Understanding Down Rounds in Venture Capital Financing: Pay-to-Play Structures

Venture capital markets showed signs of improvement in the second quarter of 2023. According to Carta, early-stage companies using its platform raised $15.4 billion in funding during the second quarter of 2023, which was up 26 percent from the first quarter. Despite these recent improvements, however, venture capital markets are still a long way from the record-breaking numbers of 2021, and fundraising by early-stage companies was still down by 58 percent on a year-over-year basis at the end of the second quarter of this year.

In the current economic climate, many venture capital funds are less willing to lead a new financing round, which makes fundraising more challenging for early-stage companies. Further, venture capital funds often have a defined investment period and must deploy limited partners’ capital in that period. Funds that raised capital in better market conditions are now in a position where their limited partners’ capital must be deployed, and given the state of the market, such funds are investing at lower valuations more frequently. In fact, in the second quarter of this year, approximately 20 percent of all rounds featured on Carta were “down rounds,” meaning the company raised capital at a pre-money valuation that is lower than the post-money valuation from its previous financing.

In a down round, the lead investor may propose a pay-to-play structure to incentivize the company’s existing investors to participate in the round. In our own practice, we have seen an increase in demand for pay-to-play structures. In this article, we will discuss what a pay-to-play structure is, how these structures can be implemented, and the risks associated with them.

A pay-to-play structure refers to a financing round in which the existing preferred stockholders must purchase a set portion of the round or accept significant dilution to their existing equity position and the loss of certain key investor protections Click to Tweet

What is a Pay-to-Play Structure?

A pay-to-play structure refers to a financing round in which the existing preferred stockholders must purchase a set portion of the round or accept significant dilution to their existing equity position and the loss of certain key investor protections. Pay-to-play financings typically arise in a few different situations, all of which involve down-round financing. Specifically, a pay-to-play financing normally occurs in two scenarios:

  • A subset of the company’s existing investors will not commit to funding a new financing round, and the remaining investors want to incentivize the recalcitrant group to invest.
  • A new investor is willing to lead a financing round on the condition that the company substantially restructure the ownership position and rights of existing investors.

In both instances, the company normally needs new investments to continue operating at its current burn rate.

Understanding How Pay-to-Plays Are Implemented

There are different methods of implementing a pay-to-play financing. Most of our pay-to-plays, however, utilize a similar structure. This structure is intended to minimize the risk of stockholder litigation and incentivize existing investors to participate in the financing round.

The company will begin the process by conducting a rights offering to its existing preferred stockholders. The rights offering gives the company an opportunity to communicate with its existing investors about the pay-to-play and demonstrate a fair process. This is important for purposes of satisfying the director’s fiduciary duties. In the rights offering, the company will set aside a portion of the new financing round—normally less than half so that the lead investor will control the round—and allow each of the existing preferred stockholders to purchase a portion of such amount equal to its current ownership percentage of the company’s outstanding preferred stock. For a rights offering to serve its purpose, the company must give the existing stockholders adequate information about the new round and ample time to respond and participate in the financing. As an extreme example, it would not be advisable for a company to deliver the rights offering materials and ask existing investors to decide within a few business days or even within a week.

If an existing preferred stockholder elects not to participate in the rights offering, their shares of preferred stock will be converted into common stock, normally on a one-for-one basis. Such conversion may be implemented with the consent of the requisite preferred stockholders if the company’s certificate of incorporation has a mandatory conversion provision in line with the National Venture Capital Association’s model documents. The conversion may also be implemented by an amendment to the certificate of incorporation. Further, in connection with the conversion, some deals will involve a reverse split of the common stock or a harsher conversion ratio, which has the effect of reducing the ownership position of all the existing investors and management stockholders on a post-money basis in the financing round.

Each existing preferred stockholder who elects to purchase their portion of the round—or a greater amount—may exchange or convert their existing preferred stock into a separate shadow series of preferred stock. The new shadow series of preferred stock typically will have two parts:

  • An aggregate liquidation preference equal to the existing liquidation preferences of the participating preferred stockholders/
  • Certain “class” or “series” protective provisions (i.e., provisions designed to ensure the company and the new preferred stock cannot amend the certificate of incorporation or take other action that disproportionately impacts the new series).

The parties also may elect to allow the participating preferred stockholders to keep their existing preferred shares instead of converting such shares into a new shadow series. Since the pay-to-play will involve significant dilution to the common stockholders, the lead investor often will want to ensure management stockholders are incentivized to continue running the business. Thus, in most pay-to-play structures, the company will increase the size of its stock option plan and issue, or allocate, additional options to executive officers of the company to “true up” their ownership position. The company should ensure this part of the transaction is fully disclosed to the existing stockholders, because one or more of the management stockholders (e.g., the chief executive officer) often has a seat on the board of directors.

Pay-to-play structures change the balance of power among a company’s investors. After a successful pay-to-play financing, the participating investors will own a substantial percentage of the company and will control all the preferred stockholders’ material rights Click to Tweet

Understanding the Risk of Pay-to-Play Structures

Pay-to-play structures change the balance of power among a company’s investors. After a successful pay-to-play financing, the participating investors will own a substantial percentage of the company and will control all the preferred stockholders’ material rights. By contrast, the non-participating investors will lose their liquidation preferences, which offer valuable down-side protection, and all their other key protections. As a result, pay-to-play structures increase the risk of stockholder litigation related to the breach of fiduciary duties by the company’s board of directors or a similar claim.

The company and the participating investors should be mindful of this risk when structuring and implementing the terms of a pay-to-play round. To cleanse any potential conflicts of interest, the company should obtain disinterested director approval, if possible, and disinterested stockholder approval of the mechanics implementing the pay-to-play. Further, the company’s board of directors should ensure the minutes of the meeting or the action by written consent approving the transaction demonstrate that the board considered other alternatives and was engaged in the process of negotiating the terms of the pay-to-play financing. The company also should fully disclose the terms of the pay-to-play structure to all stockholders. Lastly, as discussed above, the company should, if possible, conduct a rights offering and give the existing stockholders time to consider and ask questions about the terms of the pay-to-play financing.

Despite the risk of stockholder litigation, pay-to-play structures are powerful incentives for existing stockholders to participate in a new financing because most institutional investors are not eager to forfeit liquidation preferences and other key protections. Further, from an investor perspective, pay-to-play structures also allow a lead investor to reduce the influence and ownership position of investors who are not willing to fund the company’s growth strategy.


Although the venture capital markets have shown signs of improving, down rounds are continuing to occur at relatively high rates in the current economic climate. In the context of a down round, some investors will demand that a company implement a pay-to-play structure. A pay-to-play structure is a powerful incentive for existing stockholders to participate in the new financing round, which may be critical for purposes of ensuring an early-stage company continues to receive new investment when markets are tighter.  A pay-to-play financing can also help a new investor restructure a company’s cap table and reduce the amount of “dead weight.”

The terms of pay-to-play financings must be technically sound, and there are plenty of traps for the unwary in these transactions. Since the consequences of a pay-to-play financing can be severe, a company must ensure it is mitigating the risk of stockholder litigation appropriately by providing adequate disclosure to existing investors, considering other alternatives—or documenting that there are none—and ensuring some level of fairness in the process.




Hunter Threet is an attorney in the Nashville office of Baker, Donelson, Bearman, Caldwell and Berkowitz, P.C. He regularly represents venture capital funds, family offices and angel investors in connection with structuring and documenting the terms of growth equity investments. He also serves as outside counsel to several emerging growth companies in the healthcare and technology industries.




1 State of Private Markets: Q2 2023, Kevin Dowd and Peter Walker, https://carta.com/blog/state-of-private-markets-q2-2023/ (July 28, 2023).
2 Id.
3 Id.

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