409A: How Common Stock vs Preferred Stock Valuations Differ

One of the most common sources of confusion for founders and employees is the gap between the price investors pay for shares and the value a 409A assigns to the company's stock. The investor wired in $2.00 per share; the 409A report says the stock is worth $0.60. Both numbers are correct — because they describe two different securities. Understanding common stock vs preferred stock in a 409A valuation resolves this apparent contradiction and explains nearly everything about how startup equity is priced.

A 409A valuation common stock vs preferred stock analysis is not an abstract exercise. It determines the strike price on every option your company grants, the perceived value of employee equity packages, and whether your option grants comply with IRC Section 409A. This article explains the mechanics from the ground up.

Why a 409A Values Common Stock, Not Preferred

A 409A valuation exists for one purpose: to establish the fair market value of the common stock that underlies employee stock options. Employees and service providers receive options on common stock — never on preferred. Preferred stock is reserved for investors who negotiate for it as part of a priced financing round. Because IRC Section 409A governs the taxation of deferred compensation, and stock options are a form of deferred compensation, the regulation is concerned exclusively with the value of the security employees will eventually own: common stock.

This is why a 409A report does not simply restate the price of the last preferred round. Preferred stock and common stock are economically distinct instruments with different rights, different risk profiles, and therefore different values. The preferred price is an important input — arguably the most important one — but it is not the answer. The appraiser's task is to work from the observable preferred price to the unobservable common-stock value, a process governed by the 409A valuation methodology framework.

What Preferred Stock Gets That Common Doesn't

Preferred stock commands a higher price than common stock because it comes with a bundle of contractual rights that protect investors and enhance their returns. These rights are the entire reason for the price gap.

The most important is the liquidation preference: in a sale or wind-down, preferred shareholders are paid back first, typically 1x their original investment, before common shareholders receive anything. Preferred also frequently carries a dividend preference, anti-dilution protection that adjusts the conversion ratio if the company raises a later round at a lower price, protective provisions giving investors veto rights over major decisions, and registration rights that help investors achieve liquidity. Common stock has none of these. It is the residual claim — it receives whatever is left after every senior security has been satisfied.

What is the difference between common stock and preferred stock in a 409A valuation?

In a 409A valuation, preferred stock is the senior, investor-held class with liquidation preferences and protective rights, while common stock is the junior, employee-held class that receives only residual value after preferred is paid. Because of these superior rights, preferred is always worth more per share, and the 409A measures common stock's lower fair market value for option pricing.

The table below contrasts the two classes across the dimensions that drive the valuation difference.

How the OPM Allocates Value Between Common and Preferred

The bridge between the preferred price and the common value is the Option Pricing Model (OPM). The OPM treats the company's total equity value as something to be divided among share classes according to the liquidation waterfall, and it models each class's claim as a series of call options that pay off only above certain value thresholds, called breakpoints.

Here is the intuition. At low company values, the preferred liquidation preference absorbs everything — common stock receives nothing, so its claim is worthless in that scenario. Only once the company value rises above the total preference does common begin to participate. And only at high values, where preferred would convert to common to capture more upside, do the two classes share proportionally. The OPM uses Black-Scholes option mathematics to weight all these scenarios by probability, producing a per-class value. Common stock's value reflects the fact that it only pays off in the better outcomes, which is precisely why it is worth less than preferred.

In a 409A engagement with a recent priced round, the appraiser runs this process as a backsolve: total equity value is calibrated so the OPM reproduces the exact preferred price paid, and the model then reads off the implied common value. This is the most defensible way to perform a 409A valuation common stock vs preferred stock allocation, because it anchors to a real transaction.

Why is common stock worth less than preferred stock?

Common stock is worth less than preferred because preferred holders get paid first in any exit through their liquidation preference, hold protective and anti-dilution rights, and bear less downside risk. Common stock is the residual claim — it receives value only after all preferred preferences are satisfied — so its per-share value sits well below the preferred price.

A concrete example makes this vivid. Suppose a company has raised $10 million of preferred with a 1x liquidation preference and is later acquired for $10 million. Preferred takes the entire $10 million; common receives nothing. The same common stock that looked valuable on paper is wiped out, while preferred is made whole. That asymmetry — preferred protected on the downside, common exposed — is the structural reason common always trades at a discount in a private company. The deeper mechanics of this gap are covered in why your 409A is lower than the preferred price.

The Role of Liquidation Preferences

Liquidation preferences are the single largest driver of the common-preferred gap, and their structure matters. A 1x non-participating preference — the market standard — lets preferred take the greater of its preference or its as-converted common value, but not both. A participating preference (less common today) lets preferred take its preference and then share in the remaining proceeds as if it had converted, which depresses common value further. Multiple preferences (2x, 3x), seen mainly in down rounds or distressed financings, are even more punishing to common.

The larger and more senior the preference stack relative to the company's total value, the larger the value gap between common and preferred. A company that has raised many rounds with stacked preferences will show a steeper discount on common than a lightly capitalized company at the same valuation. A down round can dramatically widen this gap by adding senior preferences ahead of existing common.

DLOM: The Final Discount on Common

After the OPM allocates value to common stock, one more adjustment applies: the discount for lack of marketability (DLOM). Private company common stock cannot be sold freely — there is no public market, and transfer restrictions usually apply — so its value is reduced to reflect that illiquidity. DLOM for early-stage companies commonly runs 30–45%, narrowing as a company approaches a liquidity event.

Crucially, DLOM is applied to common stock, compounding the discount that the OPM allocation already produced. This is the second reason common stock value sits well below the preferred price: first the rights gap (captured by the OPM), then illiquidity (captured by DLOM). For the mechanics of how appraisers calculate this, see our guide to the Finnerty DLOM model.

How much lower is the 409A common stock price than the preferred price?

At seed stage, common stock is commonly valued at 20–40% of the latest preferred price (a 60–80% discount). The discount narrows as the company matures: roughly 40–60% of preferred at Series B, and 50–75% at Series C and later, approaching parity only as a successful exit becomes likely and preferred is expected to convert to common.

The exact ratio for any company depends on the size and seniority of the preference stack, the volatility assumption, the expected time to liquidity, and the DLOM applied. Our 409A valuation benchmarks by stage provide common-to-preferred ratios drawn from market data.

Common Mistakes When Comparing Common and Preferred Valuations

Using the preferred price as the strike price. Setting option strikes at the preferred price overcharges employees and misstates the equity's value. The strike must equal the appraiser's documented common-stock fair market value — not the investor price.

Assuming the discount is a fixed percentage. There is no universal “common is 20% of preferred” rule. The ratio is the output of an OPM allocation plus DLOM, both of which depend on the specific capital structure, stage, and assumptions. A flat percentage applied without analysis is not defensible.

Ignoring the preference stack. Founders sometimes compare common to preferred without accounting for how many rounds of senior preferences sit ahead of common. Each layer of preference pushes common value down, and a company that has raised several rounds will show a larger gap than its valuation alone would suggest.

Setting the strike below a proper common FMV. The opposite error — granting options at a strike below the genuine common-stock value to make grants look more attractive — is the dangerous one. If the IRS concludes options were granted in-the-money, employees face immediate income inclusion plus a 20% additional tax under IRC Section 409A. The safe path is a documented, independent appraisal of common stock.