Raising common stock for first rounds of venture investments can have large, unintended consequences on employee compensation and common stock valuations, especially for 409A valuations. The Boston Business Journal released an article discussing how Jamie Goldstein’s new fund, Pillar, hopes to better align the interests of management and investors by purchasing common stock instead of preferred stock. What the article doesn’t discuss is the impact that raising common often has on the compensation of founders and key employees. Since issuing common to savvy venture capital investors is considered an arm’s-length transaction, the exercise price of the options will be valued at the negotiated common price, particularly if investors purchase a minority interest. This could leave hundreds of thousands, possibly millions, of dollars of compensation behind for founders and key employees due to IRC 409A valuation rules.
The IRS requires that the exercise price of stock options issued as employee compensation be set at the fair market value of the common stock (on a minority, non-marketable basis) on the date of grant. Common stock is generally valued at a fraction of preferred raised in venture backed deals. For Series Seed or Series A companies, common stock valuations are often less than 25% of preferred valuations. This means that if Series A preferred is raised at $1, common will likely be valued at less than $0.25. Contrast this with a VC investing in common stock at $1 when the exercise price for the common options must be set at $1 since the price negotiated would be considered the fair market value of the common stock. Although the value of the total equity of the company could be identical in the two scenarios, founders and key employees would lose $0.75 for each option owned by structuring a round raise of common instead of preferred. If the company grants 1 million options, the impact would be $750,000 in lost potential upside to founders and key employees. This also will impact the Company’s ability to attract talent given all else equal an employee will choose to join a company where they have the most upside and in this case that would be at the company raising a standard VC round.
Given most companies will raise more than one round this poses a fundamental problem if the next round were raised in the form of preferred at $2 per share, then the options issued to shareholders prior to the second round raise would likely be out-of-the money. This really misaligns the interests of employees since early employees should have the most upside given they joined the company first.
Ultimately, in a successful exit event preferred will likely convert to common. Regardless of whether common or preferred is issued in the early rounds of financing, the payout received by employees will be the same.