If convertible debt causes misalignments, how are priced rounds better, and how do they really work?
If you've decided you want to avoid the misalignments and other, shall we say, infelicities of a convertible note round, what is the alternative? It's pretty simple: find investors willing to take an ownership stake in the company for a price (valuation) you find acceptable and jointly work out terms that fairly allocate the various risks perceived in the investment.
Market Dynamics At Work
Market dynamics drive price. If investors are highly motivated to own a piece of your business, they will pay more for it. This means a founder will be able to either raise more money or give less ownership away. However, if investors are hesitant, through their actions they are saying the price is too high for the amount of risk they perceive, and the founder may have to consider lowering the price (i.e. give more ownership away) to entice investors on board.
By selling company stock, the founders are agreeing to share ownership in the business and joining themselves at the hip with investors. This is a fundamental element of priced rounds. In contrast, convertible debt fund-raising is a loan that is never meant to be paid back but instead converted into stock at some future date. The time lag between converting to stock is what gives rise to misalignment.
A priced stock fund-raising is an immediate sale of a portion of the ownership of the company. What is the significance of that? It means the investors are not working against the founders on valuation. Because they hold stock just like the founders, they share the same economic situation. Nobody profits unless the stock price goes up.
Keep in mind that the concept of profit in these shared-ownership situations can be misleading. Technically it means that stock holders are entitled to a proportional share of the excess earnings of the firm (profits) that are returned to shareholders (dividends). But that's theory; in practice, with high-growth, high-potential startups, it is rare to see a distribution of profits in the early years because cash is plowed back into the company as an investment in further growth. The operative economic assumption is that superior risk-adjusted returns can be achieved by investing the money back into the company, rather than pulling it out and investing it somewhere else.
Without a realistic expectation of any near-term distribution of profits, why would a stock investor invest? They are betting on the gain from a proportional slice of the proceeds when the entire company is sold. When you think about it, in some ways this has parallels to a debt deal. If convertible debt is a loan meant to convert into stock, stock investment is a loan the buyers of the company are meant to pay back. And therein lies the beauty. Unlike debt, equity investment is money that creates no legal re-payment obligation - it is co-ownership. Without repayment obligations, if the company fails, all the owners share the pain; if the company wins, all the owners share the gain.
What's the Catch?
If the benefits of this alignment are so great, why doesn't everyone use them all the time? Because of the complexity (and resulting cost) of the transactions. These stock transactions permanently alter the capitalization of the company by adding new stockholders, who are typically purchasing an entirely new class of stock created for them. This is typically a series designated class of preferred stock with special rights and privileges that have been negotiated. Given this permanence, and the associated complexity of creating the permanence, there are a great number of different types of deal documents normally used in stock transactions.
Added complexity notwithstanding, priced rounds are not unproven or especially difficult. Many of these deals have been done successfully, so investors and startup founders can follow a well-worn, familiar path. With the help of experienced counsel who do these deals regularly, this translates into mechanics that are fairly easy to navigate. In addition, there are a number of ways to manage the costs. In reality the only tricky part is agreeing on the terms that fairly allocate the various risks associated with the investment deal.