Buried in the model Series A Certificate of Incorporation of the National Venture Capital Association is the following notation:
This Amended and Restated Certificate of Incorporation includes a sample “pay-to-play” provision, pursuant to which Preferred Stock investors are penalized if they fail to invest to a specified extent in certain future rounds of financing. The provision included herein provides for conversion into Common Stock of some or all of the Series A Preferred Stock held by non-participating investors. An alternative provision which provides for conversion of some or all of the Series A Preferred Stock held by non-participating investors into a new series of Preferred Stock (e.g., Series A-1 Preferred Stock) identical to the Series A Preferred Stock but with no anti-dilution protection and no further pay-to-play provision is also sometimes used. It is the drafters’ view that this latter provision is not seen very frequently and therefore it has been intentionally omitted from this Amended and Restated Certificate of Incorporation.
Pay-to-play provisions are designed primarily to ensure that existing investors continue to invest in the company in future rounds by creating “penalties” for those that do not fund a defined pro-rata share of the funds raised. Such provisions are not always included in early-stage funding documents. In the era of seemingly endless liquidity ended by Covid-19, even where such provisions were included in later-stage financing documents, they rarely were a source of controversy.
The working assumption was that in most cases other investors (existing or new) would step in to fill the funding gap and the pay-to-play provision would not be “activated.” There was much more focus on obtaining a pre-emptive participation right in future financings. In fact, some large later stage funds even invested in early-stage companies primarily to obtain the option for future investment in these companies.
Participating v. Non-Participating Investors
The current economic crisis will have a dramatic impact on the venture industry. Valuations will drop and funding terms are likely to become significantly more investor-friendly. A broader analysis of the likely impact can be found in my recent article, “An Entrepreneurs Guide to Surviving Coronavirus.”
One of the impacts discussed in the article is the “circling-the-wagons” effect on venture investors. On the assumption that funding from new sources will be scarce, VCs will focus on ensuring the survival of their best portfolio companies. When companies need to raise funds, in most cases it will be accomplished by “passing the hat” among existing investors. In many cases, this will create a divide between participating and non-participating investors. This divide could be the impetus for implementing retroactive pay-to-play financing terms.
What is a Retroactive Pay-to-Play Provision?
A retroactive pay-to-play is a financing term added as part of a proposed financing that distinguishes outcomes based on whether an existing investor participates in the new financing based on a defined level of participation (most often, but not necessarily, based on their pro-rata share of the company’s equity).
How does a Retroactive Pay-to-Play (“RP2P”) Differ from a “Regular” Pay-to-Play (“P2P”)
- The critical distinguishing feature of a RP2P provision is that it is a new term introduced by the participating investors. It can arise for companies that do not have P2P provisions in their existing documents or companies that have such provisions, but where the participating investors seek to modify its terms.
- Both P2Ps and RP2Ps specify negative consequences for non-participating investors. For example, both will often convert the holdings of non-participating shareholders to common. These consequences will vary from deal to deal, although in the context of a RP2P the consequences will be harsher.
- RP2Ps often go beyond P2Ps by not only “penalizing” non-participants, but also enhancing the returns for participating investors. Potential deal terms include:
- Share pull-throughs. The participating investors get all of their existing shares reclassified to shares in the new financing round, thereby giving all of their shares the benefit of more favorable deal terms.
- Enhanced pre-emptive rights in future rounds.
- Elimination of protective provisions granted to junior classes.
- Permanent waiver by non-participants of any anti-dilution protection that applies to their shares.
- Granting of warrants to participating shareholders.
- Introduction of mandatory redemption requirements for the shares held by participating investors.
- While P2Ps usually do not adversely impact founders, executives and employees, RP2Ps hurt the economic value of the common shares thereby impacting both non-participating investors converted to common, as well as founders, executives, and employees.
Can Non-Participating Investors Prevent a Retroactive Pay-to-Play?
Ironically, very often non-participating investors can block the introduction of RP2P’s due to class votes in protective provisions from prior financing rounds. Most RP2Ps require amendments to corporate documents that trigger these protective provisions.
So Why Would Non-Participating Investors Approve Retroactive Pay-to-Plays?
In many cases, the investor term sheet with the RP2P may be the only game in town. Owning less valuable equity in an ongoing business still beats owning preferred equity in a dead company.
Can Retroactive Pay-to-Plays Come Back to Bite Ventures and Their Boards?
When participating insider investors require the introduction of RP2Ps as a condition of investment, it creates aa difficult situation for management.
As noted above, often this will also adversely impact them. However, they are vulnerable to accusations that they are responsible for the state of the company that left the company with no choice but to accept the RP2P.
In addition, if the participating investors hold Board seats, approving such financing leaves the board open to claims based on a breach of fiduciary duty due to conflicts of interest. Further, a prudent non-participating investor might not take any action immediately. Rather, subject to the applicable statute of limitations, they could wait to see if the company grows and adds value and raise a claim before an exit or a major financing. At that point, they could have significant leverage.
What Risk Mitigation Steps Can Investors and Boards Take When Contemplating a Reverse Pay-to-Play?
- Explore Alternatives – The Board should actively explore other financing alternatives as soon as the need for financing becomes clear. The Board’s legal position will be much stronger if the RP2P was accepted after a reasonable effort by the Board failed to turn up better financing options. In other words, the inside investors truly were the only game in town.
- Provide Detailed Information Disclosure – Provide all shareholders with detailed information about the financing, including the extra benefits to be gained by the participating investors.
- Meticulously Comply with All Legal Requirements – Work with counsel to identify all required notices, information disclosures and approvals and follow closely. Where required notice periods are short, if possible, give earlier notice. The last thing you want to create is the impression that the financing was hasty or “railroaded.”
- Gain Approval by Disinterested Board Members – If at all possible, have the financing approved by a committee of Board members that does not include representatives of the participating investors and executives, if they stand to benefit from the financing.
- Attempt to Gain Approval by a Majority of Non-Participating Shareholders – This is particularly important if the company does not have disinterested investors. An added benefit it that approving shareholders are likely to be deemed to have waived their right to challenge the fairness of the financing.
- Conduct a Rights Offering – Offer all shareholders the right to participate, even those that do not have a contractual pre-emptive right. Since the goal here is to maximize funding, this should be acceptable to the participating investors.
- Survey the Market – Research the financing terms of similar recent transactions to establish the relative fairness of the proposed transaction. Significant departures from the “market” are likely to raise questions about the fairness of the transaction, even if it is the only game in town.
Don’t Ignore the Reputational Risk
If you are a VC considering the introduction of a RP2P as a deal term, always remember that the venture community is relatively small and unreasonable behavior is likely to be remembered for a long time. Investing at this time entails a great deal of risk, not just due to the economic crisis but because as a result of these financings, the ventures are now more reliant on an even smaller group of investors. Seeking enhanced economic terms is not unreasonable. The trick when you are “the only game in town” is not to get greedy.
Dror Futter is a partner in the Rimon, PC law firm. Dror’s practice focuses on representing startup companies in their financing and merger and acquisition transactions and their intellectual property, IT and internet agreements. He also advises companies with respect to Initial Coin Offerings and other blockchain legal issues. Dror was the co-founding chair of the PLI VC Law program and hosted their first blockchain legal program. He is a frequent speaker and writer on blockchain legal topics. He is a member of the model forms drafting group of the National Venture Capital Association, the legal advisory board of the Angel Capital Association and the legal working groups of the Wall Street Blockchain Alliance and the Digital Chamber of Commerce. Dror can be reached at dror.futter@rimonlaw.com