How to determine Preferred Stock Terms with 409A Valuations?
When it comes to dividends, the board of directors of a firm will decide whether or not to pay a dividend to common investors. If a corporation fails to pay a dividend, the common stockholder is bumped back in favor of a preferred stockholder, indicating that the latter has a higher priority. Preferred stock is a type of stock that pays dividends on a set schedule but does not have voting rights. Preferred stock combines characteristics of common stock and bonds into a single security, providing regular income and firm ownership. Preferred stock is purchased by investors to supplement their income while simultaneously receiving tax benefits.
Preferred stock and 409a valuation
Preference shares, also known as preferred stock, are stockholders’ shares of a corporation’s stock that pay dividends before common stock payments are made. If the company goes bankrupt, preferred investors have a right to be compensated for the company’s assets before common stockholders. The 409A valuation gives a system for private firms to follow when it comes to valuing private shares. When a valuation is performed by an unaffiliated or independent firm, it creates a safe harbor, which means the IRS will presume the 409A is “fair” with a few caveats.
What is preferred stock?
Preferred stock is a type of share capital that has a variety of characteristics not found in common stock, such as traits of both an equity and a debt instrument, and is classified as a hybrid instrument. Preference shares (also known as preferred stock) are firm stock that pays dividends to stockholders before common stock payouts. Preference shares, which are callable, are perfect for risk-averse investors (the issuer can redeem them at any time).
How does preferred stock work?
The right to receive dividends equal to the generally stated rate of preferred dividends, plus an additional payout based on a predetermined condition, is granted to shareholders of participating preferred shares. This additional dividend is usually only paid out if the total amount of dividends received by common shareholders exceeds a certain per-share threshold. Participating preferred shareholders may have the right to be paid back the purchase price of the stock as well as a pro-rata share of the residual proceeds earned by common shareholders if the firm is liquidated.
Types of preferred stock
Those looking to make money in the stock market can choose from a variety of investment options. Although there are four types of preferred stock we have two of them below :
Series seed preferred stock
Preferred stock is a type of stock that has rights and preferences that are superior to the rights of the common stock provided to the founders. Series Seed will be issued as preferred stock in most cases. The initial “Series Seed” equity fundraising document set, driven by a lawyer-turned-investor, was a collaborative endeavor between lawyers and investors.
Convertible preferred stock
Convertible preferreds, like convertible bonds, allow holders to change their preference shares into common shares at a set price. Convertible preferred stocks are preferred shares that can be converted into a predetermined number of common shares at a predetermined time.
Difference between preferred stock and common stock
There are various distinctions between preferred and common stock. The main difference is that preferred stock usually does not give its owners voting rights, whereas ordinary stock usually does, with one vote per share owned. Here are what sets them apart:
- Both types of stock represent a portion of a company’s ownership, and both can be used by investors to try to profit from the company’s future successes.
- Preferred stockholders have no voting rights, whereas regular stockholders have.
- Because preferred shareholders have preference over a company’s income, they receive dividends before common shareholders.
- When it comes to the firm’s assets, common stockholders come last, which means they’ll get paid after creditors, bondholders, and other stakeholders.
Understanding 409a valuation
An independent third party appraises the fair market value (FMV) of a private company’s common shares in a 409A valuation. Startups generally pay for these evaluations and then use the results to determine the price at which workers can purchase common stock.
How does a 409a valuation work?
A 409A is an impartial evaluation of a private company’s common stock, or equity reserved for founders and workers, at fair market value (FMV). The cost of purchasing a share is determined by this valuation. Early-stage companies have a 12-month window in which they can grant options at the strike price specified under their 409A. The only exception is when those companies achieve a value inflection point, such as a new round of financing, which necessitates a fresh valuation.
Why is a 409a valuation important for a business?
In this case, a 409a valuation is required to assess the option price being given to employees. The Internal Revenue Service (IRS) does not want businesses to just make up a valuation. While it’s understandable that employees want to buy the stock at the lowest possible price, if your company’s value is too low, it could be accused of using super-cheap stock options to hide income. If you qualify for safe harbor, the IRS must accept your valuation unless it can show it is unjustified. The IRS is given the burden of evidence. In general, safe harbor status is difficult to obtain unless the assessment is performed by a qualified third party.
How does 409a valuation help determine the preferred stock terms?
An independent third party appraises the fair market value (FMV) of a private company’s common shares in a 409A valuation. Startups generally pay for these evaluations and then use the results to determine the price at which workers can purchase common stock. The portion of a company’s shares designated for employees and founders is known as common stock.
How does a 409a valuation determine the stock prices?
A 409A Valuation is a third-party organization’s impartial appraisal of the Fair Market Value (FMV) of a private company’s common shares or equity reserved for founders and employees. The cost of purchasing a share is determined by this valuation.
- Option pricing method (OPM) – Investors should have a strong understanding of the factors that determine the value of an option before diving into the world of options trading. The present stock price, intrinsic value, time to expiration or time value, volatility, interest rates, and cash dividends paid are all examples of these. These characteristics are used in numerous options pricing models to calculate the fair market value of an option. The Options Pricing model is the most well-known of them.
- Current value method – In this method, the worth of the preferred classes (based on their liquidation preferences or conversion values) is subtracted from the total equity value of the company on a controlling basis (assuming there is an instant sale). The remainder is subsequently distributed to common stockholders.
- Probability weighted expected return method (PWERM) – PWERM is a multi-step process for estimating the value based on the probability-weighted present value of distinct future scenarios. To do this, the valuation analyst consults with the company’s management to evaluate the range of possible future outcomes for the company, such as an IPO, sale, dissolution, or continuation of operations until a later exit date. Following that, the future equity value for each scenario is calculated and assigned to each share class.
- Hybrid method – The hybrid method combines both OPM and PWERM, employing probability-weighted scenarios, but with an OPM to assign importance to one or more of them. When a corporation has visibility into a specific departure path (such as a strategic sale), yet there are still uncertainties if that scenario fails, the Hybrid Method may be used. In this example, a PWERM with a probability assumption that the sale will go through might be used to estimate the value of the shares under the strategic sale scenario.
Does the 409a valuation really help determine the preferred stock terms?
When a firm attempts to raise money from investors in an arm’s length negotiated transaction, a 409A valuation isn’t always an accurate reflection of its true value. Rather than common stock, most businesses issue preferred stock to cash investors. While the terms of preferred stock vary from business to company (and even across different classes of preferred stock issued by the same firm), the liquidation preference is the primary feature that distinguishes preferred stock from common stock.
Simply put, the liquidation preference means that preferred stockholders receive their money first in the event of a company liquidation or sale. A 409A, on the other hand, calculates the fair market value of the common stock, not the entire firm. As the value of the shares underlying the stock option rises, the lower the exercise price for the stock options, the wider the spread per share becomes.
This potentially significant economic opportunity for stock option holders permits startups to engage new personnel with lower cash remuneration on the assumption that the employee will more than make up the difference through the possible increase in stock options equity value. For example, a startup’s 409A valuation for an initial round of preferred stock with simple terms is typically between 10% and 30% of the price at which the preferred stock was issued.
How to find the value of each preferred stock price
The following is a simple formula for determining the value of the preferred stock:
The amount on which the dividend is computed is equal to the par value of one share of preferred stock. To put it another way, par value refers to the face value of a single share of stock.
- Waterfall analysis – A general ‘waterfall’ is a visual representation of the sequential breakdown of a starting value (ex: revenue) to a final result (ex: profit) by depicting intermediate values and ‘leakage’ points. Companies can use this to track data at each step.
- Backsolve method – The backsolve method is a valuation method for determining the value of common shares in organizations with complex capital structures where no recent transactions involving common shares have occurred.
Calculation example
Using the dividend discount strategy, if ABC Company pays a 25-cent dividend every month and the needed rate of return is 6% per year, the expected value of the stock would be $50. The yearly dividend of $3 (0.25 x 12) was divided by the yearly discount rate of 0.06 to yield $50, but you could also use the yearly dividend of $3 (0.25 x 12) and divide it by the yearly discount rate of 0.06. To put it another way, you must first discount each future dividend payment to the present, then add the values together.
Need help to determine preferred stock terms with Eqvista?
Preferred stock is a hybrid instrument that combines the characteristics of both common stock and bonds. It combines the stability and consistency of bond income payments with the equity ownership benefits of common stock, including the possibility for the shares to appreciate in value over time. Eqvista has a team of experts who can help you in determining preferred stock. Just fill up the signup form and get started today.
