Understanding the Difference Between 409A and Preferred Stock Financing Valuations
Written By Haley Kopp
If you've ever raised a venture round and then issued stock options, you may have noticed something strange: the valuation your investors used to buy preferred stock is much higher than the value your 409A appraisal gives for common stock. How can the same company have two very different valuations at the same time?
Let’s break it down.
1. What is a 409A Valuation?
A 409A valuation is an independent appraisal of the fair market value (FMV) of a company’s common stock. It's required by IRS Section 409A to ensure that stock options are not granted at below-market prices (which could trigger nasty tax consequences).
Key characteristics of the 409 valuation:
● It reflects the value of common stock, not preferred stock.
● It’s usually prepared by a third-party valuation firm.
● It must follow specific IRS guidelines to provide "safe harbor" protection.
● It tends to be conservative by design, minimizing the risk of IRS penalties.
2. What is a Preferred Stock Financing Valuation?
In a venture financing, investors typically buy preferred stock, which comes with special rights like liquidation preferences, anti-dilution protection, board seats, and more.
The valuation you see on the term sheet (usually something like "$20 million pre-money") is typically:
● The value per share of preferred stock, not common stock.
● A negotiated number, reflecting what investors are willing to pay for a stake in the business.
● Often influenced by growth potential, competitive dynamics, and investor appetite
3. So Why Are They Different?
Because preferred stock and common stock aren’t equal. Preferred stock has rights and protections that common stock doesn’t. In an early-stage company, those differences can be significant.
That means:
● Investors pay a premium for preferred shares because of the upside and downside protections.
● Employees receive common stock options, which are worth less, even though they represent the same company.
4. Why It Matters
● Founders and boards need to understand both valuations to communicate clearly with employees and investors.
● Employees need to know that a low 409A value doesn’t mean the company is doing poorly. It just means their option grants are affordable.
● Investors want to see the company issue equity responsibly, without inflating employee comp or triggering tax risks.
Final Thought
Think of it this way: 409A is about taxes and compliance; preferred valuation is about negotiation and growth. They serve different purposes, and understanding both is key to managing equity wisely.
Haley Kopp is a corporate lawyer focused on representing start-ups and small companies in formations, venture capital, angel investor financings, mergers and acquisitions, and general corporate matters.
Haley's diverse experience gives her a practical approach to solving complex business issues, whether guiding companies through financing rounds or corporate transactions. Her office can be reached at (619) 512-3652.
This guide is meant for educational and informational purposes only and should not be considered legal advice. It is essential to consult with an attorney or other advisors regarding all legal and other important matters.
