Demystifying the VC term sheet: Pay-to-play provisions

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

For the past couple of months, I’ve been exploring some of the more confusing terminology of VC term sheets.  In my last post, I discussed “drag-along” or “bring-along” provisions, which grant to the investors the right to compel the founders and other stockholders to vote in favor of (or otherwise agree to) the sale, merger or other “deemed liquidation” of the company.  In today’s post I examine so-called “pay-to-play” provisions, which can be an important protection for the company.

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What are Pay-to-play provisions? Pay-to-play provisions are designed to provide a strong incentive for investors to participate in future financings.  In their simplest form, such provisions require existing investors to invest on a pro rata basis in subsequent financing rounds or they will lose some or all of their preferential rights (such as anti-dilution protection, liquidation preferences or certain voting rights).

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 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, in effect, be punished. (That’s called “eve of financing” pay to play).

Pay-to-play provisions can, however, 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.

What does a typical example look like? Here’s what a typical pay-to-play provision may look like in the term sheet (the bracketed language offers various alternatives):

[Unless the holders of [__]% of the Series A elect otherwise,] on any subsequent [down] round all [Major] Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the [Major] Investors.  All shares of Series A Preferred of any [Major] Investor failing to do so will automatically [lose anti-dilution rights] [lose liquidation preferences] [lose the right to participate in future rounds] [convert to Common Stock and lose the right to a Board seat, if applicable].

What are some key issues for founders? There are several issues founders should focus on.  First, they must understand that pay-to-play provisions will not typically be included in a Series A term sheet – and that’s something they’ll need to raise and appropriately discuss with the investors.

A reasonable position might begin like this: “We are looking for investors who are in for the long haul and will agree to support the company throughout its lifecycle.”  From there, pay careful attention to how the investors respond.  (There may be disagreement within a syndicate.)

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If you encounter resistance, offer to limit the pay-to-play provisions to down rounds – the reasoning being that investors who are not willing to support the company in the event of a hiccup should not benefit from the anti-dilution protection (particularly if it’s a full ratchet) and should lose some or all of their preferential rights.

It may be unrealistic to expect angel and certain non-lead investors (including strategic investors) to participate in future financing rounds.  Accordingly, appropriate carve-outs should be negotiated and inserted into the term sheet, and the pay-to-play provisions will need to be contractual (i.e., outside of the Certificate of Incorporation) because each share of the same series needs to have the same rights, preferences and privileges as other shares of that series in the company’s charter.

Finally, from a capitalization (and drafting) perspective, it’s simpler to have the preferred stock automatically convert to common stock rather than a new class of shadow preferred.  Moreover, automatic conversion into common stock obviously provides a stronger incentive to the investors to participate in a future financing round and has the added benefit of reducing the company’s “preference overhang.”

(Missed previous installments in this ongoing series?  Click to learn more about the following issues:)

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• dividends
• price-based anti-dilution provisions
• exploding term sheets and no shop provisions
• valuation
• liquidation preferences
• stock options
• protective provisions
• drag-along rights

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.