This article is one in a series of articles explaining various terms commonly seen in term sheets issued by venture capital funds in connection with equity financings.
What are pay-to-play provisions?
As the name suggests, “pay-to-play” provisions require existing investors to pay (i.e., invest) in order to continue to play (i.e., maintain investor rights). Specifically, pay-to-play provisions usually require existing holders of preferred stock to purchase, on a pro rata basis, additional shares of the Company in a future financing. In the standard play-to-play scenario, if the investor does not reinvest, then some or all of its preferred shares will be converted to common stock or a more junior class of preferred stock (usually on a 1:1 basis). As a result, the investor may lose certain rights, preferences, and privileges associated with preferred stock, which may include the loss of a liquidation preference, a right to participate in subsequent financing rounds, a right to vote as a preferred stock holder in situations where the Company needs the preferred holders to approve certain material Company acts, and the right to elect a “preferred designee” to the board of directors, among other rights.
Why would a Company engage in a pay-to-play scenario?
Pay-to-play provisions are perceived by existing investors as very aggressive, and so must be administered with due care. A common pay-to-play scenario occurs if, for example, a Company is in financial distress, hasn’t received a standard term sheet, and desperately needs cash. A “restructuring” or “down round” term sheet is then delivered by a lead investor, offering a lifeline, but with a pay-to-play provision. In this scenario, all existing preferred stock would immediately convert into common stock. These existing investors (now holding common stock) would then have an opportunity to invest in the new round at the lower valuation, and thereby convert their common stock (that was just converted from their prior series of preferred) into the new money preferred stock.
The above scenario accomplishes a few primary objectives. First, existing investors have a strong motivation to invest, lest they lose their rights as preferred investors. Second, pay-to-play provisions tend to attract new investors, who will be more attracted to a situation where existing preferred holders are “cleared” or crammed down and only the truly motivated investors who invested in the round will remain as preferred holders on the cap table, with the end result being a recapitalization of the Company with a lower valuation.
Pay-to-play provisions are also sometimes used in financings where there are milestone or multiple-tranche closings. When investors are required to invest additional funds when the company achieves a commercial or regulatory milestone, a pay-to-play provision can work as a deterrent for investors who might be considering backing out of their commitment.
Things to consider
Because pay-to-play provisions can cause friction with existing investors, these provisions should be implemented and communicated delicately and with a solid business rationale.
Some VCs, for example, will only invest in early-stage rounds. (It’s simply not in their business profile to invest in subsequent rounds.) Implementing a pay-to-play could potentially alienate this sort of investor, along with other investors who cannot afford to reinvest.
Given the complexities of pay-to-play provisions, and the potential to aggravate existing investors, Companies are strongly encouraged to consult with legal counsel before considering pay-to-play strategies and any related negotiations.