About a decade ago, setting the strike price of stock options for employees who worked at private companies was a relatively simple process. Everyone used the rule of thumb that valued common stock as a percentage of preferred stock (e.g. 10% or 20%), and that was good enough.
Times have changed.
"Thanks" to the passage of the JOBS ACT and IRC § 409A in 2005 -- and the final Equity Task Force guidance in 2013 -- the methods used to set the strike price for stock options have changed considerably. These days, if you want to issue stock options in an audit-defensible way, you're going to need a 409A Valuation report from an independent third party.
However, that doesn't mean that rules of thumb aren't still useful. Many of us in the industry still track the “common stock to preferred stock ratio” as a sanity check. You may have heard "common stock as 25% of preferred stock" bandied about as a good rule of thumb ratio. But as each company is a bit different, a single data point won't tell the whole story.
Here's our 2018 study of how we priced Common Stock as a percentage of Preferred Stock:
A few things worth noting:
- Because every company is different, median numbers won't tell the whole story. As you can see, during the first raise, you can expect a range of common stock to preferred stock which could be as low as 22% or as high as 29% (a 1.3x difference), when thinking about the 1st to 3rd quartile.
- In 2018, a number of companies have raised down-rounds during their third raise. This has resulted in the lower-band of the relative ratio of the Common Stock to Preferred Stock at that stage.
- Assessing the relative Common Stock to Preferred Stock ratio based on the stage of a company (Seed, A, etc) introduces some issues, as not all companies raise in the same order, and some companies raise in a rolling manner. Additionally, some Seed rounds are more akin to a Series B, and some B rounds are similar to a Series A. We have used an internal process to cluster these various groups into the above grouping (first round, second round, etc). These loosely align with the traditional first price round (“Series Seed”), second priced round (Series A), etc.
- There are other rules of thumb that you can use if issuing stock options after you have raised financing via Convertible Notes or SAFEs.
We hope you found the study helpful. If you need help with your upcoming 409A Valuation, just reach out to us and we can get your a valuation report within 4 business days.
Preferred Return has performed over 4,000 valuations for startups, including Cruise Automation, Sift Security, Kickstarter, Hired and Blue Bottle Coffee; they have performed token-related valuations for Ripple Labs, Chia Networks, Promethean Labs and MobileCoin. The firm has logged hundreds of hours in audits with the Big Four, national and regional audit firms and they are regularly recommended by Cooley, DLA Piper, Gunderson, WSGR, Goodwin Procter, Orrick, and Perkins Coie.