%% https://eqvista.com/startup-fundraising/priced-vs-unpriced-financing-rounds/ https://www.firstbase.io/blog/the-firstbase-guide-to-priced-and-unpriced-financing-rounds %% Priced equity rounds involve issuing new shares at a set price per share, typically after a thorough valuation of the company. This is the most traditional form of investment and is commonly seen in later stages of funding, such as Series A, B, C, and beyond. In a priced round, investors receive equity in exchange for their capital, with the company’s valuation being a critical factor in determining the price per share and the amount of equity the investors receive. Here's how priced financing rounds work: - An investor invests money in the startup in return for preferred stock in the firm at a price per share that is defined after agreeing on the company's valuation. - Determining a company's valuation requires the startup undergoing a [409a valuation](https://eqvista.com/409a-valuation/complete-guide-for-409a-valuation/). A 409a valuation is an independent appraisal of the fair market value of your startup’s common stock, legally required by the US Internal Revenue Code to establish the proper strike price for employee stock options. - The 409a valuation helps determine the pre-money valuation, which is the valuation of the firm before the new investment. - The post-money valuation is the valuation after the new investment is added. It is the sum of the pre-money valuation and the amount of the new investment. - Using the pre-money valuation, we arrive at a price per share by dividing the pre-money valuation by the total number of outstanding shares. For example, if the pre-money valuation is $10 million and there are 1 million shares outstanding, the price per share is $10. - The price per share helps determine the number of shares to be allocated to the new investors who have invested in the priced financing round, which determines their equity stake in the firm. - Investors who participate in a priced round may also gain special powers and privileges, such as voting rights, anti-dilution rights, liquidation preferences, and perhaps a seat on the board. To illustrate how priced equity rounds work, here are a few examples: ``` Example 1: Series A Round - Pre-Money Valuation: $10 million - Amount Raised: $5 million - Post-Money Valuation: $15 million - Price Per Share: $10 (assuming 1 million shares pre-investment) - New Shares Issued: 500,000 ($5 million / $10) - Equity Stake for New Investors: 33.33% (500,000 / 1.5 million total shares) ``` ``` Example 2: Series B Round - Pre-Money Valuation: $50 million - Amount Raised: $10 million - Post-Money Valuation: $60 million - Price Per Share: $50 (assuming 1 million shares pre-investment) - New Shares Issued: 200,000 (10 million / 50) - Equity Stake for New Investors: 16.67% (200,000 / 1.2 million total shares) ``` #### Steps Involved in a Priced Equity Round ##### Valuation Assessment A valuation assessment is the foundational step in a priced equity round, where the company and potential investors agree on the company's worth. This valuation reflects the company's current status and future growth potential. - **Due Diligence**: Investors conduct extensive due diligence, reviewing the company's financial statements, business model, market position, competitive landscape, technology, intellectual property, and legal standing. This process involves examining past financial performance, current financial health, projections, and potential risks. - **Market Analysis**: Investors analyze the market dynamics, including the size, growth rate, trends, and competitive landscape. They assess the company’s position within the market, its unique value proposition, and its potential for capturing market share. - **Financial Projections**: Detailed financial projections are created to estimate future revenues, expenses, and profitability. These projections are based on historical data, industry benchmarks, and the company’s growth plans. - **Comparable Analysis**: Investors often use comparable analysis, evaluating the valuations of similar companies in the same industry and stage. This benchmarking helps in assessing a fair valuation for the company. - **Negotiation of Valuation**: After thorough analysis, the investors and the company negotiate and agree on the pre-money valuation, which is the value of the company before the new investment. This valuation will determine the price per share for the new equity being issued. ##### **Negotiation of Terms** Once the valuation is set, the **Negotiation of Terms** begins. This step is crucial as it defines the relationship between the company and its new investors. - **Liquidation Preferences**: Investors negotiate liquidation preferences to protect their investment. This term dictates the order and amount of payouts in the event of a liquidation event (such as sale or bankruptcy). A common term is a 1x non-participating preference, meaning investors get their money back before common shareholders receive anything, but do not participate in the remaining proceeds. - **Board Seats**: The composition of the board of directors is negotiated, including how many seats investors will hold. This ensures that investors have a say in the company’s strategic decisions. Founders aim to maintain control while giving investors enough influence to feel secure. - **Anti-Dilution Provisions**: These provisions protect investors from dilution in future funding rounds. Weighted average anti-dilution adjusts the conversion price based on the average price of new shares issued, while full ratchet adjusts the price to the new, lower price of the latest round. - **Voting Rights**: The voting rights associated with the new shares are negotiated. This includes whether the new shares will have enhanced voting rights compared to common shares and what decisions require investor approval. - **Dividend Rights**: Terms regarding dividends, whether cumulative or non-cumulative, are discussed. Cumulative dividends accumulate if not paid out, while non-cumulative do not. - **Conversion Rights**: These rights detail the conditions under which preferred shares convert to common shares. This could be automatic upon certain events like an IPO or voluntary at the investor’s discretion. - **Protective Provisions**: Investors negotiate specific rights that give them veto power over certain key decisions, such as issuing new shares, making significant changes to the business, or approving large expenditures. ##### Term Sheet Agreement The **Term Sheet Agreement** is a non-binding document outlining the key terms and conditions of the investment. It serves as a blueprint for drafting the final legal documents. - **Key Terms**: The term sheet includes the agreed-upon valuation, the amount of capital to be raised, price per share, and the resulting equity ownership for new investors. - **Investment Structure**: Details on the type of shares being issued (e.g., preferred stock), and the rights and preferences attached to these shares are included. - **Capitalization Table (Cap Table)**: A snapshot of the company’s ownership structure post-investment, showing the distribution of equity among existing and new shareholders. - **Closing Conditions**: Conditions that must be met before the investment can close, such as regulatory approvals, legal due diligence, and any required changes to the company’s governance documents. - **Exclusivity and No-Shop Clauses**: These clauses prevent the company from seeking or accepting other investment offers for a specified period, ensuring that the negotiations proceed in good faith. ##### Legal Documentation The **Legal Documentation** phase involves drafting the final, binding agreements based on the term sheet. These documents include: - **Stock Purchase Agreement (SPA)**: This document details the terms of the share purchase, including the number of shares, the price per share, the total investment amount, and the closing conditions. - **Amended and Restated Certificate of Incorporation**: This document updates the company’s charter to reflect the new class of shares and the rights associated with them, such as liquidation preferences, conversion rights, and voting rights. - **Investor Rights Agreement (IRA)**: This agreement outlines the rights and protections of the investors, including information rights, rights to future financings, and board representation. - **Voting Agreement**: This agreement governs the voting rights and procedures for shareholders, ensuring that certain major decisions require investor approval. - **Right of First Refusal (ROFR) and Co-Sale Agreement**: These agreements give investors the right to purchase shares before they are offered to third parties and the right to participate in any sale of founder shares. - **Due Diligence Documentation**: All necessary due diligence documents are reviewed and finalized, ensuring that the company has met all legal and financial requirements. ##### Closing the Round The final step, **Closing the Round**, involves the actual transfer of funds and issuance of shares. - **Transfer of Funds**: Investors transfer the agreed-upon investment amount to the company. This transfer is typically done through escrow accounts to ensure security and compliance. - **Issuance of Shares**: In return for their investment, the company issues new shares to the investors. These shares are recorded in the company’s cap table, reflecting the new ownership structure. - **Update Cap Table**: The company’s cap table is updated to include the new shares and the resulting equity distribution. This table is crucial for tracking ownership percentages and future equity issuances. - **Post-Closing Activities**: After closing, the company and investors engage in post-closing activities such as finalizing any remaining legal documents, updating company records, and ensuring compliance with all regulatory requirements. - **Ongoing Relationship Management**: Establishing and maintaining a positive relationship between the company and its new investors is essential. Regular communication, reporting, and strategic alignment are key to ensuring a productive partnership. ##### Advantages of Priced Equity Rounds ##### For Startups 1. **Clear Valuation**: - A priced equity round establishes a clear valuation for the company, which can be beneficial for future fundraising, strategic planning, and attracting top talent. 2. **Aligned Interests**: - Investors become equity holders, aligning their interests with those of the company. They are invested in the company’s long-term success and growth. 3. **Credibility and Stability**: - Successfully closing a priced equity round can enhance a company’s credibility and stability. It signals to the market that the company has been thoroughly vetted and valued by reputable investors. 4. **No Debt Obligation**: - Unlike convertible notes, priced equity does not involve debt, so there are no repayment obligations or accruing interest, which can relieve financial pressure on the company. 5. **Strategic Value**: - Investors in priced equity rounds often bring more than just capital; they can offer strategic advice, industry connections, and operational support, which can be invaluable for the company’s growth. ##### For Investors 1. **Ownership and Control**: - Investors receive immediate equity in the company, giving them ownership and potential influence over company decisions, often through board seats or voting rights. 2. **Clear Returns**: - The investment terms are clear and straightforward, providing investors with a defined equity stake and potential for returns based on the company’s performance and exit scenarios. 3. **Legal Protections**: - Priced equity rounds involve comprehensive legal agreements that include protections such as liquidation preferences, anti-dilution provisions, and rights to future financings. 4. **In-Depth Due Diligence**: - The thorough due diligence process provides investors with a deep understanding of the company’s business model, financial health, and growth prospects, reducing investment risk. 5. **Aligned Incentives**: - With equity ownership, investors have a vested interest in the company’s success, aligning their goals with those of the founders and management team. ##### Disadvantages of Priced Equity Rounds ##### For Startups 1. **Complexity and Cost**: - Priced equity rounds involve extensive due diligence, legal documentation, and negotiations, which can be time-consuming and expensive. The legal fees and administrative costs are significantly higher compared to convertible notes or SAFEs. 2. **Dilution**: - Issuing new shares dilutes the ownership stakes of existing shareholders, including founders and early employees. This can impact control and decision-making within the company. 3. **Loss of Control**: - New investors may require board seats or other governance rights, which can lead to a loss of control for the founders. Investors may influence key decisions and company strategy. 4. **Pressure for Performance**: - With a clear valuation and new investors, there is increased pressure to meet growth targets and financial milestones. Failure to deliver can lead to down rounds or loss of investor confidence. 5. **Rigidity**: - The terms of a priced equity round are fixed and legally binding, which can limit the company’s flexibility in future negotiations or strategic pivots. ##### For Investors 1. **Upfront Capital Commitment**: - Investors must commit significant capital upfront, which is locked into the company’s equity and cannot be easily liquidated until an exit event. 2. **Valuation Risk**: - If the company’s valuation does not grow as expected, investors may face lower returns or potential losses. The initial valuation sets a high bar for future growth. 3. **Complex Negotiations**: - Priced equity rounds involve complex negotiations around terms, protections, and governance rights. This requires significant time and legal resources. 4. **Illiquidity**: - Equity in private companies is illiquid, meaning it cannot be easily sold or transferred until the company goes public or is acquired. This can tie up investor capital for extended periods. 5. **Operational Influence**: - While having influence over company decisions can be beneficial, it also requires active involvement and oversight, which can be time-consuming and resource-intensive for investors. ##### Legal and Regulatory Considerations Priced equity rounds involve comprehensive legal agreements, including: 1. **Stock Purchase Agreement (SPA)**: - Details the terms of the share purchase, including the number of shares, price per share, and total investment amount. 2. **Investor Rights Agreement (IRA)**: - Outlines the rights and protections of the investors, including information rights, board representation, and voting rights. 3. **Amended and Restated Certificate of Incorporation**: - Updates the company’s charter to reflect the new class of shares and any changes to the company’s capital structure. 4. **Voting Agreement**: - Governs the voting rights and procedures for shareholders, including any special voting rights for the new investors. 5. **Right of First Refusal (ROFR) and Co-Sale Agreement**: - Provides investors with the right to purchase shares before they are offered to third parties and the right to participate in any sale of founder shares. ##### Conclusion Priced equity rounds are a fundamental component of startup financing, providing a clear and structured way for companies to raise significant capital while establishing a firm valuation. While they offer numerous advantages, including clear ownership stakes, aligned interests, and strategic value, they also come with complexities and potential drawbacks such as dilution, loss of control, and high legal costs. Understanding the intricacies of priced equity rounds is essential for both founders and investors to navigate the fundraising landscape effectively and make informed decisions that support the long-term success of the company. - A price round requires more upfront accounting and bargaining than a **convertible round**, but it also gives you a clearer sense of how much your firm is actually worth. An investor lends you money in return for **preferred stock** in your firm at a **price per share** defined by the valuation after agreeing on your [company’s valuation](https://eqvista.com/company-valuation/3-methods-of-company-valuation/). The firm’s value determines the **price of preferred stock** at the time of purchase. This means that investors obtain [equity](https://eqvista.com/equity/) as soon as the price is fixed. Founders who are certain of their company’s value, who predict **rapid expansion**, and who need a large amount of funding may want to consider priced rounds.