NOTE: This is the seventh post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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The Pay-to-Play provision is another term that can have significant economic impact on the investors and the company, and it dovetails nicely from the discussion of Anti-dilution Provisions in our last post because in a down-round financing (where the company’s valuation is lower than in the prior round) it helps mitigate the negative impact of anti-dilution protections. A Pay-to-Play provision provides that any investor failing to fully exercise her “Preemptive Rights” to participate in a future financing will have some or all of her shares of preferred stock converted into common stock or into another class of preferred stock with lesser rights (losing her anti-dilution protection and other rights in the process).
A Pay-to-Play is clearly company-favorable because it penalizes investors who do not pony-up when the company needs more funding, but it also has positive consequences for those investors who do invest in future rounds because it prevents other investors from free-riding. Lead investors are often willing to accept a Pay-to-Play provision (and some even prefer to include one) where there is a syndicate of smaller investors who the lead investor wants to ensure will continue to play ball, particularly if the lead investor has the voting power to block any future financing where it does not want the Pay-to-Play to apply (see our earlier post on Voting Rights and Protective Provisions). Smaller investors, by contrast, are most likely to object to a Pay-to-Play.
Note that although the NVCA’s model term sheet only applies the Pay-to-Play to a “down-round” financing (where the company’s valuation is lower than in the prior round), it can be applied to “up” rounds as well, though investors are usually much more willing to participate when the company’s valuation is on the rise.