Why is my 409A valuation so much lower than my investors' valuation?
FundraisingValuationStock optionsTax
A 409A valuation is an appraisal of the fair market value of your common stock, done so the company can set the exercise price of stock options at or above that value, which is what Section 409A of the tax code requires. Your investors' valuation is a negotiated price for preferred stock, which carries a liquidation preference, anti-dilution protection and often a board seat, none of which the common has. The two numbers value different securities for different purposes, and a common share worth a few cents alongside a preferred share worth a dollar is the normal state of an early company, not a sign anything is wrong.
What the 409A is for
If a company grants options with an exercise price below the common stock's fair market value, the holder faces immediate tax and a 20 percent penalty under Section 409A, and the company's cap table becomes a diligence problem in the next round. An independent appraisal from a qualified valuation firm gives the board a safe harbor: if it relies on the appraisal in good faith, the IRS has to prove the valuation was unreasonable rather than the company having to prove it was right. The appraisal is good for twelve months, or until something material happens, and a financing is material, so a new 409A follows every round.
Why it comes out low
The appraiser starts from the company's value, often anchored to the last round, and then works out what a share of common is worth given that the preferred is paid first in most exit scenarios and that a minority stake in a private company cannot be sold. Those two discounts, for the preference stack and for lack of marketability, are what turn a $1.00 preferred price into a $0.15 common price. Early on, when an exit is far off and the preference would take most of a modest sale, the gap is widest. It narrows as the company grows into its preference stack.
Why investors do not anchor on it
Investors know what a 409A is and know it prices common stock with those discounts applied. They price preferred stock on the company's prospects and on what comparable companies raised at. A future round is negotiated, not appraised, and a low 409A number in the data room is expected. What does hurt is the reverse: a company that skipped 409A appraisals and granted options at a made-up price, because that is a tax problem for every employee and a cleanup the investors will require before closing.
A low 409A is good news for the people receiving options. A lower exercise price means more of any eventual gain is theirs, and it is one of the few things about a startup's valuation that early employees should want to be small.
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Written by the lawyers who built Arabella. This is legal information, not legal advice for your situation, and reading it does not make us your lawyers. For a real dispute or a high-stakes decision, talk to a licensed attorney. More questions.