409A vs Preferred Price: Key Differences You Should Know

Equity allocation impacts different financial aspects of a startup, ranging from fundraising to employee compensation. Granting ESOPs (Employee Stock Ownership Plans) is an effective strategy to create a sense of ownership in your employees and motivate them to work harder for the company's success.

Before allocating any ESOPs to the employees, you must determine the value of common stock of your enterprise. Here, you have two options to choose from: 409A valuation and preferred price. A 409A valuation defines the Fair Market Value (FMV) of your company's stock, while the preferred price is the amount that investors pay for a share during the latest investment round. 

Understanding the difference between 409A and preferred price helps you navigate the complex facets of equity distribution and valuation efficiently. This blog offers a comprehensive analysis of 409A valuation and preferred price and how they impact private companies.

Understanding 409A Valuation

409A valuation is an independent appraisal process conducted by a qualified third-party valuation firm or expert. Along with the FMV, it also helps set the 'strike price' at which your employees can exercise their stock options. This valuation process gets its name from the Section 409A of the Internal Revenue Code (IRC) in the US. 

As per the provisions of this section, the Internal Revenue Service (IRS) requires that your ESOPs have been issued at the FMV. A 409A valuation ensures compliance with the US Tax Code by providing a 'safe harbor' for your common stock. The safe harbor status offers your employees protection against any possible penalties from the IRS due to the undervaluation of the stock.

The 409A valuation is not a one-time event. It must be updated every 12 months or whenever there is a material event related to the company, like a merger or acquisition. This ensures that the strike price of options aligns with the current value of the common stock of your company.

What is Preferred Pricing?

Preferred price is the ‘price per share’ that investors agree to pay during your startup's latest funding round. Unlike common stock, preferred shares come with additional rights and privileges like liquidation preference (getting their money back first in case of a sale), making them more appealing to investors.

The determination of the preferred price is a strategic process involving negotiations between your management team and the investors. It considers factors like your company's financial performance, market conditions, and the perceived value of the future growth potential.

As a startup founder, understanding the implications of preferred pricing is essential for you. It can affect the dilution of ownership, your control over the company, and the distribution of proceeds in the event of a sale or liquidation. For employees, the preferred price can impact the value of ESOPs, especially if they are tied to the preferred price instead of the 409A valuation.

Preferred Price and Its Impact on Company Valuation

The preferred price reflects the perceived equity value of your startup in the eyes of investors and directly impacts your company’s value in the following ways: 

• Investment Decisions: A high preferred price sets a benchmark for future funding rounds. Investors in the next round might expect a similar or even higher valuation, putting pressure on your company to deliver exceptional growth. However, an excessively high valuation can lead to challenges such as a 'down round' where future investment comes in at a lower valuation.
• Equity Structure: With each funding round, you issue new shares at the preferred price. This increases the overall number of shares outstanding, possibly diluting the ownership percentage of existing shareholders, including founders and employees holding common stock. This can have implications for control and decision-making within the company.

409A Vs Preferred Price: Key Differences

Here are the main distinctions between 409A vs. preferred price:

Purpose

The 409A valuation serves a specific purpose in terms of tax compliance and employee compensation. It is used to set the strike price for stock options, ensuring that they have been issued at the FMV. 

On the other hand, the preferred price is the value at which new investors acquire shares of your company during a funding round.

Frequency

The frequency of these valuations also differs. A 409A valuation is typically conducted every 12 months or when there is a material event, such as a major acquisition or a new product launch. 

In contrast, the preferred price is usually determined during each funding round, reflecting the negotiated stock value of the company at that specific point in time.

Methodology

The methodologies used for 409A valuations and preferred pricing are distinct. A qualified third-party appraiser conducts a 409A valuation using either the income, market, or asset-based methods to determine the FMV of your common stock. 

The preferred price, however, is often based on negotiations between the company and investors. It can also be affected by factors like investor expectations, market conditions, and the specific terms of the investment.

Impact on Employees

Changes in 409A valuation can affect the cost of ESOPs, as it determines the strike price at which employees can exercise their options. 

Changes in preferred price can affect the ownership percentage of existing shareholders, including employees with common stock. This is because, with each funding round, new shares are issued at the preferred price, increasing the total number of shares outstanding.

Regulatory Requirements

The 409A valuation is a regulatory requirement from the IRS under Section 409A of the IRC. This valuation ensures that the stock option grant is priced at FMV, keeping your startup in compliance with tax laws. 

On the other hand, the preferred price is not governed by any specific law. However, it is subject to general securities laws and regulations. This means you must ensure transparency and avoid any misleading information during negotiations with investors.

Valuation Result

When it comes to the valuation result, the 409A valuation typically yields a lower value compared to the preferred price. This is because 409A valuations consider factors like illiquidity (difficulty of selling shares) and minority discounts (reduced value for non-controlling shareholders). 

These discounts account for the fact that common stock is less liquid and carries fewer rights compared to preferred stock.

Implications of These Differences for Startups and Investors

The differences between 409A vs preferred price can have significant implications for startups and investors in various operational and financial aspects:

• Equity Pricing: The disparity in 409A valuation and preferred price can lead to different pricing structures for ESOPs and investor shares. A lower 409A valuation means lower strike prices for stock options, making them more attractive for employees.
• Tax Implications: An incorrect 409A valuation can lead to severe tax penalties for startups. If the IRS determines that your 409A valuation was too low and options were issued below FMV, it could impose penalties and additional taxes.
• Investor Relations: A high preferred price can lead to higher expectations from investors. They may expect quicker returns or more significant growth, which can put pressure on your startup. Managing these expectations effectively is essential for maintaining healthy investor relations and ensuring the long-term success of your startup.

• Employee Morale: Significant disparities between the 409A valuation (used for employee stock options) and the preferred price (paid by investors) can impact employee morale and retention. If employees perceive that their stock options are undervalued compared to what investors are paying, it could lead to dissatisfaction and potentially affect retention.
• Fundraising: The preferred price plays a vital role in fundraising efforts. A higher preferred price can increase the amount of capital you can raise in funding rounds. However, it is important to strike a balance, as an excessively high preferred price might deter potential investors who may view it as overvalued.
• Company Ownership: The differences in these valuations can significantly affect the ownership structure of your startup. A higher preferred price can lead to more dilution of ownership, influencing control and decision-making within the company.

Conclusion

Understanding the differences between 409A vs. preferred price goes beyond adding to your financial understanding. It is a strategic advantage that can guide your startup's financial decisions, shape your equity structure, and influence your relationships with employees and investors.

In the 409A vs preferred price debate, each option has its unique purpose, methodology, and implications. By understanding these differences, you can navigate the complexities of startup finance with confidence, ensuring that your strategy aligns with your startup's growth objectives.

As a startup founder, you don't have to navigate this journey alone. As a professional valuation provider, Qapita offers expert guidance to help you understand these valuations and their implications for your startup.

• 409A Valuations: Qapita is a global leader in providing 409A valuations, having performed over 500+ valuations and designed over 1,000+ plans for more than 1,800+ clients.
• Valuation Reports for Compliance: Qapita provides comprehensive valuation reports to ensure your compliance in multiple jurisdictions and across accounting standards.
• ESOP Expense Accounting: We help startups stay compliant with their ESOP expense accounting needs with employee-level, grant-level, vest-level, and department-level reports and automate disclosures to ensure compliance requirements.

Our analysts have multi-year experience in delivering audit-ready valuation reports. They dedicate time to understanding your business and are available to guide you through and clarify the results and methods used to determine your company's FMV.

Ready to empower your team and fuel your startup's growth? Contact Qapita today and schedule a consultation with our valuation experts.