Fundraising Terms: Pay-To-Play

Hello founders!

Welcome to another episode of your favourite fundraising terms series. This week we’ll be studying another economic term, “Pay-to-Play”.

The pay-to-play provision is usually relevant in a down round financing and can be very useful to the entrepreneur in situations where the company is struggling and needs another financing. With a pay-to-play provision, investors must keep investing pro-ratably in future financings (paying) in order to not have their preferred stock converted to common stock (playing) in the company.

The idea behind a pay-to-play clause is that the threat of losing these preferential rights will encourage investors to make additional investments in the company in cases where the valuation has been adjusted downward. Furthermore, this clause will prevent those investors who do not make additional investments from free-riding—retaining all their preferential rights and, as a consequence of the dilutive effect of the down round, be entitled to additional shares under their anti-dilution protection.

A typical pay-to-play provision follows:

Pay-to-Play: In the event of a Qualified Financing (as defined below), shares of Series [x] Preferred held by any Investor which is offered the right to participate but does not participate fully in such financing by purchasing at least its pro rata portion as calculated under “Right of First Refusal” will be converted into Common Stock.

A Qualified Financing is the next round of financing after the Series [x] financing by the Company that is approved by the Board of Directors who determine in good faith that such portion must be purchased pro rata among the stockholders of the Company subject to this provision. Such determination will be made regardless of whether the price is higher or lower than any series of Preferred Stock.

The pay-to-play clause typically only applies to future (down) rounds. It is possible, however, that new investors in a down round are only prepared to invest in the company if the pay-to-play clause also applies to the down round in which they plan to make their first investment. In such cases, the pay-to-play clause can be drafted in such a manner that it also applies to investors who made their investment in a previous round. This will force these old investors to participate in the new (down) round and will prevent the founders from being diluted due to the investors’ anti-dilution protection.

There are various levels of intensity of the pay-to-play provision. The preceding one is pretty aggressive when compared to the following softer one:

If any holder of Series A Preferred Stock fails to participate in the next Qualified Financing (as defined below), on a pro-rata basis (according to its total equity ownership immediately before such financing) of their Series A Preferred investment, then such holder will have the Series A Preferred Stock it owns converted into Common Stock of the Company. If such holder participates in the next Qualified Financing but not to the full extent of its pro rata share, then only a percentage of its Series A Preferred Stock will be converted into Common Stock (under the same terms as in the preceding sentence), with such percentage being equal to the percent of its pro rata contribution that it failed to contribute.

When determining the number of shares held by an Investor or whether this “Pay-to-Play” provision has been satisfied, all shares held by or purchased in the Qualified Financing by affiliated investment funds shall be aggregated. An Investor shall be entitled to assign its rights to participate in this financing and future financings to its affiliated funds and to investors in the Investor and/or its affiliated funds, including funds that are not current stockholders of the Company.

Another less onerous version is the automatic conversion into a new series of preferred shares, which is identical to the existing series but which may not have: (i) anti-dilution protection (or may have less favourable anti-dilution protection), (ii) liquidation preference, (iii) special voting rights, or (iv) a combination of the above. The forfeiture of rights under the pay-to-play clause is generally proportionate to the extent that the investor fails to participate in the new round.

Pay-to-play provisions are generally good for the company and its investors. It causes the investors to stand up at the time of their original investment and agree to support the company during its life cycle. This is not a lifetime investment guarantee; rather, if other prior investors decide to invest in future rounds in the company, there will be a strong incentive for all prior investors to invest or subject themselves to total or partial conversion of their holdings to common stock. A pay-to-play term ensures that all the investors agree in advance to the rules of engagement concerning future financings.

The pay-to-play provision impacts the economics of the deal by reducing liquidation preferences for the non-participating investors. It also impacts the control of the deal since it reshuffles the future preferred shareholder base by ensuring that only the committed investors continue to have preferred stock and the corresponding rights that go along with the preferred stock.

There are situations where the pay-to-play provision may not be appropriate, especially in early rounds if you have investors who generally do not participate in follow-on rounds as a matter of business practice. There are many circumstances where reasonable investors who like your company can’t or won’t participate in a financing round—their venture fund is over, or they are strategic or angel investors and don’t have the funds or charter to continue investing—a pay-to-play provision will inappropriately penalize them in the future for supporting you at the beginning when you critically needed their funding. Make sure that you understand the future funding dynamics of your VC partner and treat them accordingly.

We hope you found this insightful. See you next time!