In recent months, funding rounds featuring “pay-to-play” provisions have surged. These provisions aim to encourage reinvestment and attract supplemental funding.
During the recent financing boom, these provisions were largely absent due to a thriving market. However, as capital began to dry up, they started resurfacing.
Earlier this year, Sequoia Capital generated headlines when it declined to participate in a pay-to-play financing proposed by one of its portfolio companies.
Rather than reinvesting or facing severe dilution, Sequoia chose to walk away, with its board representative resigning. Although the company ultimately secured funding from other investors, this situation highlights the complexities and challenges involved in recapitalization.
But their implementation requires thorough evaluation to anticipate and mitigate potential risks. So, what exactly is pay-to-play, and how is it reshaping today’s venture capital landscape?
What is Pay-to-Play?
Pay-to-play provisions are commonly used in venture capital, particularly in Down Rounds or recapitalizations. Their primary purpose is to incentivize existing investors to participate in new financing rounds and, in some cases, to penalize those who choose not to invest further.
“Pay-to-play provisions are punitive to Preferred Stock investors who fail to invest to a specified extent in certain future rounds of financing,” James Rosenbluth, a partner in Pierson Ferdinand’s corporate department, explains. “Such provisions typically include mandatory conversion into Common Stock of some or all of the Preferred Stock held by the non-participating investors.”
Under a pay-to-play structure, existing investors are generally required to purchase a predetermined pro-rata allocation of shares in the new round. This means they must invest an amount proportional to their ownership stake to maintain preferred rights.
Depending on the agreement, failure to do so can result in penalties, such as the conversion of their preferred shares into common shares.
Recent Rise
When it comes to the prevalence of pay-to-play provisions, their usage tends to rise and fall on a cyclical basis. The last time they were so widespread was in the aftermath of the 2008 financial crisis.
While not engulfing the entire VC landscape, the increase in pay-to-play provisions marks a significant shift in venture capital, with their prevalence reaching historic highs in the U.S.
Cooley’s Q3 2024 report found that pay-to-play provisions appeared in 8.5% of deals, down slightly from 8.7% in Q2. Despite these trends, deal terms largely favored companies:
“The percentage of deals with a one-time liquidation preference and the percentage of deals with nonparticipating preferred stock remained high, representing 96% of deals for both provisions for Q3 2024. For the first time since the inception of this report, 100% of reported deals had broad-based weighted average anti-dilution protection, with no deals having full ratchet anti-dilution protection.”
Cooley’s went on to add that Q3 2024 was only the third time in the report’s history that the percentage of deals with a pay-to-play provision has exceeded 8%.
Typically seen in later-stage rounds, these provisions are now increasingly seen in Series A rounds, signaling heightened pressure on early-stage companies to secure committed investors early.
As Rosenbluth points out, the trend of pay-to-play is “an inverse relationship between the level of portfolio company valuations in general and the prevalence of pay-to-play provisions. “
“Various macroeconomic factors such as geopolitical turbulence, supply line disruptions, the current high interest rate environment, and moribund IPO and M&A markets put downward pressure on company valuations, which often leads to an increase in VC term sheets that incorporate pay-to-play provisions.”
Pros and Cons
While these provisions ensure that existing investors’ continued contribution will support long-term viability, their implementation is not without controversy.
Critics argue that pay-to-play provisions can unfairly penalize early investors, particularly those who supported the company during its uncertain beginnings but now lack the funds to participate in subsequent rounds.
This group often includes early employees or smaller venture funds that have exhausted their reserves. For these stakeholders, pay-to-play can feel like a betrayal, forcing them to accept significant dilution or the loss of preferential rights, effectively erasing their contributions to the company’s early success.
Supporters, however, view pay-to-play as a necessary tool for survival.
By ensuring that only committed investors remain, these provisions provide struggling companies with a fresh infusion of capital and a cleaner capitalization table—both of which can be critical for securing future funding.
Staying Power
“There is nothing novel about pay-to-play provisions,” Rosenbluth says. “It’s just that they often crop up in VC transactions more frequently in times of challenging economic conditions, but their incidence tends to recede like winter’s frost when market conditions begin to thaw.”
When deciding if pay-to-play is right for a startup, there are several issues founders should focus on.
First, they should understand that such provisions are not typically included in a Series A term sheet. Founders must take the initiative to raise the topic and engage investors in a thoughtful discussion.
It’s also important to recognize that not all investors, such as angels or strategic investors, may participate in future rounds. In these cases, carve-outs should be negotiated and explicitly reflected in the term sheet.
“Before undertaking a Down Round and agreeing to the insertion of a pay-to-play provision in its charter, the company, in consultation with experienced legal and financial advisers, should undertake a careful review of alternative financing strategies,” says James Rosenbluth.
He adds that it should be a “last resort after all viable alternatives are considered and necessary steps taken at the board level to minimize potential liability exposure.”
About the Author: Tess Danielson is a journalist and writer focusing on the intersection of technology and society.
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