This guide covers the basics of raising a priced round. The target audience is startups raising their first priced round, whether Series Seed or Series A. But many of the concepts here are also relevant for subsequent priced rounds.
For startups that are not at the point of raising a priced round, we recommend reviewing our guides for SAFE and convertible note financings.
- What is a Priced Round and How Does it Work?
- When Should You Raise a Priced Round and When Should You Not?
- How to Prepare for a Priced Round
- Determining How Much to Raise and Valuation
- What to Expect in a Term Sheet and How to Negotiate
- The Priced Round Deal Documents
- Closing and Post-Closing Tasks
What is a Priced Round and How Does it Work?
In a priced round, a startup sells equity at an agreed valuation to investors. That is, the startup sells shares at a set price. For example, a startup might sell shares at a price of $1 per share. If an investor invests $1M in the round, the investor would own 1M shares in the startup.
The lead investor for the priced round will likely be a venture capital firm and the other new investors are also likely from venture capital firms, though there may be angel investors included too.
The equity purchased by investors in a priced round will be preferred stock. This preferred stock will allow investors to exert substantial control over the major decisions the startup can make, including the decision to sell the company. It will also confer various preferential economic rights on the investors, including liquidation preferences and others discussed in more detail in this post.
When Should You Raise a Priced Round and When Should You Not?
For early stage startups, this question is most often presented when raising a seed round, where SAFEs and convertible notes are more commonly used. However, if a startup has a lead investor and is raising a sufficient amount (at least $1 million), it may be worth raising a priced round. This is especially true if the lead investor prefers a priced round. But if the lead investor is comfortable with a SAFE financing, that option often makes sense at the seed stage.
For at least some startups, their first priced round will be a Series A. While numbers vary significantly, it’s likely that a startup raising a Series A is seeking to raise at least $5-$10 million from investors at a valuation that translates into selling approximately 20% of the startup to new investors.
To raise a Series A, a startup will almost certainly need to have achieved product-market fit. The idea with a Series A is to take the invested capital and use it to rapidly scale up based on the product-market fit your startup has found. If your startup doesn’t have product-market fit but needs capital, your chances are better with investors who typically invest at seed or even pre-seed.
After Series A, startups should expect to raise priced rounds moving forward, with the exception of bridge financings. Convertible notes are usually used for bridge financings, which allow a startup to raise more capital before closing their next priced round. Bridge financings are often raised from existing investors with the idea of helping a startup that’s doing well but is low on cash to gain extra runway and/or reach a stronger position for raising capital in their next priced round.
How to Prepare for a Priced Round
Startups that have sold SAFEs or convertible notes may think that financings are relatively simple. They’re in for a rude awakening when they go to raise their first priced round. A priced round doesn’t just happen. The founders (particularly the CEO) will put in substantial preparation work to find, pitch, and close investors. Equally as important, though, is the work to ensure the startup’s entity and capitalization structure is set up to take investment from venture capital and that the startup’s house is in order to pass due diligence.
Review and, if Necessary, Remediate Entity and Capitalization Structure
A startup raising a priced round should be a C-corporation. Most, though not all, venture-track startups are incorporated in Delaware. If your startup is already incorporated in Delaware as a C-corporation, your entity structure is likely in good shape for accepting venture capital.
Related Post: Where Should I Incorporate My Startup?
If your startup is not a C-corporation, you have work to do. In this case, your startup is likely an LLC. The startup will need to be converted from an LLC to a C-corporation prior to the priced round. To read more about the reasons for this–as well as the mechanics of converting an LLC to a C-corporation–check out our related post: The Startup Guide to Converting an LLC to a C-Corporation.
As with entity structure, investors will expect to see a certain capitalization structure, i.e., who owns what and in what amounts. In general, investors in the first few priced rounds (e.g., Seed, Series A) will expect the founders to still own the majority of the equity in the company immediately prior to the financing. It’s likely not a problem if earlier stage investors own a modest amount of the company. It also shouldn’t be a problem if employees, consultants, or advisors have received reasonable stock option grants.
However, it will almost certainly be a problem if the startup has sold too much of the company to investors prior to the first 1-2 priced rounds. For example, if a startup sold 25% of the company in exchange for a $500,000 “friends and family” round, and another 25% of the company in exchange for a $1 million seed round, potential Series A investors would likely pass on the opportunity, concluding that too much of the company has already been sold (and for too little investment). Part of the concern here is that founders whose equity is severely diluted early on will not have sufficient motivation to stick around and scale the startup.
A related cap table concern can come from startups selling too many SAFEs prior to the first priced round. SAFEs can be very helpful tools for raising money prior to venture capital, but their ease of use can lead startups to sell to many of them without understanding the impact on the cap table when the SAFEs convert into equity in the priced round. The result can be a lopsided cap table where early stage SAFE investors own a disproportionate share of equity, founders are excessively diluted, and potential priced round investors may choose to pass on the opportunity for similar reasons to those raised in the prior scenario where the startup sold too much equity to early stage investors.
Tip: Raising multiple SAFE rounds has become particularly dangerous with the advent of the post-money SAFE in 2018. Post-money SAFEs don’t dilute other SAFE investors, but rather dilute founders and other existing stockholders. You can learn more about this in our related post: The Ultimate Guide to SAFEs for Startups.
If your startup has a messy or broken cap table, it’s important to make efforts to remediate it prior to or in connection with raising money, or risk rejection from new investors. The messaging can be that it is in everyone’s long term interest for the company to raise additional capital, and so sacrifices may need to be made for the benefit of all.
Create, Populate, and Organize a Data Room
A data room is an online home for company records. The main purpose of a data room is to facilitate the due diligence process that investors, acquirers, and other third parties may conduct on the company when evaluating opportunities to invest, acquire, partner, or otherwise do business with the startup. To learn more about what investors will expect to see in a data room, check out our post: What Venture Capital Investors Look for in Legal Due Diligence.
A data room is perhaps the most underutilized tool by startups targeting venture capital for the first time. The kind of data room a startup presents to investors sends a powerful message about the company and its team. A thorough, well-organized data room suggests that the startup is industrious, transparent, and forward-looking. An incomplete, haphazard data room suggests that the startup is, at best, disorganized, and at worst, hiding something. For venture capital funds that will invest in only a small fraction of the startups they consider, a shoddy data room gives investors an easy reason to back out.
Startups should not put off creating a data room until the last minute for several reasons. First, creating a strong data room will take time and thought. Doing it last minute makes it much more likely that the product will be lacking. Second, the process of developing a strong data room will often surface issues that should be remediated before the financing. This helps make the startup look cleaner in diligence and shortens the diligence process–an important factor in an environment where time tends to kill deals.
Determining How Much to Raise and Valuation
Amount Raised
Startups need to have a target amount they want to raise in a priced round. “As much as we can” is not an acceptable position to take. Founders should be prepared to seek a specific amount (or at least a reasonably narrow range) and to justify why that amount is needed. Investors understand that precision can be challenging for early stage startups, so the point is not necessarily for founders to be right in all their predictions, but rather to show that the founders have a coherent vision and plan for implementing that vision.
For most early stage startups, the main input for determining how much to raise will be the startup’s anticipated burn rate. This is usually equal or close to the startup’s monthly expenses, given that many early stage startups have little to no revenue. Once you have your burn rate, you can determine how much money you’ll need to raise, i.e., your runway using simple arithmetic.
Example: Let’s say a startup with no money in its bank account has a projected monthly burn rate of $100,000 for the next 18 months. And let’s assume the startup doesn’t project any revenue during this period. The startup will need to raise at least $1.8 million to cover expenses for that period.
For a startup raising a Series A, the objective is usually to raise enough to sustain operations for somewhere between 12-24 months. With that in mind, and with your projected burn rate, it’s relatively straightforward to calculate a target raise amount. Then you get to defend it.
Valuation
The company and investors will need to agree on a valuation for the company. The valuation of the company determines how much of the company investors can buy with their investment.
There are two ways to talk about valuation: pre-money valuation and post-money valuation. These terms are descriptive. The “pre-money” is the value of the company right before the new money is invested, i.e., “pre” the new money. The “post-money” is the pre-money plus the amount of new money invested, i.e., “post” the new money.
Example: Acme Inc. is raising $5M from Series A investors. The agreed pre-money valuation is $20M. The post-money valuation is $25M. The effective ownership percentage of the Series A investors is 20%.
As a general rule, a lower valuation means investors will own more of the company (and founders will absorb greater dilution), and a higher valuation means investors will own less of the company (and founders will have less dilution). Consider a variation on the above example to illustrate the point.
Example: Acme Inc. is raising $5M from Series A investors. Originally, investors had agreed to a $20M pre-money valuation, but after a rocky due diligence process, investors are now insisting that the pre-money valuation must be $15M; Acme reluctantly agrees. Following the Series A, the post-money valuation is $20M. Hence the effective ownership percentage of the Series A investors is 25%--a 5% increase from the ownership percentage had the $20M pre-money valuation been used.
Founders who fixate on the amount raised and overlook valuation do so at their own peril. Startups should view the two concepts as inextricably linked. The goal should be to sell no more than a certain percentage of the company to investors. From there, the founders can always determine what valuation they’ll need in order to hit their target percentage.
Option Pool
It's critical for startups not to lose sight of the impact of the option pool size on the effective valuation of the company. Investors will require the startup to increase the size of the option pool in connection with the financing, typically so that there’s a pool of somewhere in the range of 10-20%.
Here’s the kicker though: the investors will insist that the increase in the option pool occur prior to the financing, meaning that only existing investors will be diluted. The practical effect of this is that any increase in the option pool size will represent an effective decrease in the pre-money valuation.
Example: Acme Inc. is raising $5M from Series A investors. The investors have agreed to a $20M pre-money valuation but are insisting that the post-money option pool be 20% rather than 10%. In that case, the additional 10% will come out of the pre-money valuation, meaning that although the stated pre-money valuation is $20M, it’s effectively an $18M pre-money valuation.
What this example illustrates is that valuation and the option pool size should be negotiated together. After all, both are simply negotiations over price for new investors.
What to Expect in a Term Sheet and How to Negotiate
The terms and documents used in priced round financings are, in theory, mostly standardized. For example, most priced round financings use the NVCA model legal documents as a starting point. While these documents are indeed useful for lowering transaction costs, they are also lengthy and plenty of the provisions are subject to negotiation between the parties. One of the best ways to streamline the financing process is to start with a thorough term sheet, negotiated with the help of your legal team.
Offering Terms
A term sheet will begin with the basic offering terms. This should include things like the type of stock being sold to new investors (i.e., preferred stock), the closing date, the amount being raised (including amounts from conversion of SAFEs and convertible notes), the price per share, the pre-money valuation, the post-money valuation, and the post-money option pool size.
The main thing to focus on in the offering terms is usually valuation. As we saw in the examples in the previous section, it’s critical to ensure that the valuation set out in the term sheet is accurate and will lead to the target ownership percentage the startup is willing to sell to the new investors. It can be confusing to parse the term sheet language surrounding valuation and related concepts, and so it’s important to have your startup lawyer there to support and verify.
Liquidation Preference
This is an important one. The language in the term sheet will not be easy to understand for first-time founders. So make sure you’re getting help reviewing.
In its simplest form, a liquidation preference means the investors get paid before the common stockholders, including the founders. The most common type is colloquially known as a “1x liquidation preference.” This simply means the investors will have the amount of their original investment returned to them before the common stockholders are paid. A 1x liquidation preference is typically referring to non-participating preferred stock, meaning preferred stock that either takes its 1x liquidation preference or converts to common stock and participates alongside the other common stockholders.
There is another type of liquidation preference known as participating preferred stock, which is very investor friendly and is not common in an early stage startup financing. Participating preferred stock doesn’t require the holder to choose between taking their liquidation preference or converting to common stock, but rather allow the holder to first take their liquidation preference and then also participate pro rata alongside the common stockholders.
Protective Provisions
Broadly speaking, protective provisions give investors blocking rights. These blocking rights will be limited to certain major decisions, transactions, etc., meaning that investors can’t block just any decision they disagree with. But founders need to understand the degree of control they cede to investors with these protective provisions. Even if the founders still hold a majority ownership percentage in the company, they can no longer rely on that majority to push through decisions that are subject to protective provisions.
Understanding this is effectively understanding the bargain you’re making when you raise money from venture capital. In exchange for investment, founders give up the broad control they previously enjoyed. The basic nature of that bargain isn’t up for negotiation, and so founders shouldn’t expect to be able to remove protective provisions altogether, though there may be some room to negotiate the particulars.
A handful of examples of things that are typically covered by protective provisions include:
Dissolving the company.
Amending the charter document or the bylaws.
Changing the authorized number of shares.
Issuing stock senior to or equal to the Series A preferred shares.
Buying back common stock.
Selling the company.
Borrowing money.
Changing the size of the board of directors.
Issuing cryptocurrency or tokens.
Board Matters
The lead investor will typically take a seat on the startup’s board of directors. For a startup’s first priced round, the founders should still control the board despite giving a seat to the lead investor. For example, the founders may be given the power to designate two directors to the three-person board. This allows the lead investor to be involved in managing the company while allowing the founders to exercise control, subject to the protective provisions and subject to any other items in the financing documents that specify that the lead investor director’s approval must be obtained for the board to act.
If the lead investor does not take a board seat, then they are typically given a non-voting board observer right. Other investors may also be given this right.
Optional Conversion
This term is relatively straightforward in form and in practice. It gives the investors the right to convert their shares of preferred stock into common stock at any time at a 1:1 ratio. One scenario where investors often exercise their right to convert in a sale of the company when their pro rata share of common stock will have a better economic outcome than if they simply took their liquidation preference.
Anti-Dilution Provisions
Anti-dilution provisions are a challenge, especially for first-time founders. There will likely be a formula included and a wall of incomprehensible text.
What’s going on beneath all of that is actually less complicated. The point of anti-dilution provisions is to protect investors if the company struggles and has to raise a future down round, i.e., sell shares at a lower price per share than in the current financing. If this happens, the anti-dilution provision will effectively improve the economics of the investors in the current round to prevent them from being diluted by the down round.
The two types of anti-dilution provisions are weighted average and full ratchet. Whereas full ratchet is often seen as too investor-friendly, weighted average is seen as a relatively balanced approach and is thus much more commonly used.
Mandatory Conversion
The mandatory conversion provision sets out when preferred shares will automatically be converted. The two typical triggers for automatic conversion are (1) an IPO, and (2) the consent of the requisite percentage of investors. There may be some negotiation over the appropriate size of the IPO that triggers mandatory conversion. But beyond that, this is not usually subject to negotiation.
Representations and Warranties
Usually this provision is a single sentence acknowledging that “standard” representations and warranties will be made by the startup in the stock purchase agreement. What this means is that the lawyers will battle it out in the stock purchase agreement over what representations and warranties are included, so no need to get more granular in the term sheet.
Counsel and Expenses
For priced rounds, the startup is usually expected to pay its own legal fees to draft the investment documents and pay the legal fees of the lead investor’s counsel, though usually there’s a dollar cap on the latter in the term sheet. This can likely be negotiated, but startups should keep some perspective on the relative amount of expenses compared to the size of the investment.
Registration Rights
Registration rights sets out the rights investors will have for registering their shares if there’s an IPO. Registration rights and their related terms take up a fair amount of real estate on the term sheet, but fortunately they’re relatively standard in the typical term sheet. So in most cases they shouldn’t require significant negotiation.
Management and Information Rights
A management rights letter provides VCs with rights to receive information, inspect records, and consult with management on significant matters. This generally isn’t a VC power grab–the primary purpose of this letter is to help VC funds take the position they should be exempt from ERISA regulations if their LPs are pension funds.
Information rights require the company to deliver regular reports and financial statements to investors, as well as giving investors the right to inspect the company’s records. Startups typically try to limit these information rights to major investors.
Pro Rata Rights
A pro rata right is an investor's right (but not obligation) to buy a certain percentage of the shares sold in a future financing. The aim with this is for investors to be able to keep buying shares of the company in subsequent financings to preserve their ownership percentage. This can seem like a good problem to have for a startup, and it can be, but startups also often want to bring in new investors in subsequent rounds. If pro rata rights are given out indiscriminately, that can create issues down the line. The solution in most cases is to limit pro rata rights to major investors. This pro rata right is also known as a right of first offer.
Rights of First Refusal
Investors will also be given a contractual right of first refusal to purchase the shares of key common stockholders (e.g., the founders) if those stockholders sell their shares to a third party. Note that this right of first refusal will be secondary to the company’s primary right of first refusal.
Co-Sale Rights
If the company and the investors don’t exercise their rights of first refusal, then the investors will then have co-sale rights, meaning the right to sell preferred shares proportionately along with the selling key holder on the same terms as the key holder. This is also referred to as a tag-along right.
Drag-Along Rights
Priced round financing documents may include a drag-along provision. The purpose for including a drag-along right is to allow the majority of the common stockholders and a majority of the preferred stockholders to force minority stockholders to sell their shares if these majority groups favor a sale of the company. Having this mechanism not only stops minority investors from preventing or delaying a sale, it also prevents them from exercising appraisal rights.
Non-Competition Agreements
Term sheets may specify that founders and key employees must be subject to a non-competition agreement. However, use of employee non-compete agreements are prohibited in some states (most notably, California), and substantially restricted in others (Washington is one example). So non-compete provisions may not be appropriate to include in the term sheet, or they may need to be limited to founders and personnel in states where they may be enforceable.
Non-Disclosure, Non-Solicitation, and Developments Agreement
This provision will require founders, employees, and consultants to sign a standard form of agreement often titled Proprietary Information and Inventions Assignment Agreement (PIIA) or Confidential Information and Inventions Assignment Agreement (CIIA). It’s already best practice for a startup to use these for personnel, and so this term shouldn’t require negotiation in most cases.
The Priced Round Deal Documents
Priced round financing documents are typically anchored by five main transaction documents, as well as a handful of other ancillary documents which vary by transaction, investor preference, etc. The starting point for transaction documents will be the model legal documents from the NVCA.
Stock Purchase Agreement
The stock purchase agreement sets out the main economic terms of the financing, the closing mechanics, representations and warranties, and more.
Restated Certificate of Incorporation
Prior to closing the priced round, the startup will file an amended and restated certificate of incorporation to include provisions concerning the new class of preferred stock to be sold. These provisions cover matters including, among others:
Investors’ Rights Agreement
The Investors’ Rights Agreement sets out a list of rights reserved for the investors in the financing, including:
Right of First Refusal and Co-Sale Agreement
The Right of First Refusal and Co-Sale Agreement, unsurprisingly, contains the rights of first refusal with the right of co-sale with respect to sales of shares by the key holders (typically the founders). The right of first refusal is primary for the company and secondary to the investors. The investors have co-sale rights in the event that the right of first refusal is not exercised. Co-sale rights are also sometimes referred to as tag-along rights.
Voting Agreement
The Voting Agreement requires the company, its investors, and at least the key holders (if not all of the common stockholders) to agree to:
Vote all shares as required by the Voting Agreement
Maintain the size and composition of the board as agreed by the investors and existing stockholders, and vote their shares to elect the designee of the lead investor and the designees of the founders (or majority of the common stockholders) to the board
Agree to the drag-along right, if included
Common Ancillary Documents
Common ancillary documents include the following, though there may be others depending on the financing.
Closing and Post-Closing Tasks
Once all of the financing documents are form final, and once all signature have been collected from the investors, founders (and other key holders), and other signatories, the investors will wire funds and the round will close. In some financings, there may be an initial closing and one or more additional closings, usually no more than 90 days after the initial closing.
Following the initial closing, typical post-closing items for the company include:
Circulating compiled investment documents to investors.
Issuing stock certificates to investors.
Making securities filings with the SEC and state blue sky filings, as applicable.
Issuing a press release and otherwise publicizing the financing.
Obtaining a fresh 409A valuation and making any promised option grants to service providers.
Obtaining directors and officers insurance coverage
Takeaways
As we’ve seen, priced rounds are complicated and require substantial negotiation. Founders will be negotiating with investors who negotiate term sheets for a living, which will put all but the most experienced founders at a clear disadvantage. This is the time to lean on the expertise of your legal team to level the playing field with investors.
