So-called “pay to play” provisions are among the more esoteric aspects of venture capital investment negotiations. Pay to play provisions come in a variety of flavors, but whatever the particulars, the basic concept is the same: a pay to play provision “encourages” current investors to participate in a down round of financing or, if they don’t, lose some or all of their existing rights going forward. Most typically, this refers to anti-dilution protection.
From the entrepreneur’s perspective, pay to play might at first look like an intra-investor issue, and indeed, the attitudes of the various investors towards pay to play frequently diverge for a variety of mostly investor-centric reasons. However, in my view, entrepreneurs make a serious mistake when they assume that pay to play is something the investors should work out among themselves. Instead, pay to play is something that the entrepreneur should drive at the term sheet stage–to the point of suggesting that it be added to a term sheet an investor has advanced that does not include it.
What makes pay to play important in the context of the investor syndicate–that the various investors want to make sure that they are all committed to the deal for the long haul, even if the long haul includes a down round detour–makes it even more important to the entrepreneur. Investors may have a variety of internal fund reasons for not participating in a down round– most obviously, that they don’t have sufficient capital reserves to pony up. Nonetheless, from the entrepreneur’s perspective, if the business needs capital the investor’s problems are just that: the investor’s problems. The entrepreneur, in every down round case I can think of, should want every current investor to have every good reason to pony up. You may not always need negotiating leverage vis-a-vis your investors, but having it is never a bad thing.
As for the various flavors of pay to play, the two bookends are as follows:
The most severe form asserts that if an investor doesn’t play in a down round, his or her preferred stock is immediately converted to common stock at the pre-round (i.e. without any anti-dilution protection for the round that he or she is passing on) conversion price. Ouch.
At the other end of the spectrum is a pay to play provision which asserts that an investor who doesn’t play in a given down round does not get anti-dilution protection in that round, but retains all rights, including anti-dilution protection, going forward. Smart readers can no doubt see room for a wide variety of pay to play provisions falling between the two extremes.
My take is that the entrepreneur should always want the most severe form of pay to play provision he or she can get—the idea being that you can always, at the time of a down round (and with the cooperation of the participating investors in the round) back off enforcing the full force of the provision on the investors that choose not to play. On the other hand, you can’t up the ante on the pay to play after the fact. In other words, you can’t, come the future down round, increase the severity of the pay to play provision already in place.
A few concluding thoughts:
First, while pay to play is something entrepreneurs should make sure is on the table, ultimately it is in most cases an important negotiating point, but not (in my experience) something to bust an otherwise solid deal over.
Second, whatever the ultimate outcome of the pay to play discussion, having the conversation will typically smoke out any prospective investors who may have serious internal constraints on participating in any downstream financing rounds. The only worse thing then having an investor who doesn’t have any dry powder available for a future round, down or otherwise, is having such an investor and not knowing that going in.