PS#023: Priced Rounds

When discussing investments, I’m often asked about the difference between priced rounds, convertible notes, and SAFEs. When to use them, how they work, what are the benefits, what are the downsides, etc.

So, I figured I’d talk about that in more detail over the next few issues of Preferred Shares.

For startups, raising capital is a critical part of the process. The idea is to provide a startup with upfront capital so that they can scale faster than a typical bootstrapped company.

Well, the way startups are able to secure this funding is through either priced financing rounds or convertible instruments. 

Today, we’re going to discuss priced rounds.

Over the next few issues, we’ll discuss convertible instruments, including SAFEs and convertible notes.

OK, let’s get started.

What is a priced round?

Priced rounds are equity investments based on a negotiated (and agreed upon) valuation of a startup. 

In short, there is a definitive price set for the company.

After agreeing to terms, the company exchanges preferred shares in exchange for the capital from the investor. The amount of shares received for the capital depends on the final terms. 

These shares come with a clear set of operating instructions for the business based on the new ownership structure, rights and protections for the new minority VC investors, and clear expectations on the future direction of the company.

While this type of structure may require more time and effort, it’s worth it in most situations. 

Why raise a priced round?

Building a startup is hard. 

It takes a lot of people pulling in the right direction to make it work (and that’s only thinking about the aspects that are within your control). With all the variables impacting the success or failure of a startup, not having everyone on the “same page” is certainly one to avoid.

The priced round helps with this problem. 

It clearly communicates how the investment and relationship will work going forward, clearly defining everyone’s roles, rights, and responsibilities. It aligns incentives for all owners of the startup to ensure everyone is pulling in the same direction.

As I discuss in my series on How to Value a Startup, startup valuations are all about aligning incentives. This is a really important concept to understand as it lays the foundation for structuring investments.

To be a bit more tactical, here are some of the benefits for investors and founders…

Investors

• Clear valuation

• Immediate ownership

• Formalized governance

• Investor rights & protections

Founders

• Defined dilution 

• Market clearing valuation

• Ability to raise more capital

• Aligns incentives for investors 

• Clear set of operating expectations

Compared to convertible instruments, priced rounds require significantly more time/effort and usually require the founder giving up more control to investors in the new ownership structure. 

In most situations, I would argue the increased investor control (i.e., governance) is a good thing. It helps increase the chances that (1) the company is successful, (2) there are checks and balances along the way, and (3) that there is healthy discussion around the future of the startup’s business. At the end of the day, the investors are still minority owners of the business with the founder (and/or management team) holding the day-to-day control.

Also, let’s not forget, startups are very risky. The failure rate is high. 

Most of the time, the company fails and the investors lose their investment.

Providing protections for the investors who are supporting and financing startups allows those VCs to raise more funds from LPs and, in turn, invest in more startups. It keeps the whole ecosystem a float, especially considering the level of risk.

In either case, priced rounds are generally the preferred (pun intended) structure for venture capital investments. 

When to use a priced round?

Priced rounds should be considered the standard.

They work well in almost all situations and, as I mentioned, are the preferred structure in the industry. However, there are situations in which a convertible instrument (e.g., a SAFE or convertible note) makes more sense. 

We’ll be discussing these situations and the convertible structures in much more detail over the next few issues.