If your startup continues to follow the proverbial "hockey stick" of uninterrupted, exponential growth that you presented in your seed round pitch deck, you might always have easy access to capital and never encounter a pay-to-play transaction.
However, the vast majority of startups must survive periods when access to capital is more limited, even if the company's value proposition remains strong. So, what happens when a promising startup with an existential need for capital cannot attract sufficient investment on traditional terms to survive long enough to see those prospects come to life?
For companies facing these circumstances (and the investors that believe in them), the best answer is often a pay-to-play transaction, which is shorthand for a fundraising that includes a mix of positive and negative incentives for existing investors to drive the necessary capital into the company.
This "15-Minute Founder's Guide: Pay-to-Play Transactions" is meant to equip founders with the functional knowledge they need to protect their company's interests, maintain investor relationships, and emerge successfully from what is often one of the most challenging periods in a startup's life cycle.
Whether you're reading this proactively or in the midst of a cash crunch, you'll be better equipped to deliver positive outcomes for your company, your team, and your investors.
The following sections break down what pay-to-play transactions are, when they are typically implemented, and how they get approved as well as the key risks associated with pay-to-play transactions and how to mitigate them.
What does "pay-to-play" mean?
Simply put, a pay-to-play transaction is a fundraising transaction in which the company's existing investors are required to re-invest in the company (i.e., "pay") to continue enjoying full value in the company bargained for at the time of their initial investment (i.e., "play").1
What are the "sticks" in a pay-to-play and
what is a "cram down"?
The "sticks" are the negative consequences for
failing to participate in a pay-to-play transaction. Failure to
invest new capital can lead to the loss of some or all the
investor's previously agreed-to rights and economics. To
illustrate, the liquidation preference2 or any special
voting or approval rights3 associated with a
nonparticipating investor's shares may be terminated. This is
typically accomplished through converting the nonparticipating
investor's preferred stock into common stock in a process
commonly referred to as a "cram down."
By default, cram downs convert a nonparticipating investor's preferred stock into common stock on a 1-to-1 basis, thus leaving the nonparticipating investor's overall ownership position unaffected (except for the dilution resulting from any new money raised). In other words, following a 1-to-1 cram down, nonparticipating investors would be entitled to the same share of proceeds from an upside exit of the company as they would otherwise. However, in extreme scenarios, pay-to-play cram downs may convert each share of preferred stock held by a nonparticipating investor into one-half, one-tenth, or one one-hundredth of a share of common stock, thus dramatically reducing the ownership percentage (i.e., entitlement to proceeds on exit) of nonparticipating investors.
What are the "carrots" in a
pay-to-play?
In addition to the sticks, pay-to-plays often involve a set of
"carrots" (i.e., positive incentives for participating
investors). Common carrots include (i) the restoration of prior
preferred stock with the same or even superior terms than
previously negotiated — sometimes referred to as a "pull
through"; (ii) a high ownership percentage for new money
through a low valuation and/or warrant coverage; (iii) a
liquidation preference that is senior to other series of preferred
and/or greater than 1× relative to the new money invested;
(iv) special governance rights on the board or heightened approval
requirements; and (iv) information rights, reporting rights, and/or
board observer rights.
Which carrots and sticks are appropriate to use?
Generally, the best set of structures for a pay-to-play
transaction is one that incentivizes investors to commit to invest
as much needed capital as possible while simultaneously being the
least punitive to the company's stockholders as possible.
The facts and circumstances facing each company going through a pay-to-play will drive which of the various carrots and sticks are appropriate for the deal. As the deal evolves, founders should collaborate with the committed and potential investors to make sure the terms will attract sufficient new capital and consult with company counsel to help design a fair deal and process to mitigate the risk of legal claims as much as possible (especially from nonparticipating investors). In this process, key factors often include (i) the company's financial position, runway and burn rate, revenue pipeline, and timeline to profitability; (ii) what proportion of the investor group is expected to participate; (iii) whether the investor group is generally aligned in their rights (e.g., later-stage investors that invested at a high valuation may not be aligned with early investors that invested at a low valuation); (iv) whether any changes to the management team are part of the deal; and (v) the relationships and egos among the stakeholders.
The end result is that pay-to-play transactions come in many flavors with terms that are often determined in an iterative process of negotiations among the company, lead investor, and other key stakeholders. Overall, the pay-to-play process is generally very taxing and almost never fun for founders.
When do pay-to-plays usually occur?
Generally, a pay-to-play transaction is a last resort for a startup. Raising a new round of capital on traditional terms is almost always preferable relative to applying any sticks to the existing investor base, which comes with extra process, expense, and risk.
Nonetheless, many startups with promising long-term prospects face near-term cash-out dates at times when they can't draw sufficient capital commitments from investors on traditional financing terms.
In these cases, participating investors face a "free rider" problem: paying to keep the company alive for everyone's benefit while others contribute nothing but still keep their rights and upside opportunity. The mechanisms proposed in a pay-to-play transaction aim to solve the free rider problem and stimulate new capital commitments by ensuring that future investment returns primarily flow to participating investors and the continuing management team, with nonparticipating investors largely missing out.
Are pay-to-plays legal and permitted under shareholder agreements?
Yes, with the appropriate approvals, pay-to-play transactions can be legal and enforceable under Delaware law (as well as some other common governing law jurisdictions for startups).
The approval requirements for pay-to-play transactions may vary depending on the company's domicile and the substance of the company's organizational documents and shareholder agreements. Despite this variability, pay-to-play transactions generally require approval from (i) the company's board of directors; (ii) a majority of the company's stockholder base; (iii) a majority of the company's investor base (i.e., stockholders other than the founders and team); and (iv) any additional parties stipulated in the company's stockholder and investor agreements (e.g., investor representatives on the board, individual investors, or specified subsets of investors).
In addition, whenever members of the company's board of directors are affiliated with investors that are participating in or leading the pay-to-play round (as is often, but not always, the case), a conflict of interest may occur. For example, the investor-affiliate director may personally benefit from a transaction structure that's worse for the company (e.g., a structure that provides the director's affiliated fund with extra liquidation preference relative to other stockholders). In cases like these, which, again, are common, conflicted directors need to disclose the nature of their conflict of interest to the rest of the board as part of the approval process. Depending on the composition of the board and the number of directors with conflicts, proper approval for the transaction may require consent of the disinterested members of the board, the disinterested stockholders, or subsets thereof.
It's worth emphasizing that determining which approvals are required for a pay-to-play transaction is often a complex and nuanced exercise with no "right" answer. Therefore, founders should always work closely with legal counsel to understand the applicable approval requirements for all aspects of the pay-to-play transaction and ensure that the process for proceeding with the deal (including how it's socialized with stakeholders) aligns with all such requirements and parties' risk tolerance for the transaction.
What are some of the key risks of pay-to-plays and how should companies think about mitigating these risks?
A properly approved pay-to-play transaction can be legal and enforceable, but proper approval does not eliminate all associated legal risks. Even in the context of an immaculate transaction and approval process, parties are nonetheless free to bring legal claims or threaten to bring legal claims to challenge the transaction.
Therefore, founders should think of compliance with the approval process for a pay-to-play transaction as a minimum set of requirements. But just as importantly, founders should also think more broadly about the entire transaction as an investor relations exercise, especially catered toward nonparticipating investors that are losing rights and economics. To state the obvious, stakeholders that trust and respect the founders are much less likely to sue than those that don't.
To help mitigate the risk of legal claims from investors or other stockholders challenging a pay-to-play transaction, founders should seek input from stakeholders, properly balance incentives for a fair outcome, proactively manage conflicts of interest, promote transparency and credibility, have a strong "rights offering" process, and design a thorough approval process, all as discussed in the following subsections.
Seek input from stakeholders
As previously discussed, pay-to-play transactions can come in many
different flavors, and choosing the right set of terms often
requires an iterative process of communication and negotiation with
key stakeholders. Given the urgency of the company's
fundraising needs, among other things, founders (and everyone else
involved) understandably often feel a temptation to "lock
in" to a proposed set of terms and move toward closing.
However, soliciting and being open to input from a broad group of
stakeholders almost always results in productive contributions to
the transaction (e.g., terms can often be adjusted to accommodate
the unique circumstances of various investors, unlocking their
participation, without jeopardizing participation from other
investors). In addition, the exercise of seeking input from
stakeholders often de-escalates feelings of unfairness and
increases the credibility of the deal in the eyes of stakeholders,
thereby reducing litigation risk.
Properly balance incentives for a fair
outcome
The guiding principle for any management team in designing a
pay-to-play transaction should be negotiating the very best deal
they reasonably can for the company and its stockholders.
This means the nature and extent of the carrots and sticks should be limited to what's strictly necessary to incentivize the needed new capital commitments. Anything more could be considered unfair to stockholders. For example, if, in the process of aligning on deal terms, prospective investors indicate the same capital commitments for a 1-to-1 cram down as they would for a 1-to-10 cram down, the company should choose the structure with the less punitive sticks.
One key consideration is which investors the carrots and sticks should apply to and whether they should apply to all investors equally. To illustrate, if a startup's investor base is a mixture of smaller, less-sophisticated investors and larger, professional investors, applying the stick incentives to the smaller investors may be counterproductive; it may fail to drive capital commitments (perhaps these investors were angels with no capacity to invest again, regardless of any sticks that may apply) all while increasing litigation risk (less sophisticated investors are often less predictable and less motivated by reputational interest that would dissuade them from bringing claims). In a case like this, it may benefit the company overall, including the larger investors, to exempt smaller investors from the sticks altogether.
Proactively manage conflicts of interest
As discussed in the "Are pay-to-plays legal and permitted under
shareholder agreements?" section, conflicts of interest
are very common in pay-to-play transactions, and they can be
proactively managed. Founders should be aware of the interests of
each member of the board and sensitive to any conflicts that arise,
including the optics of each conflict and how it may expose the
company to additional risks.
In some cases, it's helpful to establish a committee of the board comprising directors without any conflicts of interest to independently represent the best interests of the company and its stockholders. An independent committee can go a long way to improve the optics to other stakeholders and reduce litigation risk even if the committee were to arrive at the same outcome as the full board would have.
Promote transparency and credibility
Recalling that a primary driver of litigation risk in a
pay-to-play transaction is emotional discontent among investors, in
socializing the company's decision to proceed with a
pay-to-play transaction, founders should put themselves in the
shoes of their stakeholders throughout the process.
For example, an investor whose first outreach from the company in months or years is a communication that a pay-to-play transaction is underway may react strongly and negatively. Even if the founders have been practicing good investor relations all along, it's often helpful to increase the frequency of investor updates in advance of the deal, including transparency about the challenges the company is facing (e.g., describe how and why efforts to raise capital on more favorable terms have stalled, describe the company's cash position) as well as the founders' view of why the company's prospects remain strong. Of course, too much transparency can be counterproductive, so it is an art.
As another example, founders should place extra emphasis on presenting competency and credibility in all stakeholder communications leading up to a pay-to-play transaction. Clear, consistent, and comprehensive communications are critical to maintaining the trust the founders have built up over time, and excelling in this area gives the company the best chance to persuade investors to participate and approve the deal.
Have a strong "rights offering"
process
An important risk mitigation component of any pay-to-play
transaction will be the set of steps the company takes to ensure
that all investors have an opportunity to participate and meet the
conditions, often referred to as the "rights
offering."
Once the terms of the round are approved, founders will work with counsel to prepare a notice to existing stockholders disclosing key facts about the company's current situation, the need for capital, and the final terms of the pay-to-play. This notice will also include a form to request indications of interest from investors as to whether they wish to participate in the transaction. Rights offerings will generally have a fixed period of time for existing investors to make their decision and close their new investment.
The window for participation is a balance between ensuring that no investor can claim they were practically cut out of the deal — a longer period is better in this regard — and the company's urgent need for capital. In the end, most rights offering periods are between 30 and 60 days. More generally, the rights offering can help mitigate litigation risk by, among other things, (i) creating a uniform dialogue with the investors that describes the good reasons why the company has chosen this path and (ii) stimulating additional participation and consent from investors that hadn't previously committed to participate.
Design a thorough approval process
One of the most effective risk mitigation measures at a
company's disposal is a thorough approval process. Documenting
the efforts, discussions, and considerations of the management team
and the board in the lead up to a pay-to-play transaction is
extremely helpful, not only in the event of a dispute with
investors but also in avoiding disputes with them (if the
founders can demonstrate to investors that the deal was a result of
a robust process, investors will be less inclined to bring
claims).
In addition, the laws of Delaware and most other states where startups are commonly incorporated allow companies that obtain proper approvals for transactions to qualify for heightened protections against investor claims. This is often referred to as the "business judgment rule." Therefore, as discussed in the "Are pay-to-plays legal and permitted under shareholder agreements?" section, founders should generally aim to obtain approval from the broadest set of stakeholders possible and work closely with legal counsel to design a process that results in the company qualifying for the added protections of the business judgment rule.
Conclusion
Pay-to-play transactions are densely packed with hard decisions, tough conversations, and dynamic, high-pressure negotiations. In short, pay-to-play transactions are not for the faint of heart, and getting the best outcome for your stakeholders requires emotional stamina from all parties as well as mastery of how these deals work.
Therefore, understanding how pay-to-play transactions work and being prepared to navigate them will pay dividends for founders who find themselves in this scenario. While pay-to-play transactions are never a first resort for startups, they keep both the company and its chance to scale alive. Hopefully this founder's guide helps founders and their startups find themselves among the many, many others that have gone through pay-to-play transactions and found success on the other side.
Footnotes
1. Pay-to-play transactions are closely associated with "down round" financings (i.e., financings in which the valuation applied to the new investment is below the valuations applied to prior rounds, resulting in heavy dilution to existing stockholders) because pay-to-play features most often arise in down rounds. However, a down round does not necessarily imply the presence of pay-to-play terms.
2. "Liquidation preference" refers to a right of investors to be repaid for their investment (often with a multiple of the initial investment) before any proceeds are distributed to common shareholders during a sale or liquidation event. As such, liquidation preference is a form of downside protection.
3. Any rights held by nonparticipating investors via side letters may be affected by a pay-to-play transaction. Therefore, it's important to review all side letters carefully to understand if or how side letter rights are affected.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
