Pay-To-Play" Investment: Unlocking Opportunities Or Unfair Advantage

A pay-to-play provision is a requirement for an existing investor to participate in a subsequent investment round, especially a down round. If an investor does not purchase their pro-rata portion of a subsequent investment round, their preferred stock will be converted into common stock or another less valuable series of preferred stock. This provision is designed to incentivise investors to participate in future financings and ensure the future support of all investors. It is relatively new, having been popularized since the beginning of the 21st century, and while it may seem harsh, many investors will agree to it.

Characteristics of "Pay to Play" Investment

Pay-to-play provisions are common in biotechnology or life sciences deals

A "pay-to-play" provision is a requirement for an existing investor to participate in a subsequent investment round, especially a down round. If an investor does not purchase their pro-rata portion of a subsequent investment round, their preferred stock is converted to common stock or another less valuable series of preferred stock.

Pay-to-play provisions are extremely rare in technology investment deals. However, they are very common in biotechnology or life sciences deals. This is because companies in these fields require a large amount of capital to get a product to market. Early investors in biotechnology or life sciences companies need to be prepared to provide additional cash in future financings.

For example, consider a company called Tough Times, Inc. that is in the market for another round of financing. Tough Times has raised prior rounds of financing at very favourable terms and valuations over the past three years and has double-digit revenue. However, in March, some clients cancelled contracts, some prospects didn’t sign, their revenue forecast needed to be changed, they had to lay off some people, and they reduced salaries. Now, in order to stay afloat, Tough Times needs an infusion of capital.

Tough Times does not receive a term sheet. They continue to cut costs and look at ways to extend their runway. Then, they get a term sheet from Opportunity Ventures. The founders think it looks unusual, so they send it to their lawyer for review. She says that it is a "cram down, with a pull-up" or a "pay-to-play". As part of their proposal, Tough Times suggests that the company hold a "rights offering", whereby all preferred stock that was just converted to common stock will be given the opportunity to participate in the financing led by Opportunity Ventures. If they participate at their pro rata level, the common stock that was just converted from their preferred stock will be "pulled up" and re-converted to a new series of preferred stock.

A pay-to-play provision incentivises investors to participate in future financing

A "pay-to-play" provision is a requirement for an existing investor to participate in a subsequent investment round, especially a down round. This means that investors are incentivised to continue to pay to play, or to keep contributing to financing, to avoid having their preferred stock converted into common stock. This is a relatively new provision, having been popularized since the beginning of the 21st century. While it may seem harsh to some, many investors will agree to it, which can significantly help support a new enterprise.

A pay-to-play provision often takes the form of a term sheet, which outlines the terms and conditions of the investment. If an investor does not participate when requested, they face consequences that can range from losing some privileges like anti-dilution protections to having their preferred stock converted to common stock or another less valuable series of preferred stock. This can happen in two ways: either by automatic conversion into a "shadow" series of preferred stock (with the applicable rights stripped out) or by automatic conversion into common stock, resulting in the loss of all preferential rights (so-called "strongman" pay-to-play).

Pay-to-play provisions are designed to provide a strong incentive for investors to participate in future financings. They are often hotly negotiated in the context of a down round, particularly where a subset of existing investors is leading such a round and requires the other existing investors to participate or be punished. However, they can also be drafted to apply to any future financing, regardless of whether it is a down round or not, to ensure the future support of all investors.

Pay-to-play provisions are extremely rare in technology investment deals but are common in biotechnology or life sciences deals because those types of companies require a large amount of capital to get a product to market. Early investors in these fields need to be prepared to provide cash in future financings and go the distance.

If investors don't pay up, they lose their preferential rights

A "pay-to-play" provision is a requirement for an existing investor to participate in a subsequent investment round, especially a down round. If an investor does not purchase their pro-rata portion of a subsequent investment round, they face consequences. These consequences can include losing some privileges like anti-dilution protections or having their preferred stock converted to common stock or another less valuable series of preferred stock.

Preferred stockholders have a higher claim on distributions (e.g. dividends) than common stockholders. They also usually have no or limited voting rights in corporate governance. In the event of a liquidation, preferred stockholders have a greater claim on assets than common stockholders but less than bondholders.

Pay-to-play provisions are extremely rare in technology investment deals but are common in biotechnology or life sciences deals. This is because those types of companies require a large amount of capital to get a product to market. Early investors in biotechnology or life sciences companies need to be prepared to provide additional cash in future financings.

A hypothetical example of a pay-to-play financing scenario is as follows: a company, Tough Times, Inc., is in the market for another round of financing after experiencing financial difficulties. They receive a term sheet from Opportunity Ventures, which includes the following pay-to-play terms: all current preferred stock is converted to common stock at a 1:1 ratio. Opportunity Ventures will then lead a preferred stock financing round at a valuation of roughly 25% of the last round. As part of their proposal, Tough Times suggests that the company hold a "rights offering", whereby all preferred stock that was just converted to common stock will be given the opportunity to participate in the financing led by Opportunity Ventures. If they participate at their pro-rata level, the common stock that was converted from their preferred stock will be re-converted to a new series of preferred stock.

Pay-to-play provisions are often negotiated in the context of a down round

A "pay-to-play" provision is a requirement for an existing investor to participate in a subsequent investment round, especially a down round. If an investor does not purchase their pro-rata portion of the subsequent investment round, their preferred stock is converted into common stock or another less valuable series of preferred stock. Pay-to-play provisions are negotiated in the context of a down round, which is when the valuation of a company is reset to a lower level. In this scenario, the company's stock is converted from preferred to common, and the investor is required to maintain their ownership percentage by purchasing more shares. This can be a risky proposition for investors, as the company is essentially admitting that its previous valuation was too high.

Pay-to-play provisions are often used in down rounds as a way to protect the company and existing investors. By requiring investors to purchase more shares, the company raises additional capital, which can be used to stabilize its financial position. Additionally, existing investors may be protected from dilution by having their preferred stock converted to common stock. This gives them the opportunity to maintain their ownership percentage by purchasing additional shares at the lower valuation.

Down rounds can be challenging for companies and investors alike. The company's previous valuation is often seen as a failure, and the new lower valuation can be a blow to the company's reputation. For investors, the decision to participate in a down round can be difficult. On the one hand, they may be concerned about the company's prospects and the potential for further losses. On the other hand, they may recognize the opportunity to increase their ownership at a lower valuation.

Negotiating pay-to-play provisions in the context of a down round can be complex. The company and investors must agree on the terms of the provision, including the valuation of the new shares, the conversion ratio of preferred to common stock, and the consequences for investors who do not participate. It is important for all parties to carefully consider the potential risks and rewards of such an arrangement before agreeing to the terms.

Overall, pay-to-play provisions in the context of a down round can be a valuable tool for companies and investors to navigate challenging financial situations. By providing a mechanism for raising additional capital and protecting existing investors, pay-to-play provisions can help stabilize a company and set it on a path to recovery. However, it is crucial for all parties to approach these negotiations with caution and a thorough understanding of the potential risks and rewards.

Pay-to-play provisions are relatively new, having been popularised in the 21st century

The concept of "pay-to-play" is not new and has been used in various sectors, including politics, entertainment, engineering, finance and corporate finance. However, pay-to-play provisions in the context of startup investments are relatively novel, gaining popularity in the 21st century.

Pay-to-play provisions are contractual agreements between investors and startups, designed to incentivise investors to participate in future funding rounds. This mechanism encourages investors to continue financing the company throughout its lifecycle, reducing the risk of investors pulling out their support. The provision is particularly relevant for startups, as they often rely on multiple rounds of funding to survive and grow.

The provision is structured to be either punitive or rewarding to investors. If an investor does not participate in a new funding round, they may face negative consequences, such as the conversion of their preferred stock into common stock, resulting in a loss of privileges and rights. On the other hand, investors who choose to participate may be rewarded with benefits such as superior terms or a pull-through transaction, where their existing preferred shares are exchanged for a new class of preferred shares.

Pay-to-play provisions are more commonly used during market downturns when startups face challenges in securing investments. In such situations, the provisions can be crucial for startups to ensure they receive the funding necessary to sustain their business. While these provisions may be beneficial for startups, they can have serious consequences for existing investors, who may be forced to continue investing to avoid dilution of their shares and loss of privileges.

Overall, while pay-to-play provisions are a relatively new concept in the investment world, they have become an important tool for startups to secure funding and manage their investor relations.

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