Published on
February 9, 2023
Pay to play provisions in venture capital usually only arise during challenging financial times, and currently, such times are upon us. Start-up founders are increasingly looking for additional financing, leading to a rise in pay to play provisions.
What is Pay to Play?
A pay to play provision is a clause in a venture capital term sheet that requires existing investors to participate in future rounds of investment. This provision often involves a reset of the company's valuation (usually at a lower value) and mandates that every VC must participate on a pro rata basis. VCs who don't participate will see a reduction in their ownership percentage, a process referred to as "cramming down."
The reset of the valuation takes place through a series of reverse stock splits, which results in the issuance of a large number of new shares. This dilutes the ownership positions of:
Investors who don't participate in the new capital round face a significant loss of ownership, which is intentional. The new investors don't want to carry "dead weight," but the start-up needs more capital. From the perspective of newer VCs, if you're not important to the company or don't want to protect your equity position, why should you benefit from the new incoming capital?
On the other hand, those who have helped build the start-up will feel penalized. They may not have the funds to participate in the pay to play, but they have a longer history with the company than the new investors.
When Might a Pay to Play Provision Be Enacted?
Due to the current financial climate, pay to play provisions are more likely to come into play. For example, the NASDAQ correction in 2022 and the Bessemer Cloud Index correction have made start-up financing more challenging.
If a company is doing well but not thriving, it may have to ask its existing investors for more venture capital. Some of the VC funds may be less interested in providing more capital, especially if they're older and have exhausted their VC fund reserves. In such cases, the other investors who are optimistic about the company's future may become aggressive.
If you are part of a VC syndicate with investors you work with regularly, it's less likely that a pay to play provision will be introduced. This is because VCs who work together regularly don't want to dilute each other.
However, it's not always the existing VC investors who introduce pay to play clauses. It could also be an outside investor in conjunction with some inside VCs who also have capital. In such cases, pay to play is a necessary solution for start-ups in need of funding but with limited resources. It only occurs during market downturns, when VC fund reserves become more valuable, and many companies ask for additional funding from their existing investors.
Outcomes of Pay to Play Provisions
One of the biggest criticisms of Pay to Play provisions is that they can create a divide among investors, who may have previously been working together as a united front. By requiring existing investors to participate in subsequent rounds, it can create a situation where some investors are seen as more committed or important to the company than others, which can lead to hard feelings and damaged relationships.
Another potential negative impact is that Pay to Play provisions can create a sense of desperation among startup founders. If they are unable to secure sufficient capital from existing investors, they may feel compelled to accept Pay to Play terms, even if it means diluting their equity and losing ownership of their company. This can be especially difficult for founders who have been with the company for a long time and have made significant sacrifices to help build the company to where it is today.
On the positive side, Pay to Play provisions can help companies secure the capital they need to grow and succeed. This can be especially important during periods of economic uncertainty, when access to capital may be more difficult. Additionally, by requiring existing investors to participate in subsequent rounds, Pay to Play provisions can provide some assurance that the company will be able to secure the capital it needs to succeed, and that existing investors are committed to the company's future.
It is important to note that Pay to Play provisions should be seen as a last resort, and not a preferred option. Companies should always strive to secure capital from existing investors without the need for Pay to Play provisions, as this can create a more positive and supportive environment for the company's future success. Additionally, companies should aim to maintain at least 12 to 18 months of runway, so that they are not forced into a situation where they need to rely on Pay to Play provisions to secure capital.
In conclusion, Pay to Play provisions can have both positive and negative impacts on a company, and should be carefully considered before accepting such terms. It is always recommended to explore all other options for securing capital before accepting Pay to Play provisions, and to be aware of the potential consequences of such terms.
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