How to prepare for a tender offer
CartaX works with private companies to help them plan secondary liquidity transactions. Read below to see the key considerations to think about before designing a tender offer.
Tender offers are typically company-approved transactions that allow private company shareholders to sell some or all of their shares. As private companies are remaining private longer, tender offers have become a popular way to satisfy early investors and reward longtime employees by offering them liquidity.
Running a tender offer can be a great way for private companies to:
- give employees the opportunity to monetize the equity they’ve earned;
- allow early investors to realize returns; and
- meet surplus investor demand after a primary round of financing.
When companies design a tender offer, they set participation and pricing parameters for the transaction. These parameters determine who can buy and sell, as well as the volume of shares that are expected to trade. Those parameters may affect tax considerations and the company’s 409A valuation.
The CartaX capital markets team works with private companies to help them plan a transaction tailored to the company's goals. Below, we've outlined key considerations that C-suite executives may want to think about as they begin designing a tender offer.
Step 1: Decide who can buy the shares
The first thing executives need to decide is who can purchase the shares.
There are two types of private company tender offers: share buybacks and third-party tender offers. In a share buyback, the company repurchases shares from its shareholders—typically, their employees, investors, and (in some cases) former employees. In a third-party tender offer, the company allows investors to purchase shares from existing shareholders.
During a share buyback, a company can either use cash on its balance sheet to repurchase the shares, or it can use capital it just raised during a primary fundraise. From the company’s point of view, the latter option is often more expensive, because it means they’ll likely be issuing new preferred stock to buy back existing shares.
Typically, the primary goal of a share buyback is to provide employees with liquidity. Buybacks also have the advantage of being less administratively complex than a third-party tender offer.
Third-party tender offers
Approximately three-quarters of private company tender offers administered by Carta in 2021 involved third-party purchasers.1 Typically, these investors have already engaged with the company and expressed their interest to purchase shares. Often, executives make this choice if they know, based on investor demand, that an upcoming primary round will be oversubscribed. In these cases, the tender offer can allow investors to buy additional shares from existing shareholders.
Similar to a primary fundraise, companies conducting a third-party tender will typically identify a lead investor and then fill out the buyer group. As companies build out this pool of potential investors, they should determine whether the lead or any other investor in the group already has a substantial ownership position in the company, as it may impact some tax considerations.
Step 2: Set a transaction price
In a buyback, the company sets the price it’s willing to pay for shares, and shareholders decide how many of their shares they’ll sell based on that price, if any. Usually, this means pricing the tender offer at or near the share price of a recent fundraise.
In a third-party tender offer, companies set a transaction price based on investor demand before the offering period begins. Company executives and investors will agree on the price before the tender offer’s offering period begins.
The timing of a tender offer can affect the price of its stock. With companies looking to meet surplus investor demand after a primary round, we often see common stock priced in line with the last primary, or at a discount. The discount usually results from the fact that investors during a primary fundraise are normally buying preferred shares, while shares traded during a tender offer are often common shares.
As reported in Carta’s Liquidity in 2021 Report, the execution price for nearly half of secondary transactions administered by Carta were discounted relative to the most recent preferred round. Approximately two-thirds of these transactions occurred within three months of the company’s most recent fundraise. The exact percentage of the discount varied widely (from as much as 43% to as little as 2%), but the median discount was 10%.
For a third-party tender offer that doesn’t soon follow a primary capital raise, companies will need to negotiate a price with the investors, similar to how a company might receive and evaluate term sheets during a primary financing.
Step 3: Establish transaction size and eligibility
In addition to pricing, eligibility parameters will set limits on the size of the transaction. For example, will this transaction be for employees only, or will it include former employees? Will early investors be included? Eligibility will impact things like taxation for employees, as well as your company’s next 409A valuation.
At Carta, employees may sell up to 20% of their vested holdings in any given transaction during a secondary transaction. Ex-employees and affiliates may sell up to 10% of their holdings per transaction, while investors can sell up to 5%. These participation levels result from Carta’s decision to prioritize current employees while still including non-employees in each transaction. The company also commits to offering liquidity multiple times each year, so that shareholders can space out the sales of their shares as a part of their personal tax strategy.
Some shareholder types, like founders, tend to hold far more shares than other participants. When determining eligibility across shareholder subgroups, you should consider balancing the number of shares that larger sellers are permitted to sell against the number of shares that investors have indicated they’d like to buy. CartaX can help you run a dynamic model to evaluate the eligibility caps for different subgroups before finalizing the parameters for participation.
Step 4: Consider the tax impact to employees
Participation parameters also help determine whether a private company tender offer is considered compensation for employees if the IRS were to audit the transaction. In a compensatory transaction, any gains above the company’s current fair market value (FMV) or 409A valuation price would be taxed as ordinary income for sellers, rather than as capital gains, and that tax obligation would be withheld from the proceeds. For employees who may have exercised previously and hold shares, this can be especially frustrating as it may result in a higher-than-expected tax burden.
The buyers and sellers you invite to participate in a tender offer will have the greatest impact on whether the transaction would be considered compensatory. For example, if a buyer is in close proximity to the company—as in the case of an existing board member or large shareholder—a transaction would likely be deemed a compensatory event for employees. Similarly, if the company permits only current employees to sell their shares, the transaction could look more like compensation than if early investors are invited to participate alongside them.2
These considerations are complex, and it’s important to discuss them with your outside counsel before you run the tender offer.
Step 5: Understand the impact to your 409A valuation
A common misconception among founders is that holding a secondary transaction will cause a company’s 409A valuation to rise sharply. From Carta’s years of experience in the 409A and secondary liquidity space, we’ve learned that this isn’t necessarily true. Like any secondary event, a tender offer will likely cause a 409A valuation to rise. But most companies find that it’s not a meaningful increase if they have put the proper controls in place around relevant factors, like the number of permitted participants.3
The CartaX team can help founders and executive teams understand how a transaction’s characteristics could affect the weighting in a 409A valuation. We look at a number of factors, including the parameters set around who can participate, whether a particular buyer represents the majority of the demand, how often the company wants to run a secondary transaction, and the timing of a secondary in relation to a primary capital raise. Each of these levers can have a different impact on the 409A valuation. With the right guidance, companies can better understand what the outcome might be before finalizing the tender offer’s structure.
If you're planning to run a tender offer to meet your liquidity goals, we believe you should start with these five key considerations. If you have questions or want more guidance on tender offers, fill out this form to speak with the CartaX team.
1 As reported in Carta's Liquidity in 2021 Report.
2 Please see: Tax Issues Related to Startup Secondary Sales (Thomas Reuters/Fenwick & West, LLP; 2019) for more information.
3 For more on this topic, see Carta's blog on Secondary market liquidity and fair market value.
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