Pay to play clause in venture capital and its use to align interests


Paris Street, Rainy Day - Gustave Caillebotte

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We continue now with the first part about the pay to play clause, where we saw what this type of clause or agreement consists of. In this case, we will see some additional details beyond the mere concept.

The use of this type of clause in the Spanish market is still complicated, probably due to both the reluctance of investors and the characteristics of the Spanish investors and start-ups involved, as we will see below. 

The Spanish venture capital industry does not have the track in number of financings/rounds as we see in other bigger markets. While in the US it is common to see start-ups reaching series E, F, G and so on, in Spain very few companies pass through those number of series (and once series of this type appear often responds to complementary rounds). Additionally, venture capital firms (and private equity firms) operating in Spain usually do not have the financial capacity to participate in successive financings, such as the case of the US and UK firms.

To implement the pay to play clause in Spain, Spanish start-ups need to reach more series, mainly through its internationalization and adapting the adverse effects of this clause, in order to diminish the risks assumed or perceived by investors.

The pay to play clause suffers an excessive residual use due to weak understanding of its possibilities and variations by many involved parties. Despite this clause appeared as a simple conversion from preferred shares to ordinary shares in case the investor is not following a future financing under certain circumstances (a qualified financing), its characteristics are more complex, useful and full of nuances than such mere conversion.

The obligation by the investor to participate in a future financing according to a pay to play clause may include and obligation to contribute within a certain minimum degree previously agreed. Therefore, it is not necessary to always coerce the investor to participate in the financing on a pro rata basis. Furthermore, regarding the adverse effects of not participating to the next financing, these do not need to be always the loss of all economic and political preferential rights (i.e., their conversion from preferred to ordinary shares). This effect can be the loss of certain specific rights, either entirely or partially. For example, the effect may be the loss of the liquidation preference right or part of this right (a decrease of the amount protected by the liquidation preference). Therefore, the series A investor with preferential rights that does not participate in series B, may continue be holder of class A preferred shares, but these class A liquidation preference rights would be withdrawn, while the series C investor may receive this liquidation preference right.

Along with all this, the pay to play clause allows to identify those investors who are really interested in the start-up future. This point is especially important when several investors participate in the financing, thus aligning the interests of these co-investors and ensuring that all of them provide an equivalent or similar commitment with the future development of the start-up.

In those cases where the venture capital firm already knows that it will not be able to participate in the next financing, the start-up should not push the investor to accept a pay to play clause, but for this to happen it is necessary transparency and honesty from the investor. As venture capital firms have mandatory investment policies that may prevent them from participating in subsequent rounds, or they may not have the financial capacity to do so, in these cases this type of clause is not appropriate. Therefore, if the venture capitalist explains it, the agreement will be reached easily without this clause. Additionally, the parties will already acknowledge that in the next round a new investor will be required to continue the start-up development and, therefore, the agreements on economic and political preference rights will have to be settled according to this reality.

As it can be seen, the use of the pay to play clause allows the parties to go beyond the simple negotiation of an economic right, by offering the opportunity to the parties to discuss about its commitments and adapt the terms of the investment agreement and the shareholders’ agreement to the needs that the start-up will face in the next financing.