Pay-to-play:

 

A typical startup goes through multiple private investment rounds before it is merged, acquired or goes public. The pay-to-play terms define re-investment requirements in future investment rounds by existing preferred stock holders in order to maintain their current preferred status. Non-participation in future rounds can lead to conversion of some or all of their preferred stock into common stock (sometimes the conversion is to a “shadow” preferred stock).  Sometimes pay-to-play terms are set up such that they are effective only during down rounds. Additionally, pay-to-play provisions may be written such that they are enforceable only on investors who have a pre-defined level of preferred stock ownership. This is relevant for early stage angel investors who are less likely to have the ability to make pro-rata follow on investments.

 

There are typically two major varieties of pay-to-play provisions: aggressive pay-to-play where the investor is required to reinvest to at least the full extent of the pro rata share or else risk conversion of all preferred stock to common stock. The second less-intense pay-to-play is more flexible with the extent of investment in future round. In this case, the percentage of preferred stock converted to common stock is proportional to the percentage of the pro rata contribution that the investor failed to re-invest. For example, if a VC held 10% of XYZ Inc after Series A financing; a pay-to play requirement would need the VC to re-invest in Series B financing. If the VC owns only 5% of XYZ Inc at the end of Series B financing, then half of Series A preferred stock would be converted to common stock (please note I am skipping some of the nuances of the terms here).

 

Down rounds can lead to significant dilution in ownership of original investors. Anti-dilution provisions in a term sheet provide a level of protection to the original investors from dilution. Typically anti-dilution and pay-to-play provisions are tied and a lack of participation in future financing rounds voids an investor’s anti-dilution provisions as well. The risk of dilution, loss of preferred stock and thus liquidation and participation preferences make for a compelling reason for an investor to participate in future rounds when term sheets include pay-to-play provisions. For obvious reasons, entrepreneurs seek pay-to-play provisions in term sheets as it assures them with future financing. Having said that, entrepreneurs do need to be aware of scenarios where lack of participation from investors can allow participating investors to significantly de-value the company and force recapitalization that drastically hurts the entrepreneurs.