A solution to incentivize investors to participate in a financing is called the “pay to play” provision. Basically, investors that do not participate to their full pro-rata percentage of the financing are punished by losing certain rights.
Pay to play provisions tied to dilutive financings provide that only investors that participate in the dilutive financing are entitled to the benefit of the anti-dilution formula in effect. Investors that do not participate do not receive any anti-dilution protection. This technique is beneficial for both for the company and for the investor group because it encourages all investors to continue to fund the company during those times when such incentive is most needed, i.e., when the company is undertaking a difficult financing.
The incentive to participate in a dilutive financing can be strengthened by a variation on the pay to play concept. Instead of merely losing anti-dilution protection with regard to the initial dilutive financing in which the investor does not participate, the investor loses anti-dilution protection with regard to such initial financing and all subsequent dilutive financings which may occur. Mechanically, this can be accomplished by creating a “shadow” series of preferred stock identical in all respects to the original series but without any anti-dilution protection. In the event that an investor fails to participate in a dilutive financing, all shares of preferred stock held by such investor are automatically converted into the shadow preferred.
Another harsher variant of the pay to play concept provides that upon an investor’s failure to participate in a dilutive (or potentially any) financing, such investor’s preferred stock is converted into common stock with the result that such investor will lose not only its anti-dilutive protection, but also its liquidation preference and other special rights of the preferred. This approach may appear to be somewhat draconian, as it seems unfair where a particular investor may be unable to participate due to circumstances outside of its control. This may be especially applicable to funds out of money, or strategic investors or angels that do not expect to participate in subsequent rounds. Most investors do not want to give up the liquidation preference and preferred rights other than anti-dilution protection merely because they decided not to participate in a particular dilutive financing.
A disadvantage of the automatic conversion approach, whether into common stock or preferred stock, is that once an investor has been converted, the pay to play provision provides no further incentive for that investor to participate in the next dilutive financing. If the goal for the company and the lead investors is to maximize the incentive for all investors to participate in all dilutive financings, the better approach would be to provide that if an investor fails to participate in the initial dilutive financing, such investor receives no anti-dilution protection with regard to such financing, but in the event that such investor elects to participate in a subsequent dilutive financing, such investor would be entitled to anti-dilution protection with regard to such subsequent financing. Although this formula can be implemented with regard to multiple dilutive financings by creating several series of shadow preferred, each having a different conversion rate, this approach results in a very complicated capital structure for the company which can become overly cumbersome.
Another approach involves providing for a “springing warrant” which is then issued to each investor that participates in a dilutive financing. This warrant is exercisable (at a nominal exercise price) for the additional number of shares of common stock equal to the number of additional shares which the applicable anti-dilution formula would allocate to such investor. This approach results in a simpler capital structure for the company as it avoids the necessity of creating the shadow series of preferred.
The pay to play concept is based upon requiring participation by the investor in the dilutive financing. The appropriate level of participation needs to be carefully considered. Pay to play clauses are often written to require each investor to participate in the dilutive financing to the extent of its percentage ownership of the company. Although this is typically the amount of the financing which the investors are entitled to purchase by reason of their contractual rights of first refusal, this approach may not work properly because the sum of the ownership percentages of the various investors will be less than 100%, and the primary purpose of the pay to play clause is to assist the company in raising the total amount of financing which it requires. Requiring each investor to purchase a percentage of the dilutive financing equal to its pro rata ownership among the investor group won’t quite work either because the sum of these percentages will always be 100%, leaving no room for a potential new investor.
Conceptually, the optimal approach is to require each investor to purchase a percentage equal to its pro rata ownership among the investor group of that portion of the financing allocated to the existing investors by the board of directors of the company, with the balance of the financing (if any) being purchased by the new investors. Under this formula, if all of the preceding investors participate, together with any new investors, the company will receive 100% of the funds it is seeking to raise. If the required percentage is higher than the percentage which such investor has a contractual right to purchase, the company must offer the investor the opportunity to purchase this greater amount in order to implement the pay to play clause.
[Note: this post and others on anti-dilution are based on (and complete sections of text copied from) an article titled “The Venture Capital Anti-Dilution Solution” written by Mike O’Donnell and Anton Commissaris.]