stock take a market value approach when it comes to valuing a security that is for sale. Recent financing rounds may provide a yardstick of the neighborhood that a security might be priced at, but they in no way provide an exact price that a security should be sold at on the secondary market. Moreover, a financing round that occurred three to six months in the past may no longer be an accurate reflection of the current value of the company. Not all company stock is created equal, as well. Liquidity rights attached to a stock will play a significant role in its price, as will the amount of information that an investor has access to. With that in mind, I will briefly outline how those variables affect the pricing of securities on the secondary market.
Common vs. Preferred
Shares which are higher in the capital structure and possess less liquidation preference risk, will obtain a higher price in secondary transactions. Investors therefore will want to acquire preferred shares over common shares, because in the case that the company dissolves, the preferred shareholders will be paid back before the common shareholders. As a rule of thumb, common shares are sold at between a 10% and 30% discount to preferred shares in the secondary market. However, as the company gets closer to an IPO, the discount may shrink to as low as 10%, or may even be equal to the price of the preferred stock. In companies with significant VC backing, this will be especially pronounced since VCs will typically acquire senior preferred shares. If a company is heavily backed by VCs that have a lot of liquidation preference, the secondary investor will receive its proceeds last, and therefore the risk of loss is larger. In some cases, the common shares may be worth as low as 10% of the value of the preferred shares during the seed stage, and may climb to as high as 100% of the value of the preferred shares by the time the company goes public, due to forced conversion of the preferred shares into common shares.
The total value of the preferred shares compared to the common shares also affects the price of the securities. For example, if a company is valued at $30M and there are $20M of preference shares, the common shares may be sold at a significant discount compared to the preferred shares. On the other hand, a company that is valued at $300M, in which $20M are preference shares — its common shares will be valued at less of a discount compared to the preference shares.
The cooperation of the company’s management will allow the buyer to make a more informed decision about the price it is willing to pay. It is likely that the more an investor knows about a security, the higher it will pay for it. Conversely, if a management team is not willing to meet with an investor, and key metrics such as financial performance and projections are not shared with an investor, the investor will likely discount the price of the shares. It’s often in the company’s best interest to share such information with a limited number of strong investors, as a means of ensuring that a suitable investor joins the current ownership group. To properly evaluate the price of the shares, investors will need the company’s most recent capitalization table, its corporate documents, such as its articles of association, bylaws, and investment agreements, past and projected financials of the company, an investor presentation, and a recent board presentation.
The seller cannot simply expect to receive a price per share amount equal to the last round of financing or a per share amount equal to the last 409a. Founder and employee shares, which are typically common shares, will almost always sell at a discount to preferred shares, with the discount being less dramatic the closer the company is to going public. Moreover, the price paid for securities will typically be higher when the company cooperates with the buyer, allowing more information to be disclosed.