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.

I passed on an investment this week because the terms of the deal didn’t include the right for investors in the current round to maintain their percentage ownership in the company, through additional investment, in future rounds. This is usually outlined in the term sheet, in legalese, as “Preemptive Rights,” “Right of First Refusal” or even “Right of First Offer.” Basically, such a right simply allows early investors to keep themselves from being diluted in future investment rounds. There is no free ride in this situation, of course, the investor must pay for their pro rata share at the next round’s price, just like everyone else. What was particularly troubling about the term sheet in question was that it was pretty clear that the lead investor excluded such rights from the terms in order to have the ability to flush out smaller, early investors in subsequent rounds of financing.

I’ve seen this before (although less frequently over time) and it boggles my mind. Yeah, if you have a boatload of little investments the cap table can be a bit complicated, but that’s just math. Generally speaking, smaller investors don’t have any strong voting rights, board seats or other forms of control so punting on them doesn’t improve the speed or operations of the company. It’s treating form well ahead of function.

So why explicitly exclude or inhibit any investor small or large from investing in your next round? Are you afraid that you might scare off a large, future investor who doesn’t want smaller investors involved financially? Think about it. Are there rational people who would take this position? If so, are these people you want to deal with? To me, the fact that existing investors want to invest more money to retain their ownership is a hugely positive signal indicating that the people who know a lot about the company have faith in its progress and opportunities for success. As an entrepreneur, don’t you want to encourage such behavior?

By not explicitly giving investors pro rata rights (keep in mind that this provision simply grants the investor the right, it’s not a requirement – I’ll write a post on “Pay-to-Play” term sheet weirdness soon), you not only create a problem in subsequent rounds of funding, but you also create a problem now, in the current round. If, as a potential investor, I fear that I may not be able to prevent my dilution in future rounds, how anxious a I going to be to get involved. I’m not. Thus, my exit from the deal this week.

As my long-time friend and corporate general counsel, Peter Johnson, always says, “it’s, at worst, giving them the sleeves of your vest.” “Them,” in this case, being the investors you want to have involved in the company now and, hopefully, in the future.

BTW, there are loads of resources on the web discussing term sheets from many points of view. I highly recommend you take a look at Brad Feld’s and Jason Mendelson’s term sheet series as a starting point.