You Gotta Pay to Play . . . Or Not

Last week, I wrote a post about the right of an investor to maintain their percentage ownership in a company through the pro rata rights provision often found in investment agreements. In that post, I referenced another provision that often crops up, pay-to-play. In its most basic form, the pay-to-play term causes an investor to lose certain antidilution protections if they don’t participate in later financings at a pro rata level. This loss can take a variety of forms. These range from a conversion of all the shares purchased by the investor in previous rounds from preferred to common (ouch!) to the loss of the right to participate in future rounds (a mild spanking).

I get why certain investors want this term in there – if a co-investor is not going to continue to invest in the company in subsequent rounds, why should they retain the rights and privileges of a holder of preferred stock? The same rights and privileges that investors investing their pro rata portion.

I understand the logic, but as an angel investor, I find little to like about the provision in virtually any form. If I, as an investor, supported the company early on and took on all the risks involved with an early investment, why should I ever lose the rights that came along with assuming that risk? That was the exchange at the time – money for some ownership and rights associated with the form of ownership. In my opinion, no future acts (legal, up-and-up ones, that is) should cause the retraction of rights I already have (superseding those rights is topic for another day).

When I invest in a company, I always reserve some money for the next round. Since I generally invest in startups, I consider what a reasonable jump up in the A round valuation might be and hold enough in reserve to maintain my pro rata share in the company through that round. If the A round is a large – dollar-wise – or there are rounds beyond the A round that I haven’t reserved for, I can easily find myself in the position of not having the funds needed to maintain my share. A pay-to-play provision, in these cases, would cause a draconian (yeah, I’m biased) removal of the rights I had already paid for through investment and risk. It just doesn’t make any sense.

I could whine or cry and say that such terms are unreasonable or unfair, but that would be stupid. In the end, I can only do one thing when I run across a pay-to-play provision in  a term sheet, treat it as a big negative in my investment decision. I strictly stay away from deals that go as far as converting the preferred shares of those who don’t invest their pro rata percentage in future rounds to common. I treat as a negative, but don’t always walk away from deals with such provisions that are less onerous. Like I said, I understand why big, later stage investors want this term in the agreement. From my point of view, though, it punishes those who took the biggest risk when the company needed it most.


  1. 1, Assuming there is no bad faith involved, it may turn out that those who took the biggest risk when the company needed it most… would be the those who continue to invest in the later stages.
    2. Another reason/perspective why certain investors want this term in there – the comfort that their co-investor is more likely to continue to invest in the company in subsequent rounds

    1. Saul, I think your point #2 is an excellent one. In that respect, investors may feel more comfortable about getting the money necessary in future rounds, thus, making the current round more appealing to them. This applies to a greater extent in later rounds than in initial, seed rounds.

      On your first point, tough, I feel there are almost always more variables in early rounds than in later ones. With more uncertainty, comes greater risk. If there was more risk in later rounds, valuations would go down. In that case, the whole idea of pro rata share goes out the window.

  2. this is very interesting.

    I have a question.

    Would it be in the best interest for a startup’s to have a lower valuation for the second round so the founder’ shares aren’t diluted as much?
    college student startup blog

    1. You mean, of course, a higher valuation. If your goal is to minimize dilution, you want the highest valuation possible. Keep in mind that higher valuations don’t always correlate to success.

      Or was this just an advertisement for your blog? 🙂

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