Pay-to-play clause in venture capital

Comblat le Chateau - Paul Signac

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Pay-to-play clauses in financing rounds for startups and scale-ups, consist of agreements regarding economic rights aimed at incentivizing reinvestment and commitment from investors in the company already invested. This is done through the obligation for the investor to invest additional amounts in future financing rounds to maintain their preferential rights.

The pay-to-play clause refers to an agreement that existing investors in the company must participate in subsequent financing rounds, typically pro rata to their percentage of share capital, to retain certain privileged rights they hold (usually through their preferred shares). Participation in future financing rounds means investing a minimum amount under the agreed terms for the next financing round.

There are many ways to approach the pay-to-play clause, which can be more or less harmful for the affected investor. Especially, depending on which privileged rights the investor loses if they do not participate in the next round. In the worst-case scenario (for the affected investor), the investor may lose all their privileged rights, going from holding a certain class of preferred shares to holding ordinary shares. However, this option is very exceptional. In the rare instances where this type of clause is observed, typically only some privileged rights are lost, such as the liquidation preference, the anti-dilution clause, the right to appoint members of the board of directors, the right of first refusal, or certain veto rights in the board of directors or the general shareholders meeting. In this regard, in the entry "Pay-to-Play clause in venture capital and its use for aligning interests" we already saw that the use of these clauses is more flexible, creative, and useful than it seems, so that in financing rounds, they could be an instrument not only much more common but also very useful.

While this clause is usually approached as a specific and autonomous provision within the shareholders' agreement, it can be configured as part of other agreements. For example, the anti-dilution clause can be accompanied by the obligation for partial reinvestment by the investor in the down round that triggers this clause, in order to benefit from the rights to acquire additional shares at a reduced price. This way, the investor, in addition to being partially compensated by the anti-dilution clause, shows their continued commitment to the company. It should be noted that, especially if the down round compensation system via 1:1 ratchet has been agreed upon, the exercise of the anti-dilution clause in the down round can significantly increase the already existing problem in the startup/scale-up. Since the execution of the pay-to-play clause is very detrimental to the first non-professional or institutional investors (especially investors from pre-seed and seed series), this type of clause does not apply to the earliest and least professional investors. The pay-to-play clause can also be configured as part of a follow-on clause, meaning as part of the agreements related to a negotiated investment round to be executed in different phases.

It should be noted that, in practice, early investors who do not want to participate in future investment rounds may be forced by new investors to participate in them. They may have to give up certain rights if they do not invest, or they may be invited to sell their stake (through a secondary transaction) to one or several of the new investors. All this particularly responds to the desire to simplify the distribution of share capital (cap table), when, due to various rounds already executed, the company accumulates too many shareholders for its agile management. Additionally, it should also be considered that when the company performs well and the new investors strongly believe in the company, these new investors will have reasons to request that the waiver to the pay-to-play clause. In other words, the existing shareholders can agree (with the approval of the new investors they are negotiating with) to exempt the investors affected by this clause so that their non-participation does not result in the loss of any of their privileged rights.

Finally, it should be considered that each investor has its particularities, so this clause may not make sense (for example, for business angels), or under certain circumstances, the venture capital firm may not be able to participate in the future round (for example, if their investment period has ended, if the new round falls outside their investment policy, if participation in the new round would result in a breach of their mandatory investment and/or diversification ratios, etc.). Therefore, it makes sense that these types of cases are considered as exceptions to the pay-to-play clause, to find a reasonable fit for it.