Comparison
409A Valuation vs Preferred Valuation: Key Differences Explained
A 409A valuation is an independent appraisal of a startup's common stock fair market value — used to set the strike price for stock options. The preferred valuation is the post-money valuation established in a VC financing round for preferred shares. 409A is always lower than preferred valuation because common stock carries no liquidation preference or investor rights. The gap is the foundation of startup equity compensation.
What is 409A Valuation?
A 409A valuation — named after Section 409A of the IRS tax code — is an independent third-party appraisal of the fair market value (FMV) of a company's common stock. It's required by law before issuing stock options to employees and contractors. The 409A must be performed by a qualified independent appraiser and is valid for 12 months (or until a material event like a financing round). For early-stage companies, 409A valuations are often 10–30% of the preferred valuation because common stock has no liquidation preferences, anti-dilution rights, or other investor protections. Setting options below FMV creates serious tax penalties for employees under IRC Section 409A, hence the regulation. The 409A creates the legal basis for employees to receive options at a discount to the company's market value.
What is Preferred Valuation?
The preferred valuation (or VC round valuation) is the pre-money or post-money valuation established in a venture financing. It reflects the price institutional investors are willing to pay for preferred stock — which comes with liquidation preferences, anti-dilution rights, board representation, and other protective provisions. Preferred stock is worth more than common stock by design — its additional rights create economic value, especially in downside scenarios. When a company says 'we raised at a $50M valuation,' they mean $50M post-money for preferred shares. The 409A for the same company might value common shares at $5–15M FMV — a significant discount that lets employees receive options at a bargain price relative to the preferred round.
Key Differences
| Feature | 409A Valuation | Preferred Valuation |
|---|---|---|
| What's being valued | Common stock FMV | Preferred stock in VC round |
| Purpose | Set option strike prices legally | Establish company financing valuation |
| Valuation method | Independent appraisal (DLOM, PWERM) | Investor negotiation |
| Typical ratio | 10–33% of preferred valuation | 100% (the reference point) |
| Who sets it | Third-party 409A provider | VC investor + founder negotiation |
| Validity | 12 months or until material event | Permanent for the round |
| IRS requirement | Yes — legally required for options | No |
When Founders Choose 409A Valuation
- →Before issuing any employee stock options (required)
- →After a financing round — the old 409A may no longer be valid
- →When hiring key employees who will receive significant equity
- →Annually if no financing has occurred
When Founders Choose Preferred Valuation
- →When raising a venture round and negotiating with investors
- →When communicating company valuation for press, recruiting, or benchmarking
- →When calculating dilution from new financing rounds
Example Scenario
A startup raises a $10M Series A at a $30M post-money valuation (preferred stock). They need to grant options to a new VP of Engineering. Before granting options, they get a 409A appraisal from a firm like Carta or Preferred Return. The appraiser values common stock at $3/share — roughly 10% of the $30M preferred valuation — based on the liquidation preferences that benefit preferred investors first. The VP receives options at $3/share (the 409A FMV). If the company sells for $100M, preferred investors get paid first per their liquidation preferences, and the remaining upside flows to common — making $3 a fair price for common stock today.
Common Mistakes
- 1Not getting a 409A before issuing options — this creates tax liability for employees
- 2Using an old 409A after a financing round — a new round triggers a required revaluation
- 3Confusing 409A FMV with the 'real' company value — both are valid for different purposes
- 4Telling employees the company is 'worth $30M' without explaining that their options are on common stock, not preferred
Which Matters More for Early-Stage Startups?
Both are critical — for different reasons. The preferred valuation is your company's headline and fundraising benchmark. The 409A is your legal compliance tool and the basis for employee equity. The gap between them is the discount employees effectively receive on their equity — and understanding that gap is key to explaining the actual value of option grants to your team.