Pay to Play: It’s About Breakfast

By: Paul A. Jones

Among the many variously simple and arcane provisions of venture capital term sheets, one of the more mysterious to many less experienced entrepreneurs and investors is the so-called “Pay to Play” provision. The mechanics of Pay to Play are reasonably straight forward: if, in a subsequent down round financing after a round where a Pay to Play provision was installed, an investor in the earlier round refuses to participate in the new round (usually to the full extent of the investor’s pro rata participation in the earlier round), that investor will lose various of their special rights and privileges acquired in the earlier round of financing. So, for example, an investor subject to a Pay to Play provision that refuses to take its pro rata share in a subsequent round would typically lose, going forward, its anti-dilution price protection and future round participation rights.

If the mechanics are reasonably clear, it is often less clear who the a priori winners and losers are. Who, initially, wants to see a Pay to Play provision on the term sheet, and why? And who is likely to resist a Pay to Play provision?

In terms of a first order analysis, Pay to Play is an intra-investor issue. Typically, one or more investors favor the Pay to Play (lets call them the Pigs, in that, as pigs regard breakfast, these investors consider themselves fully committed to the investment) and the other investors the Chickens (in that they, like the chickens that provide the breakfast eggs, are interested in the proceeedings, but perhaps not really committed). The Pigs are motivated by a concern (just how much of a concern will be revealed by how hard they fight for the Pay to Play provision) that if the company for some reason needs more money at a lower price in the future the Chickens will either not have any more eggs to contribute (one possibility) or will for some reason refuse to provide any more eggs. Pay to Play, then, is a mechanism for the Pigs to say to the Chickens “when we say we are in this together, for better or worse, we really mean it.”

Now, this analysis is fine so far as it goes, and many entrepreneurs assume, based on this line of thinking, that they, as entrepreneurs, don’t really have anything at stake in the Pay to Play negotiation. Which is a mistake. Because while the implementation of a Pay to Play provision in a down round primarily pits Pigs against Chickens, the outcome of the dispute can have a big impact on what served at breakfast – which is to say whether and how the portfolio company is financed. Look at it this way: a Pay to Play provision encourages current investors to participate in future down rounds, which is always (off hand, I can’t think of an exception) a good thing for the company. And that is true even where, a priori (i.e. in the round where the Pay to Play is or is not imposed) the investors are all Pigs (or all Chickens, for that matter).

Conclusion? While Pay to Play provisions may seem, at first blush, like something an investor syndicate can solve internally, in fact, Pay to Play is something entrepreneurs should be concerned with from the get go. So, if as an entrepreneur your prospective investors offer a term sheet without a Pay to Play provision, my advice to you is to ask for one.  Depending on the broader context of the deal, you might decide to fight hard for it, or just use it as a bargaining chip. But it has real value – both to give you a sense of what investor attitudes are to future rounds, and to have in your back pocket in the eventuality of a future down round – and thus should be on the table .

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