409A Valuations and Common vs Preferred Stock

When a private startup raises venture capital, investors buy preferred stock with special rights — a claim ahead of everyone else if the company is sold or liquidated, and sometimes guaranteed dividends. Employees, by contrast, usually receive stock options on common stock, which has none of those protections and sits behind preferred stock in a payout. Because of these different rights, common stock is legitimately worth less per share than preferred stock, even though they represent ownership in the same company.

A 409A valuation, named after the US tax code section that requires it, is an independent third-party appraisal of what that common stock is actually worth. Its main purpose is to set a fair strike price for employee stock options: if options are priced too low relative to the stock's real value, the IRS treats the difference as immediate taxable income for the employee, plus penalties, so companies commission these valuations (typically annually, or after a major event like a new funding round) to stay compliant.

Worked example. A startup raises a Series B round at $10.00 per preferred share, implying a headline valuation based on that price. Its 409A valuation, accounting for the fact that common stockholders are paid only after preferred holders in a sale, might value the common stock at $3.50 per share — about a 65% discount to the preferred price. New employee stock options are then granted with a $3.50 strike price, not $10.00, which is both legally required and far more valuable to the employee if the company succeeds.