While private markets experienced an overall downturn of secondary transactions in 2022, secondary transactions, particularly tender offers, have become a popular way since then to provide liquidity to founders and early stage investors of private companies without having to sell the company or pursue a public offering.
Implications of secondary transactions and tender offers
There are numerous accounting, tax, and legal implications for companies impacted by secondary transactions.
The primary element often overlooked is these secondary transactions are often deemed compensatory to participating employees, and companies are required to record compensation expense and a related withholding liability for the gain certain early investors and employees received from the tender offer. The impact to the companies’ financial records under GAAP can be significant and should be considered.
What is a tender offer?
Tender offers are mechanisms that enable various shareholders, typically comprising employees, founders, and initial investors, to sell their stock to one or more investor groups or even back to the issuing company itself, at a price that has been set in advance.
These deals are often struck in tandem with preferred equity funding rounds with the sale price equaling the preferred stock price for that funding round. As these investors seek to increase their stake in a company in a tender offer, they’ll seek out common shareholders to increase their desired ownership.
Secondary transactions come in various structures. Often, when investors execute on secondary transactions, companies themselves aren’t involved in the transfer of shares or consideration, and the exchange of funds and shares are handled by companies’ equity administrators to facilitate the transfer of ownership.
Given these transactions can occur directly between the common shareholders and the investors, companies can often overlook the potentially significant accounting implications for their financial reporting under U.S. generally accepted accounting principles (GAAP).
Determining whether the transaction is compensatory
There are three primary questions to consider in determining whether a secondary transaction is compensatory in nature:
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
Is the company executing or involved with the transaction?
Is there a clear purpose for the transaction other than compensation?
Is the transaction price greater than fair value?
The companies will be aware of the secondary transaction as part of the transfer of shares. When becoming aware of these events, the company should initiate the preparation of a valuation, generally prepared in accordance with IRS rule 409A, prepared by a third-party appraiser.
This may already be prepared as a part of a secondary transaction to calculate the fair value of their common stock. If the price paid for the common shares is above the 409A valuation, there needs to be further consideration over whether there’s a compensatory nature to the transaction.
Given the common holders, who are often employees and founders, are receiving a price greater than the fair value of their shares’ worth, the compensatory nature of the transaction comes into question.
Importance of a 409A valuation
It’s vital to have a 409A valuation as close to the secondary transaction date as possible. If a 409A valuation is too far removed from the secondary transaction, its value in supporting the transaction becomes diminished.
Is the company executing or involved with the transaction?
If the company itself is purchasing common stock from employees or founders, industry standards and accounting guidance strongly indicate these are compensatory events. If an outside investor is purchasing the shares, an assessment must be made whether or not the investor is a related party or has a preexisting relationship with the company.
If the investors have a previous relationship to the company — meaning the investor is an existing shareholder — it’s presumed they’re acting on behalf of the company, and therefore the transaction could be considered compensatory in nature. If there’s no previous relationship with the investor, there should be a clear purpose for the transaction other than compensation.
Depending on the facts and circumstances, if the companies are involved in the deal, negotiating prices or other elements of the transaction, this fact may lead to the conclusion that these are compensatory events as well, suggesting the company is involved in the deal with their employees and founders.
Is there a clear purpose for the transaction other than compensation?
The company must assess and conclude whether there’s a clear purpose for the transaction other than compensation. Some of the questions management should consider include:
Does the company expect any benefit from the deal?
What is the sellers’ employment status? Are they employed by the company, or have they recently been terminated?
Have any changes been made to share rights as a result of the deal?
Overall, unless there is a definitive and defendable reason for the transaction other than for compensation, accounting standards suggest there’s reason to conclude these events are compensatory in nature.
It should be noted, regardless of the conclusion, the consideration and judgments made need to be clearly and concisely documented creating contemporaneous documentation in the books and records of the company.
What are the significant accounting implications if the event is compensatory?
There are two primary implications to companies’ financial statements under U.S. GAAP if the transaction is deemed compensatory:
Stock-based compensation expense
Withholding tax liability
Stock-based compensation expense
The company must recognize stock-based compensation expense under Accounting Standards Codification (ASC) 718 Compensation–Stock Compensation. The amount to be recorded is the difference between the selling price and the 409A valuation. This difference should be multiplied by the total shares sold as a part of the secondary.
Often this expense is significant to companies, and disclosures in the notes to the financial statements explaining in more detail the reason for the increased year-over-year expense is beneficial to users of the financial statements.
There are disclosure requirements for related party transactions under ASC 850 and stock-based compensation expense under ASC 718 that should be considered as well in the preparation of financial statements.
Withholding tax liability
If these amounts are considered compensation by the IRS, the difference between the selling price and the 409A valuation will be subject to income taxes and Federal Insurance Contributions Act (FICA) contributions.
It's the company's obligation to withhold these taxes and report them accordingly. Therefore, a withholding liability must be calculated and recorded by the company under ASC 450 Contingencies. For tax purposes, determining the compensatory nature may be a different conclusion from a financial accounting perspective.
Companies must take careful consideration to conclude on the nature of the event from a tax perspective as well. There are no clear standards surrounding this matter, so consult your tax provider for further tax advice.
Other items to consider
Companies must fully consider the legal implications of secondary transactions even if they aren’t a party to the negotiations.
Companies should consult their legal counsel for all legal and HR implications of these deals. Additionally, there may be other complicated accounting and tax implications to these deals as well.
