VC Term Sheets – Pay to Play Provisionsby Scott Edward Walker on May 19th, 2011
This post originally appeared as part of the “Ask the Attorney” column I am writing for VentureBeat. Below is a longer, more comprehensive version, which is part of my ongoing series on venture capital term sheets. Here are the issues I have addressed to date:
- common mistakes dealing with VC’s
- liquidation preferences
- stock options
- exploding term sheets and no-shop provisions
- anti-dilution provisions
- Board control
- protective provisions
- drag-along provisions
In today’s post, I examine “pay-to-play” provisions, which can be an important protection for the founders.
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 (e.g., anti-dilution protection, liquidation preferences, certain voting rights, etc.) – 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 round and requires the other existing investors to participate or, in effect, be punished (so-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 Is a Typical Pay-to-Play Provision? 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, founders need to understand that pay-to-play provisions will not typically be included in a Series A term sheet; this is an issue that they will generally need to raise and appropriately discuss with the investors. The conversation 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.” This is indeed a reasonable position, and founders need to pay careful attention as to how the investors respond. (In some cases, there may be disagreement within a syndicate.)
Second, if founders get push-back from the investors, they can 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. This too is a reasonable position.
Third, 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 contractual (i.e., outside of the Certificate of Incorporation) because each share of the same series must 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 into 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.”
What Are “Pull-Up” Provisions? “Pull-up” or “pull-through” provisions are designed to have the same effect as pay-to-play provisions – i.e., they are designed to provide a strong incentive for existing investors to participate in future financings. The difference, however, is that pull-up provisions act as a carrot, not a stick. Indeed, instead of existing investors being penalized, they are rewarded. Here’s how they generally play out:
In some Series B or later rounds, the existing investors do not have the voting power to change the terms of the outstanding series of Preferred Stock to put in place an “eve of financing” pay-to-play (as discussed above). Accordingly, they structure the new round as a pull-up financing, which permits the existing investors (e.g., the holders of the Series A Preferred) to convert or exchange shares of Series A Preferred into a new series of Preferred Stock (e.g., Series A-1) which is similar to the Series A, but convertible at a much better rate (reflecting the new valuation of the company) and with additional sweeteners (e.g., full-ratchet anti-dilution, senior in liquidation, etc.).
I hope the foregoing is helpful. This is obviously a complicated issue and warrants input from experienced counsel in connection with the negotiation of a Series A term sheet. If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott