Common Stock vs. Preferred Stock in a 409A Valuation: Which Class the Rules Actually Cover
Author: Redwood Valuation Content Team
Published: September 17, 2026
A preferred round priced shares at one number, and your 409A valuation concluded a common stock fair market value well below it. Those two prices measure two legally different securities. Internal Revenue Code (IRC) Section 409A goes further than most explanations do, because the exemption from Section 409A's requirements that a compensatory stock option relies on is available only when the option is granted on a qualifying class of stock, which for almost every company means common stock.
A 409A valuation determines the fair market value of common stock, not the price of the preferred shares your investors bought.
Which Stock a 409A Option Can Be Granted On
Under Treasury Regulation §1.409A-1(b)(5)(i)(A), a stock option is exempt from Section 409A only if, among other conditions, it's granted on "service recipient stock," a term defined at §1.409A-1(b)(5)(iii)(A) that excludes a class of stock carrying a preference as to distributions. In practical terms, a compensatory stock option is generally granted on common stock.
Service recipient stock starts with two conditions. The class has to be common stock, and it has to be issued by an eligible issuer of service recipient stock. From there, the regulation narrows the definition:
"the term service recipient stock does not include a class of stock that has any preference as to distributions other than distributions of service recipient stock and distributions in liquidation of the issuer." Source: Treas. Reg. §1.409A-1(b)(5)(iii)(A)
Take the exclusion one feature at a time. A dividend preference, or any other preference in how a company distributes value while it operates, puts that class of stock outside the definition of service recipient stock. A preference that applies only to distributions when the issuer liquidates does not, because the regulation carves those liquidation distributions out expressly. A class whose only priority is to be paid ahead of common if the company winds down and distributes its assets can still qualify; a class that is paid ahead of common while the company is a going concern, such as through a dividend preference, cannot.
This carve-out reflects a real distinction in the stock's economics, not a drafting technicality for granting options on preferred stock. Most preferred classes often carry distribution preferences that extend beyond a liquidation preference, such as a dividend preference, and those are what the exclusion reaches. That is why, in venture-backed companies, the option grants are written on common stock.
The same paragraph carries a second exclusion that has nothing to do with distribution preferences. Stock subject to a mandatory repurchase obligation, or to a put or call right that isn't a lapse restriction, falls outside service recipient stock where the purchase price is based on a measure other than fair market value.
A right of first refusal is not one of those disqualifying rights. An ordinary right of first refusal doesn't create an eligibility problem, while a repurchase formula pegged to something other than fair market value can.
Why the Two Prices Differ
Common and preferred are different instruments with different rights, so they often carry different values. Preferred classes typically have liquidation preferences, participation rights, and conversion rights, and common stock in a private company is typically less liquid than preferred stock. The gap between a preferred round price and a 409A common stock conclusion reflects the differences in the securities.
The full explanation can be found in why a SaaS company's common stock is valued differently from its preferred. For how appraisers arrive at a value for each class, see the option pricing model and Probability-Weighted Expected Return Method (PWERM), along with the discount for lack of marketability. One thing you won't find here is a ratio between preferred stock and common stock. No defensible published figure states how far below a preferred round price a common stock value typically falls, because the answer depends on the capital structure and a variety of other factors.
What the Preferred Round Price Is in the Analysis
The preferred round price is often an input to the 409A valuation, and the common stock concluded value often doesn't land near it. Treas. Reg. §1.409A-1(b)(5)(iv)(B)(1) provides that fair market value "means a value determined by the reasonable application of a reasonable valuation method," judged on the facts and circumstances as of the valuation date.
That same paragraph sets out what a reasonable method takes into account. Among the factors are recent arm's-length transactions involving the sale or transfer of the stock, along with control premiums or discounts for lack of marketability. A minority interest in common stock ordinarily calls for a discount for lack of control rather than a control premium. A priced round is often an arm's-length transaction in the preferred rather than in the common being valued, so it enters the analysis as one of the inputs the method starts from. It's a data point the analysis considers, not the conclusion it produces.
A typical route to a common stock value starts from the most recent preferred financing and backsolves to the value of the common. The preferred price is a valid starting point, but it isn't the fair market value of the common.
Age matters too. A value calculated with respect to a date more than 12 months earlier than the date it's being used may not be a reasonable valuation, and a value can stop being reasonable well before then if it fails to reflect subsequent material information.
What Happens If the Strike Price Is Set Below Fair Market Value
If a stock option's exercise price is below the fair market value of the underlying stock on the grant date, the option no longer qualifies for Section 409A's stock-rights exemption. It is then tested as nonqualified deferred compensation, and because most option agreements don't fix the time and form of payment the way 409A requires, that mismatch is what triggers a failure. The regulation sets the measuring point precisely: the exercise price "may never be less than the fair market value of the underlying stock ... on the date the option is granted." What the exercise price must clear is the common stock's fair market value on the grant date, not its value on the valuation date of the report, and not the price your investors paid for the preferred.
The consequences fall on the service provider, meaning the employee or contractor holding the option, rather than on the company. Under 26 U.S.C. §409A(a)(1), a failure produces three things:
Income inclusion by the service provider, once the amount is no longer subject to a substantial risk of forfeiture
Interest at the IRS underpayment rate plus one percentage point, running from the year the amount should have been reported
An additional income tax equal to 20 percent of the amount required to be included in gross income
That 20 percent is an additional income tax, and it isn't assessed on the company. The company's direct exposure runs to withholding and reporting, alongside indirect costs such as gross-up arrangements. A well-supported fair market value as of the grant date is the strongest defense against that exposure. See how the strike price connects to Section 409A and what supports the safe-harbor presumption and what documentation holds up.
Frequently Asked Questions
Can you grant stock options on preferred stock?
You can, but the option generally won't qualify for the Section 409A exemption. Treasury Regulation §1.409A-1(b)(5)(iii)(A) excludes from service recipient stock any class carrying a preference as to distributions, other than distributions of service recipient stock and distributions in liquidation of the issuer. Most preferred classes carry distribution preferences that trigger that exclusion.
Does a right of first refusal affect option eligibility?
Not typically. A right of first refusal by itself doesn't affect eligibility. Under Treas. Reg. §1.409A-1(b)(5)(iii)(A), what does fall outside service recipient stock is stock subject to a mandatory repurchase obligation, or a put or call right that isn't a lapse restriction, where the purchase price is based on something other than fair market value.
Should my 409A valuation match my preferred round price?
Not typically. Under Treas. Reg. §1.409A-1(b)(5)(iv)(B)(1), recent arm's-length transactions in the stock are among the factors a reasonable valuation method considers. The priced round is a data point the analysis considers, not the conclusion it produces.
How long is a 409A valuation good for?
Under Treas. Reg. §1.409A-1(b)(5)(iv)(B)(1), a value calculated with respect to a date more than 12 months earlier than the date it's used may not be a reasonable valuation, and it can stop being reasonable sooner if it fails to reflect later material information.
Can my 409A concluded value and my ASC 718 concluded value differ?
Yes. Section 409A uses fair market value on the grant date for tax purposes, while ASC 718 measures fair value for financial reporting. They're independent frameworks applying different standards of value, so a difference between them isn't evidence of noncompliance.
About Redwood
Redwood Valuation prepares 409A valuations for companies at every stage. If your 409A valuation came in well below your last preferred round price and you want to understand why, we can walk you through what the valuation measures and how it supports the strike price your board sets.