Term Sheets: What are pay-to-play provisions?
This week we continue our series on key VC financing deal terms.
This week’s question: What do I need to know about pay-to-play?
Our answer: Pay-to-play provisions are occasionally included in venture financings and require existing investors to participate in future financing rounds (typically on a pro rata basis) to maintain their rights, preferences and privileges such as anti-dilution protection. The intent is to incentivize ongoing support from current investors, especially in difficult times. However, pay-to-play is a double-edged sword: for your startup and new investors, it can bring much needed stability to the cap table and make fundraising more viable if/when tough times hit, but it may also alienate smaller and less liquid investors who are unable to participate in future rounds, potentially creating tension with current investors. More than most terms, pay-to-play provisions require careful, fact-specific analysis. Our recommendation is that pay-to-play should generally be reserved for later-stage startups with a committed and trusted group of investors.
Market Standard
There are many ways to structure pay-to-play provisions, but below are the key terms and considerations that reflect what we typically see as standard:
Down-Round Trigger: pay-to-play is typically triggered only upon a down round. This encourages continued support from existing investors and helps attract new capital by demonstrating investor alignment.
Full Pro Rata: most pay-to-play provisions require investors to to commit to keep its full pro rata percentage. Some alternatives may allow partial participation or investment thresholds based on dollar amounts.
Penalty for Non-Participation: the most common penalty for failure to participate is the conversion of an investor’s preferred stock to common stock (effectively stripping investors of their preferred stock’s rights, privileges and preferences). A softer version may convert shares to a “shadow” preferred, which retains some special rights but forfeits other important ones such anti-dilution protection, voting rights, or information rights).
Waivers: while many pay-to-play provisions are hardwired with no waiver, some allow for exceptions, such as board discretion or waiver by a supermajority of preferred stockholders to give current investors an out in specific circumstances.
Why It Matters
Pay-to-play isn’t found in every financing, but it’s an increasingly relevant tool in maturing or distressed startup situations to ensure alignment among investors and provide leverage in difficult fundraising environments. Understanding when and how to use this provision can offer meaningful protection and clarity when your startup needs it most.
