Venture Capital Deals in IT: Pay-to-Play
- 1. What is a pay-to-play provision?
- 2. Why is a pay-to-play provision necessary?
- 3. How is a pay-to-play provision used?
We continue uncovering instruments of venture capital deals in IT under the English law. Today's post is about pay-to-play, a provision encouraging stockholders to participate in the company’s fundraising.
1. What is a pay-to-play provision?
Pay-to-play is a requirement for a stockholder to provide the company with financing (“to pay”) to be able to retain its interest and/or its rights and privileges in the company (“to play”). If refused to pay, the stockholder loses its interest and/or its rights and privileges.
2. Why is a pay-to-play provision necessary?
Startups negotiate pay-to-pay to encourage investors to participate in subsequent funding rounds. In practice, this provision is, however, rarely used. Most often, investors retain the rights granted in a funding round for the entire period of their shareholding in the company, and these rights are not dependent on the investors’ participation in the future financing. Meanwhile, investors may at their sole discretion decide to co-invest in subsequent funding rounds and obtain the rights and privileges attached to those subsequent funding rounds.
Nevertheless, companies may implement this provision with a view to prevent a scenario where the-then current investors take advantage of future funding rounds without active participation from their side. In addition, companies use pay-to-play to be confident in the support of the-then current investors and their commitment to the companies’ goals and vision, which, in turn, may be a positive message for new investors.
3. How is a pay-to-play provision used?
Pay-to-play provisions may take two forms: a bonus and a sanction.
- Bonus: if the investor “pays” and participates in the funding, the investor retains its interest, rights and privileges in the company and can expect to receive additional benefits (e.g., grant of new rights / conversion into a higher stock class).
- Sanction: if the investor does not “pay” and does not participate in the funding, the investor loses its rights and privileges, and their interest in the company is diluted. As an example, a company may “take away” the investor’s veto right, anti-dilution protection, liquidation preference and/or convert its stock into a lower class (from preferred stock to common stock).
Both forms (bonus and sanction) can be used simultaneously or separately. It should be borne in mind that, in the second case (sanction), the non-participating investor “loses”, since the others, at that moment, obtain the promised benefits and, thus, put themselves in a more stable position in the company.
Pay-to-play is used to encourage investors to fund the company and retain their rights and privileges (or obtain new ones). As this provision imposes additional long term financial obligations on investors, they do not always agree to be so bound: if a fund's investment model does not imply participation in subsequent rounds, the use of such an instrument would be impossible for them.
Authors: Viktoryia Semianitskaya, Veranika Hrazheuskaya
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