How should we price common shares after a preferred share round?

Q: How should we price common shares after a preferred share round?

A: It is sometimes necessary to establish a price for the common shares of a private company when the most recently completed financing round involved the sale of preferred stock. A price may be needed for a subsequent sale of commons, in which case negotiations and the market will ultimately set the deal price, or more commonly for grants under an ESOP, where the plan documents and tax laws may make it essential that the strike price be “fair market value” on the date of grant.

The common share value may have been implicitly set in the preferred round: if the preferreds were issued for $5 million (to own 20% of the company) on a pre-money valuation of $20 million, the $20 million can be used as a market-based guide to enterprise value for the remaining equity, at least for some reasonable period after the preferred round.

At a distance from that round, the characteristics of the preferreds (nature of preference, single or double dip, etc.) may affect the value of the common stock more significantly, particularly if the company is not tracking to where the preference will be irrelevant. There are guidelines that people use for the value of preferreds versus commons (perhaps a 20% premium for preferreds that are only that, and that participate as common stock once capital has been repaid on preferreds and commons), and rough market guides can be taken from these.
Where it is important that fair market value be highly defensible (ESOP grants may often present this case), it may be wise to have a professional valuator undertake the exercise. Although the opinion is no more reliable than a similar exercise undertaken by the CFO and reviewed by the board, the additional weight carried by an independent valuation opinion may be worth the cost.