In general, we advise avoiding pay to play provisions if they aren’t absolutely necessary. There can be serious arguments and people can lose business relationships over this. Pay to play can really raise the temperature in the board room. That’s what a pay to play provision does and it can be nasty. Imagine being invested in the company for 5 to 8 years, finally getting somewhere, but you are out of reserves, and your so-called friend is basically threatening to wash you out. Pay to play provisions are unlikely to encourage friendly relations between VCs. What is the outcome of pay to play provisions? It only happens when the market is going down, VC fund reserves are becoming more valuable, and a lot of companies all ask for additional funding from their existing investors. In this situation, pay to play is a dose of tough medicine for startups that need funding but don’t have any other resources. They are often working in concert with a few of the inside VCs who also have capital. It can also be an outside investor who puts a pay to play provision in motion. However, it isn’t always the existing VC investors, who already have an equity position, who introduce pay to play clauses. This is because VCs who work together constantly don’t really like to dilute each other. If you are in a VC syndicate with people you invest with frequently it is far less likely that a pay to play provision will be introduced. Reluctance on the part of some investors can mean the other existing investors, who are very excited about the company going forward can become a little aggressive. At this point the piggy bank is empty and they don’t have a ton of cash to put into this deal. In addition, if the funds are older, they may have little to no VC fund reserves left. Some of the VC funds already invested.in the startup may be less bullish about the company and less interested in providing more capital. If a company is doing pretty well, but not outstandingly, they may have to go to their existing investors and ask for more venture capital. For example, in 2022 the NASDAQ has corrected, the Bessemer Cloud Index has corrected and startup financing is getting a little tougher to come by. When might a pay to play provision come into effect?ĭue to the current financial climate being less than ideal, pay to play provisions are more likely to come into effect. They might not have enough funds to participate in the pay to play, but they’ve been part of the fabric of the company much longer than new investors. On the other hand, the people who have helped bring the startup this far will feel as though they are being penalized. From the perspective of newer VCs, if you don’t want to defend your equity position, or you’re not important to the company anymore, then why should you get a free ride on the new incoming capital? If the VC investors don’t provide more funds, the company probably won’t be successful. The people who are putting in more capital don’t really want to carry a lot of so-called “dead weight,” but at this point the startup needs more capital. Under these circumstances, investors who don’t participate in the new capital round will lose a big percentage of their ownership, and this is by design. Anyone who is not really contributing to the company anymore.This, in turn, waters down the ownership positions of: The valuation is reset according to a number of reverse stock splits, which basically issues a lot of new shares. Any VC who does not participate will then be “ crammed down” and their percentage of ownership is reduced. This will state a valuation reset of a company (usually at a much lower value) and dictate that every VC involved must participate on a pro rata basis. A pay to play provision is part of a venture capital term sheet, and essentially requires existing investors to participate in any subsequent rounds of investment.
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