Matt Storms and Melissa Turczyn: Paying to play in the venture capital game

01 Jun Matt Storms and Melissa Turczyn: Paying to play in the venture capital game

The amount of capital that an early-stage technology company needs can be staggering. Whether it be to fund the development and testing of a therapeutic drug or other product, the hiring of a team of scientists and engineers, or the purchase or lease of a significant amount of specialized equipment or space, almost all early-stage technology companies need money and few have sufficient revenues to meet that need.
The funding cycles for these companies can be long and significant, especially for those in therapeutics, and rarely does a single outside investor fund a technology company from inception to liquidation. Even with venture capital firms, it is fairly common for them to form syndicates in making investments. With most companies, these syndicates frequently co-invest in two to five rounds of financing (plus some interim bridge financings).
While investors’ interests typically are aligned with one another when they initially co-invest, for various reasons the interests of investors can diverge over time. So, how does one investor, or the company for that matter, ensure the other investors will co-invest at later stages of the company’s development? More specifically, when times are tough or the development path is different than what was initially planned, how does an investor ensure that fellow investors will continue to invest?
The answer for some is to incorporate “pay-to-play” provisions in the investment documents. Advocates that support these provisions often assert that they are merely used to confirm the understanding of the investors of continued investment in the company throughout its growth period.
What is a pay-to-play provision?
A pay-to-play provision requires those who are subject to it to invest (“pay”) their full pro-rata percentage of ownership in the company in future rounds of financing in order to retain certain rights (“play”). In a simplified example, if an investor subject to a pay-to-play provision owns 20 percent of a company seeking a $5 million investment, that investor would be required to invest at least $1 million (20 percent of the investment the company is offering) in its follow-on round of financing. If the investor chooses not to purchase 20 percent of the offering, the pay-to-play provision would be invoked and the investor would lose certain rights.
Types of pay-to-play provisions
Pay-to-play provisions can take on a number of different forms. One possible consequence of the failure to participate fully in a future financing is the automatic conversion of existing preferred stock held by the investor who fails to fully participate. The preferred stock could be converted into common stock of the company or into a junior class of preferred stock. This has the potential to include the loss of significant rights, such as liquidation preferences, anti-dilution protections, registration rights, rights to a board seat, and the right to participate in future financings.
In addition, it is not uncommon for an investor who does not participate in the financing to suffer a substantial dilutive effect (e.g., while an investor may have owned 20 percent prior to the follow-on round of financing, the investor may only own five percent or less after the financing round).
When are pay-to-play provisions used?
Pay-to-play provisions are typically used only in venture capital firm deals. On occasion, one sees them in a transaction involving a small group of significant angel investors or angel groups (e.g., each investing more than $1 million). They are more often asked for and invoked during difficult financing times (e.g., downturns in the economy) rather than when investment capital is easier to obtain.
Pay-to-play provisions can be implemented in all rounds of financing, including up rounds (where the price for the security is greater than the previous round), flat rounds (where the price is comparable to the previous round) and down rounds (you guessed it, where the price is less than the previous round), but most frequently one sees them invoked in down-round financings. The provisions frequently do not apply to smaller investors as they are typically designed to ensure that large investors continue their commitment to fund the company.
Fiduciary duty issues
Most state courts have not addressed the enforceability of pay-to-play provisions or whether invoking them may violate the fiduciary obligations of the company’s board members. However, the heavily influential Delaware courts have addressed them and have concluded that as long as the company adheres to certain procedural steps, the provisions will not violate board members’ fiduciary obligations.
Parting thought
Pay-to-play provisions are an important tool that are most often seen in venture capital deals. They are intended to provide a strong incentive for those subject to them to further invest in the company along side other existing investors. The provisions can get complicated and they can create significant dissension, divisiveness, and distraction for management if they are invoked. As a result, while an important tool, the decision as to whether to include pay-to-play provisions should be considered carefully by both investors and the company.
Previous articles by Matt Storms
• Matt Storms: More terms for venture capital term sheets
• Matt Storms: New rules would expand the definition of “accredited investors”
• Matt Storms: In pursuit of capital, be sure to track your private offering
• Matt Storms: When raising capital, why use a Private Placement Memorandum?
• Matt Storms: Capital-raising term sheets for angels and venture capitalists
• Matt Storms: Translating the language of capital-raising
• Matt Storms: Securities compliance is part of raising capital
• Matt Storms: Raising capital through placement agents
• Due diligence and corporate clean-up
• Matt Storms: The mechanics of raising capital for your business
• Sarbanes-Oxley for the Rest of Us