by Fernando Ferreira
In the world of venture capital (VC), fundraising is an essential component of scaling startups. When it comes to raising capital, startups and investors can choose from various investment instruments, among which the priced round and convertible round are two of the most common. Both have distinct advantages and disadvantages, depending on the situation and objectives of the parties involved. In this article, we’ll dive into the definitions, benefits, and drawbacks of each approach, helping you better understand their roles in the investment landscape.
What is a Priced Round?
A priced round refers to a funding round where the value of the startup is established through a valuation. In this round, investors agree to purchase shares at a set price, based on the determined valuation of the startup. The price per share is negotiated between the founders and their investors and is often based on a detailed assessment of the company’s financials, market potential, and other factors.
Key Features of a Priced Round:
– Valuation Determined Upfront: The valuation of the company is agreed upon at the moment of the round.
– Issuance of Shares: Investors receive a specific number of shares based on the valuation and the amount they invest.
– Dilution: The dilution of existing shareholders (founders and early investors) is determined at the time of the priced round. They see their ownership percentage decrease as new shares are issued.
Benefits of a Priced Round:
1- Clarity of Ownership: Both the startup and the investors have clear knowledge of the ownership structure after the round is completed. Investors know how much equity they own, and founders can calculate their dilution.
2- Establishes Market Value: A priced round gives a clear picture of the company’s market value. It also provides future investors with a benchmark for future fundraising rounds.
3- Investor Confidence: A priced round can provide more confidence to institutional investors and more sophisticated investors who prefer the certainty of valuation and share issuance.
Disadvantages of a Priced Round:
1- Valuation Challenges: Early-stage startups often face difficulties in determining an accurate valuation. The process of valuation can be subjective, and disagreements over valuation can delay the funding round.
2- Dilution Risk: Founders may face significant dilution during a priced round, especially if the valuation is lower than expected. Less-savvy investors may press for unrealistic dilutions that will hurt both founders and investors in subsequent rounds, with the new investors in those rounds forcing a recapitalization to adjust the founders’ dilution.
3- Longer Process: Negotiating a priced round can take longer, as it involves valuation discussions, legal documentation, and other formalities.
What is a Convertible Round?
A convertible round is a funding round in which investors provide capital in exchange for a convertible instrument (usually a convertible note or a SAFE — Simple Agreement for Future Equity). In a convertible round, the investor does not receive equity immediately. Instead, the investment will convert into equity at a later date, typically during a future financing round (often the next priced round).
Key Features of a Convertible Round:
– No Immediate Valuation: Unlike a priced round, the valuation is not set upfront. The conversion price is typically determined at the next funding round.
– Conversion to Equity: Investors are granted the right to convert their investment into equity at a later stage, usually at a discount to the next round’s price and/or with other terms such as a valuation cap.
– No Dilution Calculation Upfront: Since there’s no immediate equity issuance, the dilution impact for founders and early investors is not determined at the time of the convertible round.
Benefits of a Convertible Round:
1- Faster Fundraising: Convertible rounds are typically quicker than priced rounds because they don’t require a lengthy negotiation over the company’s valuation.
2- Flexibility: The startup avoids the pressure of determining an early-stage valuation, which can be difficult when the company’s value is uncertain or volatile.
3- Reduced Legal Costs: Convertible instruments often have less complex legal documentation, reducing the legal costs and time associated with fundraising.
4- Founder-Friendly: Since there is no immediate dilution, founders can retain a larger portion of the company in the short term.
Disadvantages of a Convertible Round:
1– Uncertainty for Investors: Investors may find convertible rounds less attractive because they don’t immediately know the price at which their investment will convert into equity. This uncertainty can make it harder for them to assess the value of their investment.
2- Future Dilution Risk: For the startup and its founders, a convertible round may result in unexpected dilution once the convertible instruments convert into equity during a future priced round.
3- Valuation Caps and Discounts: While the lack of a current valuation may seem beneficial, the discount rates and valuation caps often set in convertible instruments can result in giving up more equity than anticipated.
Key Differences Between Priced and Convertible Rounds
| Feature | Priced Round | Convertible Round |
| Valuation | Pre-negotiated valuation. | No immediate valuation. |
| Equity Issuance | Shares are issued immediately. | Shares are issued later (upon conversion). |
| Dilution | Determined at the time of the round. | Dilution is unclear until the next round. |
| Speed | Typically slower due to negotiation of terms and more complex contracts. | Faster due to fewer upfront negotiations. |
| Investor Confidence | Higher confidence, as equity is issued immediately. | Higher uncertainty about exact ownership. |
| Legal Complexity | More complex, requiring detailed documentation. | Simpler legal structure. |
When to Choose a Priced Round or Convertible Round
Priced Round is usually more appropriate when:
– A company is at a stage where it has achieved its first milestones and where investors expect formal governance.
– Founders and investors want clear ownership and dilution metrics.
– The startup is prepared for the time and cost associated with negotiating a valuation.
Convertible Round is typically chosen when:
– The startup is still in very early stages, and its valuation is difficult to determine.
– The company needs to raise money between main rounds (eg, between Seed and Series A).
– Investors are comfortable with waiting for a future priced round to set the valuation.
Conclusion
Both priced rounds and convertible rounds offer distinct advantages and drawbacks, making them suitable for different stages of a startup’s lifecycle. A priced round offers clarity and certainty for both the startup and investors, but it can be time-consuming and complex, especially for early-stage companies. On the other hand, a convertible round provides flexibility and speed, though it introduces uncertainty for both parties about ownership and dilution.
Ultimately, the decision between a priced and convertible round depends on the company’s maturity, its funding needs, and the preferences of its founders and investors. Each instrument can play a crucial role in the venture capital ecosystem, helping startups raise the capital they need while navigating the challenges of growth and valuation. Remember to get in touch with our in-house experts if you’d like to know more: Contact us – Ventures.eu
