Equity · Valuation
Fair market value of private common stock, and why it sits below the preferred price.
What FMV means when there is no market, what preferred stock has that common does not, and how the number sets every option strike price.
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In short
What is fair market value for private company stock?
Fair market value is the price at which stock would change hands between a willing buyer and a willing seller, neither under compulsion and both reasonably informed. For private company common stock there is no market price, so it is determined by the reasonable application of a reasonable valuation method.
What "fair market value" means when there is no market
For a public company, fair market value is a quote. For a private company it is an estimate of what the quote would be if there were one. The tax regulations at 26 CFR § 1.409A-1(b)(5)(iv)(A) put it this way for stock not readily tradable on an established securities market: fair market value "means a value determined by the reasonable application of a reasonable valuation method". They then list the factors such a method should take into account.
- The value of tangible and intangible assets.
- The present value of anticipated future cash flows.
- The market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to the one being valued, where that value can be readily determined.
- Recent arm's-length transactions involving the sale or transfer of the stock or equity interests.
- Control premiums or discounts for lack of marketability.
That list sits on top of a much older idea. The IRS framework for valuing closely held stock traces to Revenue Ruling 59-60, 1959-1 C.B. 237, which set out how to value stock in a company with no public market by weighing the nature and history of the business, its financial condition and earning capacity, the economic outlook, and the market prices of comparable listed companies. The specific regulation changes; the underlying question — what would an informed, unpressured buyer pay — does not.
Why common stock is worth less than preferred
This is the part that confuses people, and it is worth being concrete about. An investor pays $5.00 a share for Series A preferred on Tuesday. On Wednesday the 409A appraisal says common stock is worth substantially less. Nothing improper has happened, and neither number is wrong. They are prices for different securities.
| Right | What it is worth |
|---|---|
| Liquidation preference | The investor is paid before common in any sale or wind-up. It converts a large part of the downside into a floor. |
| Participation | Where present, the investor takes the preference and then also shares in the remainder as if converted. |
| Anti-dilution protection | Re-prices the investor's conversion ratio if a later round prices lower. Common holders absorb that adjustment. |
| Protective provisions | A veto over specified corporate actions, independent of the board vote and of the size of the stake. |
| Board representation | A seat, and therefore a say in budgets, financings, hiring and whether the company is sold. |
| Dividend and redemption rights | Where present, a claim on cash ahead of common, and sometimes a right to demand repayment after a period. |
| Registration and information rights | Contractual access to financials and to a path to liquidity that common holders do not have. |
Clause names follow the NVCA model documents. Common stock has none of these; it is the residual claim, paid last and only out of what is left.
The best way to see the size of the gap is to price both securities across a range of exit outcomes. Take the illustrative company from /equity/liquidation-preference: 8,000,000 common shares, and a Series A investor holding 2,000,000 preferred shares bought at $5.00 for $10,000,000 with a 1× non-participating preference.
| Exit value | Preferred per share | Common per share | Common as a share of the preferred price |
|---|---|---|---|
| $10,000,000 | $5.00 | $0.00 | 0% |
| $20,000,000 | $5.00 | $1.25 | 25% |
| $35,000,000 | $5.00 | $3.13 | 63% |
| $50,000,000 | $5.00 | $5.00 | 100% |
| $100,000,000 | $10.00 | $10.00 | 100% |
Preferred takes the greater of its $10,000,000 preference and 20% of the exit, so it converts above $50,000,000 and the two classes then track each other exactly. The last column is the common price divided by the $5.00 preferred purchase price. At $35,000,000 the common receives $25,000,000 ÷ 8,000,000 = $3.125 per share. Ignores debt, escrow, expenses and option exercise proceeds.
An appraiser is, in effect, taking a probability-weighted view across that whole column. If most of the weight sits on outcomes below $50,000,000, the common stock is worth a small fraction of $5.00. If the company is plainly heading for a large exit, most of the weight sits where the two columns are equal, and the gap closes. Then a discount for lack of marketability is applied on top, because the holder of that common share cannot sell it.
How FMV sets a strike price
Two separate rules point at the same number. Section 409A treats an option granted below fair market value as deferred compensation, with the tax consequences described at /equity/409a-valuation. Section 422(b)(4) separately requires that an incentive stock option have an option price "not less than the fair market value of the stock at the time such option is granted" — an ISO struck below FMV loses its favourable treatment.
| Rule | Requirement | Citation |
|---|---|---|
| Non-qualified options and section 409A | An option on service recipient stock granted at or above FMV at grant, with no other deferral feature, is generally outside section 409A. Below FMV, the discount is treated as deferred compensation. | 26 CFR § 1.409A-1(b)(5) |
| Incentive stock option pricing | The option price must be not less than the fair market value of the stock at the time the option is granted. | 26 U.S.C. § 422(b)(4) |
| Ten-percent shareholders | For an employee owning more than 10% of the voting power, an ISO requires an option price of at least 110% of FMV and a term of no more than five years. | 26 U.S.C. § 422(c)(5) |
| The $100,000 limit | To the extent the aggregate fair market value of stock for which ISOs first become exercisable in a calendar year exceeds $100,000, the excess is treated as a non-qualified option. | 26 U.S.C. § 422(d) |
Statutory text as published on Cornell LII, checked 11 August 2026. Whether a particular grant qualifies depends on plan terms and individual facts.
Note what the $100,000 limit is measured in: fair market value of the underlying stock at grant, not the spread and not the exercise cost. That is one of several places where an accurate, dated FMV per share is doing work far beyond the strike price itself. It also feeds ASC 718 stock compensation expense in the financial statements, and it is the number an acquirer's diligence team will reconcile every historical grant against.
What moves FMV
- A priced round. New preferred at a higher price raises total equity value, which lifts the common — though not proportionally, because the new round adds to the preference stack ahead of the common.
- A secondary sale of common stock. An arm's-length transaction in the exact security being valued is among the strongest evidence available, and it is one of the listed factors in the regulation.
- Time and traction. Revenue growth, or the absence of it, shifts the probability weights across exit outcomes.
- A signed letter of intent. A live acquisition at a known price collapses the distribution of outcomes towards one number.
- Approaching an IPO. The marketability discount shrinks as a liquid market becomes foreseeable, which is a large part of why FMV rises steeply in the run-up.
- A down round. A lower preferred price and any anti-dilution adjustment both push common FMV down, sometimes sharply. See /equity/term-sheet for how the adjustment works.
What does not move FMV is anybody's opinion of what the company is worth. It is an appraisal against a defined standard, refreshed on a schedule, and the paper trail matters as much as the number. Companies that let the cap table drift out of sync with the valuation — grants approved on one date and papered on another, SAFEs signed but not recorded — end up with a valuation built on a share count that does not match reality.
Fair market value questions
What does FMV mean?
Why is the FMV of common stock lower than the preferred share price?
What is the common to preferred discount?
Does fair market value set my option strike price?
How often does FMV need to be re-determined?
Can a company just pick its own fair market value?
Sources
External links open in a new tab.
- 26 CFR § 1.409A-1(b)(5)(iv) — Valuation of service recipient stock — Cornell Legal Information Institute
- 26 U.S.C. § 422 — Incentive stock options — Cornell Legal Information Institute
- 26 U.S.C. § 409A — Deferred compensation — Cornell Legal Information Institute
- Valuation of assets — Rev. Rul. 59-60, 1959-1 C.B. 237 and IRS valuation job aids — Internal Revenue Service
- Model legal documents — National Venture Capital Association
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Fair market value of private common stock, and why it sits below the preferred price.
What FMV means when there is no market, what preferred stock has that common does not, and how the number sets every option strike price.
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