[zaroth]

One factor for me would be if the company was aggressive enough in its 409a valuations of common stock.

If they are valuing the common stock based on the last funding round which sold preferred shares, you are likely significantly overpaying both for your exercise price and in AMT tax, and that makes the investment significantly riskier.

If common share FMV is discounted appropriately, IMO a 409a valuation will reflect the extreme risk of common shares dilution in an unprofitable venture with large investor preferences, and you should have a very low exercise price with little to no AMT unless the company is already well into planning an IPO.

At past companies I saw common stock valuation that matched the funding round valuation, and you should never be paying that price for common shares. 1/10th that price is a good rule of thumb.

The second most important factor is that you can’t ever sell shares in a company that doesn’t have a market for its shares. That vast majority of companies do not have, and never will have, marketable securities.

The third factor for me would be if the shares are eligible for QSBS Section 1202 treatment (tax free up to $10 million), which ISO options are not, but NSOs can be but the 5 year holding period starts at the exercise date.

[akchin]

This is not fully accurate.

You have to pay AMT on the difference between your strike price and the current 409a price of common. It doesn't have much to do with where preferred is valued, other than the fact that a high preferred value, means that the updated 409a common might be higher.

So let us say, your strike price is $0.50 and you are fully vested after 4 years. The company recently does a round where preferred is at $3.00 per share and the new 409a is $1.25/share. When you leave this is what will happen - You need to pay the company $0.50 * number of options you have - You have to pay AMT on (1.25-0.5) * number of shares

With last year's tax law, one good thing is that AMT rules changed, so AMT might not apply. You should, of course, talk to your accountant/tax professional for the proper advice :-)

[zaroth]

That’s exactly what I was trying to say — specifically the 409a valuations for several companies I’ve been at were not appropriately reduced for common shares versus the preferred.

E.g. a company raising $5m Series D at a $30 million valuation, and which already has $10m in preferences. First you have to adjust the valuation because that $5m will be the first dollar out and might even be participating preferred - so they are getting 1/6th of the company for $5m but they are also getting basically a $5m note payable.

If you asked them what they would pay without the preference maybe it’s closer to $15m. Then you also have to adjust for the other outstanding preferences. So the common shares (which are likely to be even further diluted before they become marketable) in that case are presently nearly worthless.

Most people do not adequately consider the impact of preferred share preferences, future dilution, taxes, and marketability. These horseman turn a decision which might seem like at first glance to be, “Why give up the chance to participate in a future equity event?” into something more closely resembling a suckers bet.

[mavelikara]

> That’s exactly what I was trying to say — specifically the 409a valuations for several companies I’ve been at were not appropriately reduced for common shares versus the preferred.

Anecdata, but I have seen this too.

Can someone knowledgable founder here please chime in on why companies do this? Does the higher common price help the company boost its compensation packages to match those from AmaGoogFaceSoft who give publicly traded stock?

[zaroth]

Aside from companies just not generally understanding the value of a low common stock valuation? They could mistakenly believe the low common valuation will impact a future funding round.

The value can creep up over time, and then companies try to avoid the perception that the common stock would ever become less valuable, so they also might try to keep it rising.

Or perhaps more dubiously, they could be quoting stock option grants in terms of dollar value of the strike price, and want it to look higher for the same number of shares. In an offer letter, which seems like a larger/better grant; 10,000 options at a $3.80 exercise price, or 10,000 options at a $0.38 exercise price? You will almost never see a percentage value quoted, and I've heard of some companies claiming the total share count is not even public information!

[JumpCrisscross]

> One factor for me would be if the company was aggressive enough in its 409a valuations of common stock

Another factor is transfer restrictions. Most companies let their shareholders sell stock in the private markets. Some, however, are curmudgeons. The latter knock shareholders twice: once, by taking away a liquidity option, and again, by producing a selling rush at potential future liquidity events.