Priced rounds vs Convertibles (Notes and SAFE): Valuations & Calculations

Introduction

In the three earlier articles of Svested’s CapTable series, we discussed the basics of CapTables and CapTable management, and illustrated how SAFEs and Convertible Notes (CNs) get translated into equity.  Now, with this knowledge in hand, we proceed to introduce the other key fundraising method for companies: priced equity rounds.  In this article, we compare priced equity rounds against note-based fundraising, and discuss the main valuation types – pre-money and post-money – which are used in relation to these fundraising methods.

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What is a Priced Equity Round?

Priced equity rounds (or simply “priced rounds”) are equity investment rounds based on a predetermined company valuation.  Investors who join a priced round are given a specific number of company shares, at a price per share calculated based on the agreed company valuation (which is typically pre-money).

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The shares that priced round investors receive are usually preference shares, which entail liquidation priority payouts over the founders and other investors who funded the company at an earlier stage.

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Priced rounds vs Convertibles (Notes and SAFE): Which is better?

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Consideration #1: Speed 

While a full priced round typically takes between 3 and 6 months, or even longer, notes can be issued as quickly as 1 day, securing funds quickly for the company.  This is possible because when issuing notes, the incoming investors are likely to skip the full-fledged due diligence process, which usually takes months.  Also, there is no need to negotiate full-form agreements such as the Shareholder’s Agreement, Share Subscription Agreement and the Constitution, which also take months to finalise.

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Winner: Convertibles (Notes and SAFE)

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Consideration #2: Cost

Notes can be issued at minimal cost – in some cases, even for no cost at all.  In contrast, a proper priced equity round can cost a company tens of thousands of dollars.  Potentially cost-intensive expenditures include having to engage a lawyer or legal counsel to draft up documents to be signed between the company and investors.  

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Moverover, more often than not, upon the closing of the fundraising round, the legal fees incurred by the investors are generally billed back to the startup.  There are also the implicit costs of a priced round – such as time cost, manpower cost and opportunity cost.  For instance, it is likely that the founders will need to work on this full time, leaving him no time to handle their core business operations.

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Winner: Convertibles (Notes and SAFE)

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Consideration #3: Control (Before conversion)

In general, when a price round happens, the investors will have certain rights (e.g. directorship, veto rights, voting rights, restrictions), whereas for fundraising via notes, in general, noteholders do not enjoy these rights. 

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Winner : Convertibles (Notes and SAFE)

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Consideration #4: Equity Ownership

In a priced round, you know exactly how much equity to give, whereas in raising via notes, the amount of equity to be given is still unclear.  Also, noteholders enjoy dilution protection as long as they have not converted their note to equity.

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Winner: Price round

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Consideration #5: Dilution

Issuing notes grants the company access to funding without having to immediately give up equity.  This is particularly important for early-stage companies and start-ups, which cannot afford having their founders lose their majority share (and by extension, key decision-making powers) in the company.  To further ensure that they are not unnecessarily diluted, founders will need to consider whether they are planning to issue SAFEs or CNs for a start, and carefully negotiate terms such as the valuation cap and discount rate.

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However, when it is time for note conversion, the accumulation of too many notes for simultaneous conversion in a single priced equity round, runs the risk of snowballing dilutive effects on the founders and existing investors.  Should there be enough notes for conversion, with each note carrying with it a significant enough investment amount, the company’s founders may lose their majority share in one fell swoop as well.  This risk stems from how notes are intentionally designed to eventually inflate noteholders’ shareholdings when their notes are converted into equity.  

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In addition, depending on the conversion terms, the dilutive effect of note conversion may not be immediately or instinctively clear to the founders.  This is especially so for CNs, which are converted on a pre-money basis before post-money conversions are done.

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Winner: Price round (in most scenarios)

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Summary

In summary, if the founder is concerned with speed and immediate cost, raising a note wins hand down.  On the other hand, if the founder wants clarity on the equity ownership and percentage shareholdings, as well as avoid excessive dilution, a price round wins. 

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Company valuations: Pre-money vs Post-money

As suggested at the beginning of this article, a company must have a valuation, in order for it to fundraise.  There are 2 key valuation types: pre-money and post-money.

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Pre-money valuations refer to the assessed value of the company before it receives additional investment funds in its upcoming fundraising round.  On the other hand, post-money valuations refer to the company’s valuation once it has locked in the incoming investment from its upcoming fundraising round.  

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Take note that pre-money valuations and post-money valuations do have a relationship, as given by the following formula:

Post-money valuation = Pre-money valuation + Invested amount in latest round

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Let’s say that Company X has a pre-money valuation of $10 million and is raising $2 million.  This means that its post-money valuation is $12 million.  In terms of terminology, stating Company X’s valuation as “$10 million pre-money” is exactly the same as “$12 million post-money”.

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Pre- and post-money valuations: When is each used?

Pre-money valuations are often used in older CNs, as well as in some fundraising rounds, as it is easier for the founder to understand the current value of their business. 

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Pre-money valuations are also presented to prospective investors during fundraising discussions, to give them an idea of the company’s value and financial health prior to them investing anything.  These valuations also provide clarity on the company’s prevailing price-per-share, allowing investors to estimate how much they may, or should, be paying for their shares.

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Post-money valuations, on the other hand, are often used in SAFE notes, newer CNs, as well as in fundraising rounds (more commonly), as it is easier for incoming investors to understand their percentage ownership in the company, and for existing investors and the founders to understand their dilution from the round.

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For priced round investors, their percentage shareholding after the round is fixed, and can simply be calculated by taking their amount invested, divided by the company’s post-money valuation.  Hence, their percentage shareholdings are easily understandable.  For SAFE noteholders as well, their equity conversions normally take place on a post-money basis.  

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From an alternative perspective, shareholding calculations based on post-money valuations do not undergo any dilution within the round, because they are only performed after pre-money calculations – that is, equity conversions for any pre-money CNs – are completed.

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Due to the clarity provided by post-money valuation, this valuation type has become increasingly popular over the years.  

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Conclusion

In comparing priced equity rounds and note-based fundraising, founders will need to consider and weigh factors such as speed, costs, dilution, clarity and control.  While Convertibles (Notes and SAFE) presents a host of indisputable advantages, it is still extremely rare to see a company which relies primarily on note issuance for fundraising, due to the lack of clarity on the ownership structure upon conversion.

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When fundraising, one of the most important prerequisites for a company is to have a valuation, which oftens forms the bulk of the initial discussion.  Both pre- and post-money valuations are fundamentally intertwined, but are used in different situations – pre-money valuations are presented to investors for the upcoming fundraising round, while post-money valuations are preferred for CapTable calculations, for simplicity and clarity of share ownership.

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