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Fundraising 101: Priced Rounds vs. Convertible Debt

Priced rounds and convertible debt are the tortoise and hare of the investing world. Convertible debt, although quick and relatively painless, comes with more risk for investors, while priced rounds thoroughly (and, yes, slower) consider every aspect of investment before both parties jump into a deal. Although the original story preaches that slow and steady always wins the race, you should consider the pros and cons of both before jumping in.

Convertible Debt:

Convertible debt does not offer investors any ownership initially, and is not intended to be paid back.

Convertible debt is the preferred option for someone looking for a quick and easy investment, and allows investors to enter 1 by 1 instead of one large closing. Although this swift option is the more popular mode of early-stage startup investment, it comes with some drawbacks. Like the hare, the faster pace of convertible debt is that it may lead to problems at a later date. For example, issues may arise with poorly aligned incentives between startups and investors. Investors want the priced round to be low in order to maximize their equity, while startups want the priced round to be high so they give up less of their company. This issue can be reduced with caps, warrants, and discounts – but this potentially leads to other problems.

Caps often signal to future rounds (too high and it might never live up to expectations, too low and it will look like the company is in trouble and lead to a lot of dilution for the startups). Often caps are set too high, and an investor will only receive the discount when the note converts to equity. Note holders assume the risk that their notes can be changed by a majority of the holders of the note – if the majority of the holders are company insiders this can cause problems.

Notes occasionally lack other investor protections like board seats, protective provisions, pro-rata rights, drag along rights, registration rights, and fund raise minimum. Convertible debt also lacks beneficial tax provisions. Experienced investors consider notes most useful in early stage fund raising and bridge rounds.

Priced Rounds:

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A priced round is a set amount of stock for an agreed upon price.

On the other hand, priced rounds are more expensive and slower due to a concentration on well negotiated notes and strong investor protections. It may not be fast, but it comes with a certain amount of benefits for investors including preferred stock, anti-dilution rights, ratchet provisions, board seats, etc., and involves an actual price for the company. Similar to the tortoise, this mode of investment proves that patience can reap more benefits in the long run. Incentives for all parties are aligned, so everyone wants the company to get a higher valuation and applicable tax provisions can be rewarding.

There are certainly many things to consider when looking for at convertible debt versus priced rounds. How do you plan on running your race?

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One Response

  1. Jordan Green says:

    This is a good, brief summary of the issue. The one thing I want to re-emphasise is that convertible debt is terrible at creating the alignment that leads to successful early-stage investments.

    Now others will say that it all depends on how you write the agreement and they are correct. Here’s the rub, if you work for a convertible debt agreement that fixes the alignment issues you are not going to get the speed and convenience that are generally considered the primary benefits of the note process.

    In my experience founders and early-stage investors are almost always better served in the pursuit of success by a priced round than a convertible note. That’s not to say that a note can’t be successful, only that it is so much harder and less likely.

    Regardless of which structure you choose, an essential condition for success (including speed of closing) is to be prepared. Do your homework and really understand the pros and cons of various structures and terms. Don’t just listen to the shared knowledge of the founders with whom you network or follow on the web, which can be informative but, often lacks perspective. You must also heed the knowledge shared by the investors and understand their needs and wants. Sales 101 is to understand your customer and when you are selling a share of your company the investor is your customer. Understanding your investor customer well upfront will pay huge dividends down the track.

    Good luck with your deep tech venture!! We all need you to succeed so we want you to succeed.

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