What Are Preferred Stock Terms and How to Find Them With 409A Valuations

Some notable changes have occurred in the finance sector over the past decade. For example, in 2014, the Internal Revenue Service (IRS) upped its investigation or review of stock option pricing by rolling out an audit program, particularly for 409A deferred compensation plans. As a result, if you are a board member of a startup, you should be able to understand or determine preferred stock terms with a 409A valuation.

In addition, board members should have clarity regarding the entire valuation process before stock options and grants are approved. Preferred stock financing becomes critical after a startup completes Series A funding.

This article will walk you through the relationship between preferred stocks & 409A valuation and how a 409A valuation influences stock prices.

409A Valuation and Preferred Stocks

So, what exactly is a preferred stock? Preferred stocks (also known as preference shares) are shares of a corporation’s stock that pay dividends before common stock payments are handed out. What this means is that if a company were to go bankrupt, it would compensate preferred stockholders before common stockholders.

Where does a 409A  valuation come into the picture? The 409A valuation lays down the guidelines for private companies while they determine the value of their private shares. A 409A valuation carried out by an independent third-party serves as a seal of trust for people, including the IRS.

How Do Preferred Stocks Work?

Preferred stocks are capital stocks issued by some companies apart from their common stock. The dividends gained from preferred stocks are paid by the company during liquidation.

Although the conditions or terms of preferred stock vary from business to business, liquidation preference is the main distinguishing factor between common stock and preferred stock. Preferred stockholders will be paid off before common stockholders at the time of liquidation.

Are preferred stocks rare? The answer is yes. Preferred stocks are comparatively rare as companies primarily use debt with common stocks. The chunk of a company’s shares allotted for employees and founders is known as common stock.

As dividends on preferred stock is a fixed amount in most cases, the value of the preferred stock moves in the opposite direction of inflation. It means that when inflation is high, the value of the fixed dividend amounts starts to fall. It goes without saying that when inflation declines, the value of a preferred stock increases but is not higher than the preferred stock’s call price.

Determining Stock Prices with 409A Valuation

As mentioned earlier, during the 409A valuation, independent third-party companies evaluate the fair market value (FMV) of a privately-held company’s common shares. The price of purchasing a share is also calculated during the 409A valuation.

Typically, startups pay for this valuation and leverage the insights to put a price on the common stock.

• Option pricing method (OPM)

The option pricing method is a technique used by privately held companies to allocate equity value to individual ownership classes in a complex capital structure.

• Current value method

In this method, the value of the preferred stocks is removed from the company’s total equity value on a controlling basis. The remainder is then distributed among the common stockholders.

• Probability weighted expected return method (PWERM)

There are multiple steps involved when the value of a stock is determined using PWERM. In this method, the value of the equity securities is calculated based on the analysis of future outcomes of the business.  To get to the end of this, valuation analysts review the organization’s management to analyze different future scenarios (including dissolution, continuity of operations, merger, IPO, and more).

• Hybrid 

As the name suggests, the hybrid method is a blend of PWERM and OPM. This method is well-suited for companies that have a basic idea of their path of progression but also face uncertainties about the success of the business.

Final Thoughts: Does 409A Valuation Help Calculating Preferred Stock Terms

A 409A valuation may not be the true reflection of a company’s overall value when funds are raised from investors in an arm’s length negotiation. 409A valuation helps companies determine the FMV of common stock and not the value of the entire firm.

As the 409A valuation process helps companies determine stock prices, it also becomes a key tool for finding preferred stock terms.

Are you wondering how to find preferred stock terms with a 409A valuation? trica equity has your back. Our team of financial experts will help you determine preferred stock. You can book a demo with us today to learn more.