January 13, 2021
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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 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.
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?