Estate Planning with Pre-IPO Stock

In the midst of gloomy headlines covering the challenging economic environment and uncertain global economic landscape, I am happy to report some positive news from the Bay Area: wealth creation through technology innovation continues to accelerate in Silicon Valley at a pace not seen since the late 90's.  And as the economy continues to improve, highly accomplished technology companies, which have had to defer their exit strategy due to challenging capital market conditions, will pursue a liquidity event in 2012.  In general, technology companies tend to be great candidates for pre-IPO planning as they are characterized by inherently more risk, and may experience more volatile performance in the months leading up to (and after) an IPO.  On deck for early 2012 is the Facebook IPO, which will be the largest technology IPO ever.  With everyone keeping a close eye on the Facebook IPO, a successful offering will open up the floodgates for many more IPOs in 2012.

In connection with such IPOs, many relatively younger clients are becoming ultra wealthy through their equity incentives, and are grappling with financial and estate planning issues. Given their newly acquired high net-worth wealth profile, removing assets from their estate may be a priority. Additionally, today's regulatory environment may offer a unique opportunity through the $5.12 million gift tax exemption that is set to expire in 2012, and uninhibited grantor retained annuity trusts ("GRATs") strategies that are facing potential legislative pressure. Whatever strategy is employed, transfer opportunities of pre-IPO stock are tremendous, and can be highly effective even after a prospectus is filed with the Securities and Exchange Commission ("SEC"). 

This article will explore some of the traditional approaches to valuing pre-IPO stock, and discuss the larger role of secondary market trading in carrying out such valuations.  We have been called on to assist on such transfers due to our unique capabilities in this area: exclusive access to secondary market transactions in pre-IPO companies, which is part of our LiquiStatTM database ("LiquiStat"), further discussed below.

Traditional Approaches

Traditionally, to arrive at a conclusion for a pre-IPO common stock interest, a qualified appraiser will need to: (i) arrive at the value of the company on a controlling interest basis (comparables analysis, discounted cash flow method, etc.); (ii) allocate the value to the various securities (and subject interest); and (iii) perform a valuation discounts analysis to arrive at a non-marketable minority value.  To the extent that an IPO price range is established or estimated by the investment bankers, pre-IPO discount studies can provide additional support for the valuation conclusion (by analyzing the implied discount to IPO price as a function of days-to-IPO, or liquidity horizon). This is a sound valuation approach, but an expensive and time consuming undertaking, that is often consumed by gaps in the due diligence process:

•    Will the appraiser have access to the financial statements? Projections? Security agreements? Capitalization table?
•    Will the appraiser have access to management for due diligence?
•    Will the appraiser have access to the investment bankers and documentation related to company valuation range expectations?

The above information is critical for formulating a valuation opinion, but is not always available in its entirety given its sensitive nature. We always attempt (and hope) to apply this methodology, but given the above stated challenges, this methodology may lose its credence. Regardless of the strength of the traditional approach, market based evidence in the form of secondary market transactions must also be considered, and LiquiStat is the basis for this data.

LiquiStat

LiquiStat has been developed using transaction data licensed from SecondMarket (1) (www.secondmarket.com), and contains data on transactions involving Auction Rate Securities, restricted securities, bankruptcy claims, private investments in public equity, private company stock, and other asset classes.

Specifically, with respect to pre-IPO estate planning, LiquiStat provides us with data on aggregate arm's length (investor-to-investor) transactions in common stock of late stage venture-backed companies that have taken place on the SecondMarket trading platform. Currently, Facebook is the most frequently traded private company stock on the SecondMarket trading platform.  

With LiquiStat data, we can analyze recent trades of the subject interest as well as the data on companies that have already gone public to measure the pre-IPO discounts. This data serves as additional support to empirical pre-IPO discount studies. The chart below, which is indexed to $100 and the IPO date, represents a scatter plot for recent IPOs for companies that traded on SecondMarket prior to their public offering. As can be seen by the trend line, our LiquiStat data provides further support that higher discounts tend to apply the further the transaction is from the eventual IPO date. 

The chart below created from LiquiStat data represents implied pre-IPO discounts; as observed specifically for LinkedIn Corp.: