A “pay-to-play” provision in investment agreements is designed to encourage existing investors to participate in future funding rounds. Essentially, it requires current investors to invest additional capital when new financing is sought by the company, typically in proportion to their existing ownership. If they do not, they face certain penalties.
Here’s what the pay-to-play clause entails:
- Conversion to Common Stock: Investors who do not participate in the new round may have their preferred stock converted to common stock, which typically has fewer rights and protections.
- Loss of Anti-Dilution Protections: Non-participating investors might lose the benefits of anti-dilution provisions, which protect them from ownership dilution when new shares are issued at a lower price than they originally paid.
- Loss of Other Rights: Investors might also lose other rights such as board seats, voting rights, or information rights if they do not follow on in new investment rounds.
The rationale behind a pay-to-play clause is to ensure that all investors remain committed to the company through its various stages of growth and to discourage passive investors who might be waiting to benefit from the investments of others without contributing further themselves. This can also be a mechanism to prevent down rounds (raising money at a lower valuation than previous rounds) by ensuring that existing investors have a stake in maintaining the company’s valuation.
For startups and growing companies, pay-to-play provisions can provide a more stable and committed investor base and reduce the risk of having to deal with less involved shareholders. For investors, while these clauses can represent a commitment to additional capital, they also serve as a protection against dilution from new investors and ensure that only those who continue to invest actively maintain their preferential equity status.