409A Valuation vs IPO Price: Why Your Last 409A Sits Below the IPO

How this page fits with our other guides: This article covers one comparison, the 409A vs IPO price. Why common stock is worth less than the price investors pay for preferred stock in a private round is explained in our guide to the 409A price vs the preferred price. How to run 409As in the run-up to an offering, including S-1 timing and auditor coordination, is in our pre-IPO 409A valuation guide. We link to those pages rather than repeat them.

What is the difference between a 409A valuation and an IPO price?

A 409A valuation is an independent appraisal of the fair market value of a private company's common stock on a specific date, used to set option exercise prices. The IPO price is the price the company and its underwriters set for newly registered, freely tradable shares sold to public investors on the offering date.

The two numbers answer different questions. A 409A asks what a share of common stock is worth today, as a minority interest in a private company that may or may not ever go public, with no market to sell it on. Treasury Regulations Section 1.409A-1(b)(5)(iv)(B) requires that value to come from a reasonable valuation method that considers the company's assets, its expected cash flows, comparable companies, recent arm's-length transactions in its stock, and its control premiums or discounts for lack of marketability.

An IPO price asks something narrower: at what price will institutional investors buy the shares being offered, on the day the offering is priced? By then, the uncertainty a 409A had to weigh has largely been resolved. The table below summarizes the differences.

Why the Last 409A Sits Below the IPO Price: Five Drivers

When the final private 409A valuation is compared with the IPO price, the gap usually comes from five separate effects. Each one can be measured, which is how an appraiser later reconciles, or "bridges," the two numbers.

• 1. Different date, different information. A 409A is prepared as of a valuation date. The IPO is priced months later, after more quarters of revenue growth, a confidential review by the SEC, and an investor roadshow. Value created in between belongs to the IPO price, not to the earlier 409A.
• 2. The IPO may not happen. Until the offering is priced, an IPO is one possible outcome among several: staying private and raising another round, a sale, or in a weak market a delay of a year or more. A pre-IPO 409A weights those outcomes by their probabilities, usually through a PWERM or a hybrid PWERM / OPM model.
• 3. Time and risk until liquidity. Even in the IPO scenario, the value arrives in the future. The appraiser discounts it back to the valuation date at a rate that reflects the risk of getting there.
• 4. Marketability. Private common stock cannot be sold freely. Appraisers apply a discount for lack of marketability, which falls as the expected time to liquidity shortens. Our comparison of DLOM models explains how that discount is estimated.
• 5. Preferences in the non-IPO outcomes. In most venture-backed charters, preferred stock converts to common on a qualifying IPO, so at the IPO every share has the same rights. In the stay-private and sale scenarios, preferred still ranks ahead of common, which lowers common's share of value in those outcomes. Our 409A vs preferred price guide covers that mechanism in full.

One further point works in the opposite direction from what many people assume. The IPO price is not the highest value of the shares. Underwriters usually price an offering somewhat below where they expect it to trade, so the shares are fully sold. The first-day trading price, not the IPO price, is the market's view of a freely available share.

How much lower is a 409A than the IPO price?

There is no fixed ratio. The gap depends mainly on how far away the IPO is, how likely it is, and how illiquid the shares are until then. In this article's illustrative example, common stock is worth 37% of the eventual IPO price 18 months out, 55% at nine months and 79% at three months.

Rules of thumb such as "common is worth a third of the IPO price" are not a valuation method, and an appraiser cannot use them. Two companies can sit 12 months from an offering with very different 409A values, because one has hired its underwriters and the other is still debating whether to go public at all. What a defensible pre-IPO 409A valuation shows is the reasoning: the probability of each outcome, the expected timing, the discount rate and the marketability discount, each tied to evidence available on the valuation date.

The Pre-IPO Ramp: How the 409A Climbs Toward the IPO Price

To show how the drivers interact, consider an illustrative late-stage company that will eventually go public at $20.00 per share. To isolate the effect of time, probability and marketability, the example holds two inputs constant across three 409A valuations:

• IPO scenario: an expected value of $20.00 per share at the IPO, discounted at 20% a year to the valuation date, then reduced by a marketability discount that reflects the time to the IPO and the lockup that follows.
• Stay-private scenario: common worth $9.00 per share on a marketable basis, based on an option pricing model that gives preferred its liquidation preference, less a 30% marketability discount at 18 months and 25% thereafter.

The probability of an IPO rises as the company hits the usual milestones: hiring underwriters, submitting a draft registration statement to the SEC, and filing publicly.

The IPO scenario value in each row is the $20.00 discounted for the time remaining, less a marketability discount of 20%, 12% and 6% respectively. The 409A value is the probability-weighted average of the two scenarios.

A Worked Example: Bridging the 9-Month 409A to the IPO Price

Take the 409A prepared nine months before the IPO, which concluded $11.05. The $8.95 difference from the $20.00 IPO price can be split into the drivers described above:

About half of the gap comes from the possibility that the IPO would not happen, a possibility that was real nine months out. The rest comes from illiquidity and the time value of money. In practice, there is usually a sixth line as well: the company's actual growth between the valuation date and the pricing date, which moves the IPO price itself. In this example the expected IPO value was held constant at $20.00, so that line is zero.

This is the kind of bridge auditors and SEC staff ask for. It shows that a 409A valuation at 55% of the IPO price can be fully explained by facts known at the valuation date, rather than suggesting the stock was undervalued.

When the Gap Draws Scrutiny: Cheap Stock in Brief

When a company files to go public, the SEC staff reviewing its registration statement often looks at equity grants made in the 12 to 18 months before the filing. If grants were valued well below the expected IPO price and the company cannot explain the difference, the staff may question whether the stock was "cheap."

Cheap stock is primarily a financial reporting question. If the fair value used for grants was too low, the company may need to record additional stock-based compensation expense under ASC 718. It can also become a tax question: if an option's exercise price was below the fair market value of the stock on the grant date and no exemption applies, the option can be treated as deferred compensation under Section 409A. If it then fails to comply, the holder may owe income tax on vested amounts, an additional 20% federal tax and premium interest, and some states, such as California, add their own tax.

The defenses are the ones in the bridge above: timely valuations, probabilities supported by documents such as board minutes and underwriter engagement, and a fresh valuation after each material event. A valuation by a qualified independent appraiser as of a date no more than 12 months before the grant is presumed reasonable under Treasury Regulations Section 1.409A-1(b)(5)(iv)(B)(2)(i), but only if it reflects all information available after its date that may materially affect value. Our 409A safe harbor guide and material events guide cover those rules, and the pre-IPO 409A valuation guide explains SEC review and auditor coordination in depth.

What happens to my stock options when the company goes public?

Nothing changes about the option itself. The exercise price stays at the 409A fair market value on the grant date, vesting continues under the plan, and the gain becomes the spread between that exercise price and the public trading price. Most employees cannot sell right away, because a lockup, commonly 180 days, applies.

This is why a lower 409A is not a loss to employees. The IPO price vs strike price difference is the value of the option. Using the ramp above, an employee granted 10,000 options 18 months before the IPO at a $7.47 strike, whose shares trade at $24.00 when the lockup ends, holds a pre-tax spread of $16.53 per share, or $165,300. How that spread is taxed depends on the type of option:

• Nonqualified stock options (NSOs): the spread at exercise is ordinary income, and for employees it is subject to withholding. Later gains or losses on the shares are capital gains or losses.
• Incentive stock options (ISOs): exercising does not create regular income tax, but the spread is an adjustment for the alternative minimum tax. Shares sold within two years of the grant or one year of exercise are a disqualifying disposition, and the gain is generally taxed as ordinary income up to the spread at exercise.

Lockups are contractual agreements with the underwriters, not a legal requirement, and their length and any early-release terms vary. Employees should also check the plan's post-termination exercise window and the company's insider trading policy. Our guide to 409A valuations and employee stock options covers how strike prices are set and what employees should check, and the strike price guide explains the link between the 409A and the exercise price.

After the IPO: The Trading Price Replaces the 409A

The 409A valuation vs IPO price comparison ends on the first trading day. Once a company's stock is readily tradable on an established securities market, Treasury Regulations Section 1.409A-1(b)(5)(iv)(A) allows fair market value to be determined from actual trading: for example, the last sale before the grant, the first sale after it, the closing price on the trading day before or the day of the grant, or, if certain conditions are met, an average price over a period of up to 30 days around the grant. The company no longer needs an independent appraisal to price new options.

Many late-stage companies also shift new grants from options to restricted stock units before the IPO. RSUs that settle when they vest generally fall within the short-term deferral exception to Section 409A, so they have no exercise price to set. They still need a fair value for accounting under ASC 718, which before the IPO is usually supported by the same valuation work.

The Bottom Line on 409A Valuation vs IPO Price

A 409A valuation and an IPO price are not two estimates of the same thing. The 409A values private, illiquid common stock on a date when the IPO is still uncertain. The IPO price values a registered, freely tradable share at the moment the uncertainty is resolved and preferred stock has converted. The gap between them is normal, and it narrows as the offering approaches.

For founders and CFOs preparing to go public, the practical points are these. Refresh the 409A after each IPO milestone, so grants are never priced off stale probabilities. Keep the documents that support each probability, timing and discount, because a bridge to the IPO price will be requested. And explain to employees that the 409A vs IPO price spread is the value of their options, not evidence that something went wrong.

The figures in this article are illustrative, based on simplified inputs (a constant expected IPO value, a single discount rate, and a fixed stay-private value), and are not a valuation of any company. This article is general information about Section 409A, valuation practice and the taxation of stock options, not legal, tax or accounting advice. Whether a valuation qualifies for a presumption of reasonableness under Treasury Regulations Section 1.409A-1(b)(5)(iv)(B), and how a specific option or sale is taxed, depends on the facts; consult your own counsel and tax advisor.