By Fernando Berrocal

What’s the best way to fund your business? You've almost definitely heard the terms "Priced" and "Unpriced" rounds among the avalanche of new terminology you hear as a startup founder. We will explain what those phrases mean, as well as the different forms of fundraising term sheets and equity agreements that are utilized in both sorts of rounds. An unpriced round often occurs before a priced round in the startup financing timeline, while some businesses will fundraise with a priced round immediately.

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The following topics covered in this article are: “Unpriced Rounds” (SAFEs vs Convertible Notes), “Priced Rounds” (Preferred Shares), and “Legal Differences between Priced and Unpriced Rounds”.

1. Unpriced Rounds: SAFEs vs. Convertible Notes:

Most software entrepreneurs fund their businesses using an unpriced round of convertible equity in their startup during the early, pre-revenue stage. Convertible Notes or its equivalent, SAFEs, are used by almost every founder. Convertible notes are debt instruments that have a maturity date and an interest rate. SAFEs lack both of these characteristics and are more equivalent to a bond.

These equity instruments will be converted to stock at a discount to the valuation supplied at the time of the next pricing round, rather than being paid back in kind. As a result, they're frequently referred to as convertible debt financing. You'll raise money in your first priced round by selling preferred stock to investors at a predetermined price. You may also give a substantial investor a board seat if they provide a significant amount of the financing. You probably don't have to worry about this as an early-stage startup. 

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Seed Rounds are often used to refer to early unpriced rounds; the label Series Seed usually refers to a priced round. It's crucial to remember that unpriced rounds don't have a value, but convertible notes and SAFEs do have a valuation cap, which serves a similar purpose to other valuation techniques but isn't legal.

Unlike certain friends and family financing rounds, investors in unpriced rounds don't get shares for the money they put into the business right away. Despite the expense, some may argue that for early-stage fundraising, a Series Seed priced round is superior to an unpriced round. The establishment of the value cap is at the heart of these debates.

If the valuation limit is set too high, note-holders may only receive their discount plus a small amount extra in exchange for large investments—not a particularly attractive offer from their standpoint. Founders may be exposed to substantial diluting effects if the cap is set too low. Another worry mentioned with unpriced rounds is that unskilled founders will issue notes or SAFEs without taking into consideration dilution impacts on the cap table and the following round, resulting in a "dilution waterfall."

2. Series Funding: Priced Rounds:

Priced rounds involve raising funds by selling a set amount of stock at a specific price. A formal valuation (409a valuation) is required. Priced rounds involve the offering of a new class of preferred shares in your business.  Preferred shares are called so because they have liquidation advantages over common shares (known as common stock), which implies that preferred stock investors must be compensated for their investment before common stockholders.

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Preferred shares may not always equate in quantity to the common shares they represent, and they exist independently of the existing pool of common shares. Many businesses will also provide their first external board seat to an outside stakeholder at the first pricing round. Typically, this board member is the primary investor, who has put up the most money and performed most of the due diligence work for evaluating the investment agreement. A board seat is unlikely to be allocated when there are a big number of smaller investors rather than a single significant Venture Capital (VC) or Angel Investment.

For most organizations, Series A is the first of the priced rounds, while others have found that a priced "Series Seed" round, which replaces the unpriced Seed stage, is more useful in raising early-stage capital. The term sheets that regulate pricing rounds vary in complexity, with Series Seed being the most basic and each following series (for example Series A, Series B, etc.) becoming more complicated. Term sheets are often generated by investors rather than businesses; many east coast VC funds base their Series A term sheets on boilerplate contracts from the NVCA (National Venture Capital Association).

Priced and Unpriced Rounds Have Different Legal Consequences:

A pricing round requires a Security and Exchange Commission (SEC) filing that contains information on the stock offering, such as how many shares were offered for sale, at what price, and who the purchaser or purchasing organization was. Unpriced rounds do not need such a filing since the terms and agreements governing convertible notes and SAFEs are straightforward, requiring less effort to reach an agreement. As a consequence, unpriced rounds' legal expenses will be a fraction of the price of priced rounds. Businesses usually pay their investors' legal expenses as part of a priced funding round.

Ready to bring your startup to the next level? Apply to MassLight’s next batch. MassLight supplies capital and a dedicated tech team. We take equity in return. Have questions? Refer to our FAQ page.

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