Guide
Why a 409A value is lower than the price investors paid
Updated
Founders meet this as a surprise and sometimes as a suspicion, and it is neither. The two numbers are prices for two different securities, and the gap between them is the value of everything the preferred holds that the common does not.
Two different securities
A priced round sells preferred stock. Preferred typically carries a liquidation preference that is paid before the common receives anything, and often carries board representation, protective provisions, anti-dilution protection and information rights.
A 409A valuation determines the fair market value of the common stock, which has none of that. A price paid for one security is evidence about the other, and it is not the same number.
What else pulls it down
Illiquidity. The common cannot be sold, and the regulation's own language for the start-up safe harbour is about illiquid stock of a start-up corporation.
Lack of control, where the holding is a minority stake with no ability to influence a sale or a distribution. Both are ordinary valuation adjustments rather than concessions.
Why a low value is not a free win
A lower strike price is better for option holders, and the incentive to want a low number is obvious. It is also the incentive the grossly unreasonable standard exists to constrain.
The exposure runs to the employee rather than to the company, so a valuation pushed low is a risk transferred onto the people it was meant to reward, and it is checked in diligence by somebody with every reason to find it.
What to expect after a round
A priced round is the clearest material event there is, and the common value generally moves after one. Planning a grant round immediately before closing, in order to use the older valuation, is a decision to make with advice rather than an obvious saving.
The defensible sequence is unremarkable: close the round, refresh the valuation, then grant. It is slower by a few weeks and it is the version that survives being read by somebody else.