409A vs. Venture Capital Valuations

By Bobby Gojuangco

In venture-backed companies, equity typically takes two forms: common stock, which is granted to service providers (often as stock options), and preferred stock, which is purchased by investors. Preferred stock often has various rights, such as a liquidation preference, anti-dilution protection, and governance terms – each negotiated and generally resulting in a premium purchase price. In contrast, common stock is issued to service providers without a negotiated price, and is instead set at fair market value (“FMV”). What follows breaks down how each valuation works, why they differ, and what that means for your company.

409A Valuations

Stock options are typically granted to a company’s service providers, including employees, contractors, advisors, and directors. Under Section 409A of the Internal Revenue Code, an option’s exercise price must be at or above the FMV of the underlying stock on the grant date to avoid adverse tax consequences to the recipient. [1]

Companies typically obtain an independent appraisal from a qualified valuation firm to determine FMV. [2] This appraisal remains valid for 12 months, or until a material event occurs such as a capital raise or a significant increase in revenue. [3] The process starts with an estimate of the company’s total equity value, drawing on comparable company data, recent financing prices, and revenue or other financial metrics. The resulting estimate is then further discounted to reflect the lack of liquidity and, in particular, the economic preferences held by investors, discussed below.

Venture Capital Valuations

When investors buy preferred stock, they are paying for both an economic stake in the company and the negotiated preferred “rights.” These may include:

• Economic preferences (liquidation preference, anti-dilution protection)
• Governance rights, such as a board seat and protective provisions
• Additional rights, such as a preemptive right, a ROFR, and a co-sale right

The venture valuation set in a financing reflects what investors are willing to pay for that bundle of rights, weighed against the company’s growth outlook.

Understanding the Valuation Gap

Founders are often concerned that a low 409A valuation may anchor their future fundraising valuation, or signal to investors that a given financing round should be priced lower. It’s important to remember that a 409A is an independent appraisal of common stock conducted under IRS standards, while a venture valuation is the price for preferred stock agreed between the company and its investors. A 409A appraisal values common stock as of the report date, with discounts applied to reflect the holder’s lack of control over company decisions and inability to easily sell shares in a private company. A venture valuation looks forward, is negotiated based on growth expectations, and prices the special rights that come with preferred stock.

Much of the gap is driven by the liquidation preference held by preferred stockholders, which provides downside protection in low or flat exits. Common takes only what remains once those preferences are paid, so an appraiser assigns it a lower value. The larger the preference stack, whether through higher multiples, participation rights, or preferences stacked across rounds, the lower the resulting common valuation.

The gap is widest at the earliest stages, often 15% to 25% of the venture valuation for seed stage companies, and narrows as the company approaches a liquidity event. Once an exit becomes more likely, the downside protections matter less, and the common price begins to converge with the preferred price. In a successful IPO or acquisition, common and preferred typically trade at parity.

Implications for Option Recipients

The valuation gap directly benefits the service providers (e.g., employees or contractors) receiving stock options: a lower common stock FMV means a lower exercise price, allowing the grantee to capture more of the company’s growth at exit.

On the company’s side, investors frequently inspect 409A history during diligence and may ask that any gaps in timing or pricing be cured before closing. Options granted on a stale 409A, such as after a priced round without a refreshed report, can require remediation before an M&A transaction or new financing closes. [4]

Conclusion

A low 409A does not signal a low investor valuation, as the two measure different classes of stock in different contexts, and no sophisticated investor conflates them. The gap reflects the inherent difference between common and preferred stock and is expected to persist throughout the company’s early and growth stages.

[1] If options are granted with an exercise price below FMV, the optionee faces a 20% additional tax on top of ordinary income tax, plus interest, generally at the time of vesting. See I.R.C. § 409A(a)(1); Treas. Reg. § 1.409A-1(b)(5)(iv) (safe harbor for independent appraisals).

[2] A 409A appraisal performed by a qualified independent appraiser creates a rebuttable presumption that the exercise price equals FMV. The burden then shifts to the IRS to demonstrate that the valuation is grossly unreasonable. Without that presumption, the burden falls on the company and the optionee to establish FMV, which is a significantly less favorable position in any IRS examination. Treas. Reg. § 1.409A-1(b)(5)(iv).

[3] Section 409A does not define “material event” by bright-line rule. Whether a given development – a signed term sheet, a letter of intent, or a completed financing – triggers the need for a refreshed appraisal is a facts-and-circumstances determination. In practice, most practitioners treat a signed financing as the trigger, though some take a more conservative view and refresh upon execution of a term sheet.

[4] Common remediation mechanisms include option repricing and tender offers, each carrying its own tax and securities law implications. In an M&A context, parties may negotiate an escrow or indemnification arrangement to address residual Section 409A liability.

About the Author(s)

Bobby Gojuangco

Bobby Gojuangco is an attorney at Vela Wood. He focuses his practice in the areas of venture financing, M&A, and taxation.

Learn More