409A vs preferred price: why your strike and the headline valuation are different numbers
Your company just announced a new funding round at a $20 billion valuation. Your stock option strike price is $4.50 per share. The implied price per share from the round is $120. The gap isn't a mistake — it's by design. Here's exactly why.
Two prices for the same company
When a VC invests $500M at a $20B post-money valuation, they're buying preferred stock. When your company sets your option strike price, it's required by law to use the fair market value of common stock — a different class, with different rights, assessed by an independent appraiser under Section 409A of the Internal Revenue Code.1
Preferred stock is worth more than common stock in a private company. Not a little more — often 50% to 90% more at high-growth companies with heavy liquidation preferences. Both numbers are correct; they measure different things.
What a 409A appraisal actually is
Section 409A of the IRC requires that incentive and non-qualified stock options be granted at or above the fair market value of the underlying common stock at the time of grant. Options granted below FMV face an immediate tax event plus a 20% excise tax penalty — a disaster neither the company nor the employee wants.2
To establish a defensible FMV, companies hire an independent third-party valuation firm. That firm produces what the industry calls a 409A appraisal — a formal valuation of the company's common stock. Companies typically refresh it at least annually, or more frequently after a new funding round or material business change.
The appraisers use one or more of three approaches:
- Market approach: compare to publicly traded peers and recent private transactions.
- Income approach: discount projected future cash flows.
- Option pricing model / backsolve: take the most recent preferred-stock transaction price and work backward to infer what the common stock is worth given its different claim on the upside. This is by far the most common method for venture-backed companies and is why the new funding round directly influences your new option grants without matching the new round price.
The result is a "safe harbor" value — meaning if the IRS challenges the FMV, the company can defend the grant price.3
Why preferred stock is worth more: the preference stack
Preferred stock carries rights that common stock doesn't — primarily the liquidation preference. In a sale or wind-down, preferred investors get paid first, before common shareholders see a dollar. Many rounds also include participation rights (preferred gets paid back and participates in the remaining proceeds alongside common).
Here's a simplified example with real-ish structure:
| Round | Invested | Liquidation preference | Participation |
|---|---|---|---|
| Series A | $20M | 1× ($20M) | Non-participating |
| Series B | $100M | 1× ($100M) | Non-participating |
| Series C | $500M | 1× ($500M) | Participating up to 2× |
If the company sells for $800M, preferred investors can claim up to $620M before the waterfall reaches common. Whether they actually claim it depends on whether converting to common would net them more — they'll always take whichever is higher.
The appraiser models the probability-weighted proceeds common stock receives across many exit scenarios. At a company with large liquidation preferences, the common stock's fair value is substantially lower than "enterprise value ÷ fully-diluted shares" suggests.
Worked example: the gap in numbers
A late-stage company raises a Series D at a post-money valuation of $15 billion. The round price — what investors pay per preferred share — implies roughly $90 per share on a fully-diluted basis.
The 409A appraiser, backsolving from the preferred price and modeling the preference stack, pegs common stock FMV at $28 per share — about 31% of the headline number. This is realistic for a company with two-to-three rounds of heavy liquidation preferences outstanding.
Your option grant is struck at $28. You're not losing $62 per share; you're holding common stock that has a different economic claim. The headline number isn't wrong — it tells you what investors paid for preferred stock. The strike tells you what the appraiser assessed common stock to be worth today.
What this means for your equity
- Your paper value is not "shares × latest round price." It's what common stock actually gets in the range of realistic exits, probability-weighted. For a company with modest preference overhang at a very high valuation, common gets most of the upside. For a heavily structured round at a company where exit values are less certain, common gets meaningfully less.
- Option spread is taxed on the 409A value, not the preferred price. If you exercise a non-qualified option (NSO), the spread — taxable as ordinary income — is the 409A FMV at exercise minus your strike. This is usually good news: it's lower than the headline. For ISOs, the same spread becomes an AMT preference item. Model your AMT exposure before exercising.
- Tender offer pricing usually falls between 409A and preferred. Companies want to offer a price that feels real to sellers; buyers want a discount to preferred. The actual tender price is a negotiated number. Knowing both endpoints helps you evaluate whether the offer is fair. Our tender offer guide covers how to think about sale sizing once you have that number.
- On an IPO or acquisition, the structure resolves. An IPO converts preferred to common — the preference stack collapses, and all shares trade at the same market price. At that point, the gap disappears. In an acquisition, it depends on the waterfall: a high-price deal (above full preference repayment) often converts; a lower-price deal may not. The terms in your option agreement and the acquisition agreement govern.
When does the gap close — or widen?
| Event | What happens to the gap |
|---|---|
| New funding round at higher valuation | 409A rises — but usually not as fast as preferred price. Gap may widen if new round has heavier preferences. |
| Flat or down round | Both preferred and common values fall. Anti-dilution protections on preferred can widen the gap further. |
| IPO (traditional or direct listing) | Preferred converts to common. Gap collapses. All stock trades at the same price. |
| Strategic acquisition — high price | Both classes receive deal consideration; above preference threshold, gap narrows or disappears. |
| Strategic acquisition — lower price | Preference stack absorbs most proceeds. Common may receive very little. The gap becomes a real loss. |
| Company-run tender offer | Priced above 409A, below or at preferred price. Gives you a real exit at a negotiated number before the gap resolves. |
Three questions worth asking before your next decision
- What is the current 409A value? It's in your option agreement at grant and on your cap table portal. This is your exercise price; it also tells you how much the appraiser thinks common is worth right now.
- What are the liquidation terms on the outstanding preferred? Your company's cap table and any publicly reported terms give a rough sense of the preference stack. An advisor can model the common stock value across exit scenarios once you know the total preference outstanding.
- What's the after-tax number in a tender offer at the offered price? Run it through the tender offer calculator. Understanding what you'd net is the only way to evaluate whether selling in the window makes sense given the uncertainty on both sides of the gap.
Know the gap, plan around it
A fee-only equity specialist can model your specific preference stack, exercise scenarios, and tender or IPO outcomes — so you go into the window with the actual numbers, not the headline. Free intro, no obligation.
Sources
- IRC § 409A — law.cornell.edu/uscode/text/26/409A. Governs deferred compensation and requires stock options be granted at or above FMV of the underlying common.
- Treasury Regulations § 1.409A-1(b)(5) — law.cornell.edu/cfr/text/26/1.409A-1. Sets the safe-harbor valuation methods for stock rights and defines the below-FMV penalty regime (income inclusion + 20% excise tax).
- IRS Notice 2005-1 (transition guidance on § 409A) and subsequent final regulations (T.D. 9321, 2007). The three safe-harbor methods — independent appraisal, formula, and presumption based on prior equity transactions — are detailed in the final regs.
- AICPA Valuation of Privately-Held-Company Equity Securities Issued as Compensation (2004, updated 2013) — the practice aid that established option-pricing models (OPM backsolve) as the standard method for VC-backed companies. Values verified as of June 2026; regulatory amounts are structural, not year-specific.