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The Latest Changes in VC Deal Terms — Pay-to-Play

by kirkcoburn
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I’ve always told founders and investors alike that, while the term sheet is the Holy Grail for entrepreneurs, not all the terms are created equal. I discussed term sheets in this post in my series about the latest changes in VC deal terms. But there are some components of the document that may have a more long-term economic impact on the company. In that first-among-equals category is “pay-to-play.” While only used in ~ 5% of all deals, the “pay-to-play” is very important and something you should understand. I am also going to cover other provisions in term sheets that protect an investor’s equity percentage since they are closely correlated.

The phrase “pay to play” itself has such historic negative connotations that many founders blanch the first time they see it on a term sheet. According to Lexico, pay to play can be defined as:

relating to or denoting a situation in which payment is demanded, often illegally, from those wishing to take part in a particular business activity.

This definition does cast a faintly scandalous aura to the term, and it is commonly used when discussing bribery, extortion, or some other sort of unsavory financial shenanigans.

But, in the VC world, pay-to-play is different. While some VC’s really do not like this term, I am seeing it used more in energy deals. A deal where pay-to-play is part of the agreement indicates the importance of existing investors to continue funding the company for the long haul beyond the initial investment. This is a rather simplistic way of putting it, but if you’re an entrepreneur and unnerved when you hear VCs talk about a pay-to-play clause in the contract, you should be. A pay-to-play clause may benefit you and all investors; however, it can also put you at odds.

Energy entrepreneurs have a slightly different playing field than other tech founders. A few weeks ago, I reiterated the longer cycles and poor returns of most investors in this space. While everyone in the VC world appreciates the noble pursuit of a cleaner and more sustainable energy, the reality is that it isn’t as “easy” as the latest version of the little blue pill or another app that lets you share your cat videos with the universe.

However, non-traditional investors are pouring money into the clean energy sector, Again! While overall investment in the sector dropped 8% in 2018, private equity and VC funds increased investment 127%, to the tune of $9.2 billion.

Some of these investors have been here the whole time — Shell’s VC arm, Shell Ventures, is always looking for promising energy tech. Strategic investors, creative partnerships, foreign firms, and place-based funds are all getting in the clean-energy game. So are “patient” investors like the Sam Walton family fund, True North Venture Partners. When Walmart’s ready to play, you know that investing in clean energy is about to go mainstream. Yea, yea, we have heard this before, right?

How Pay-to-Play Works

Due to all of the Legal-ese on the term sheet which can get confusing, let’s dig a little deeper into the fundamentals of the concept. By now, if there’s one thing you’ve learned about VC and term sheets, it’s that nothing is really as simple and straightforward as you’d hope. I blame the lawyers…how about you?

The latest NVCA term sheet states the following:


[Unless the holders of [__]% of the Series A elect otherwise,] on any subsequent [down] round all [Major] Investors are required to purchase their pro rata share of the securities set aside by the Board for purchase by the [Major] Investors. All shares of Series A Preferred of any [Major] Investor failing to do so will automatically [lose anti-dilution rights] [lose right to participate in future rounds] [convert to Common Stock and lose the right to a Board seat if applicable].] ”

A pay-to-play provision requires a given investor to participate fully in the financing of your business venture. Full participation is defined here by anteing up in future rounds of fundraising, not just the seed or starter round, on a pro-rata basis or more. This means that, unless an investor continues to fund further rounds at a predetermined percentage, they will have limited rights and benefits as your company grows (including losing their “preferred equity status” and being moved to a common shareholder).

The upshot of all this is that, when you have a pay-to-play clause, you get more committed investors, at least that is the intended purpose. The investors get guaranteed ratio protections (for their percentage of the company). This is all great when things are going well with a startup, but when things are not going well, this provision becomes very important and can turn a company upside down especially when investors are also in a precarious position (an investor lacks cash flow to fund the next round, the investor is raising a new fund and does NOT want to mark down a company’s valuation in a coming down round, the investor wants to exit, etc…all of these issues are REALLY important to you, the entrepreneur, when raising money).

I wrote a few weeks ago about liquidation preferences. When a pay-to-play provision is in place, it will negatively impact the liquidation preferences for nonparticipating investors.

As I have written many times, energy deals take longer and the track records have not been great. When a startup is in the valley of death, losing investors can be devastating especially as the company is on the verge of a major milestone and/or customer order. When raising money in energy, it is really important to many of us large investors that are also customers so see investors keep their belief into the company. While pay-to-play is a rare tool for other industries, it is becoming more important in energy. First, it forces existing investors to keep investing (which is a good sign for new investors). Second, it is a tool to remove previous investors from keeping their preferred rights (which has more often than not created problems down the road). I will write a post on this directly since it deserves attention.

Deep Diving Into Other Key Provisions

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Exploring pay-to-play provisions before any negotiations will help you protect your company and your idea.

There are three fundamentals of term sheets that deal with protecting investor’s ownership levels besides the pay-to-play. They each cover a different way to ensure the investors’ stock is not diluted in future rounds. Your term sheet could have all three or just one of these clauses.

  • Dilution and Anti-Dilution
  • Right of First Offer
  • Preemptive Right

1. Dilution and Anti-Dilution

Dilution and anti-dilution in a VC term sheet are considerably more complicated than a garden variety stock split. What the investor wants is an assurance that, should your stock price drop in future down rounds,  they will get their initial investment back. Stock splits are not common with start-ups, but issuing new shares is. The anti-dilution clause is a bulwark against loss and can be calculated in a few ways.

Full Ratchet is the diciest anti-dilution clause for founders and the least common. In this scenario, the company’s valuation is going down and this provision protects the preferred investor’s equity fully. In other words, a full ratchet provision allows the preferred equity holder of the full ratchet to re-price their previous investment at the new share price effectively keeping their same ownership percentage into the company. For example, if Investor A bought shares in a Series A at $10/share and a Series B is a down round that is priced at $5/share. The series A holder with a full ratchet provision gets his/her Series A shares repriced at $5/share. So Investor A is happy, but Investors B and C or common stockholders in later rounds… not so much.

Broad-Based Weighted Average anti-dilution clauses are less beneficial to the original investors should the venture not succeed, but are much more common. The math is more complicated, but in this scenario, the formula considers the number of shares sold in a down round relative to the existing stock price and the difference in the price. The NVCA term sheet uses this method and we do as well; however, I have seen full ratchets…BEWARE.

No Price-Based Anti-Dilution Protection is the fairest for common shareholders, but the least interesting to an early investor. When this is tied to a pay-to-play provision, the investor doesn’t have any safety net against dilution in a down round. It is rare for a preferred investor to agree to run with the herd and assume that added risk. Their position is that since they took the early risk, there should be a greater reward.

There are always exceptions. And please note that anti-dilution clauses also have an element of creating division amongst shareholders. When there are anti-dilution clauses in a term sheet, the management team, usually holding common equity, do not want to raise money when there is a potential down round. This clause can create division amongst new investors and existing investors as well as management. I have even seen anti-dilution clauses tied to milestones (if the company hits $X revenue, the valuation equals $X x 6.2. If the company hits $Y revenue, the valuation equals $Y x 6.2). The potential problem with this is that the company can sacrifice the long-term health of the organization by focusing on short-term goals.

2. Right of First Offer

A right of first offer (ROFO) allows an investor to purchase its pro-rata percentage of new equity being raised into the company. Based upon this right, there are other terms that get negotiated along with this including Major Investor status (as seen in the Pay-to-Play language above). Major Investor status is a concept used to limit the number of investors that share certain preferred rights like a ROFO. A Major Investor is defined in the term sheet based upon equity percentage. Defining Major Investor status has become a tough negotiation point in a few of my deals. There are other terms such as accredited investor status, carve-outs, and super pro-rata rights that can also be tied to this provision.

3. Preemptive Right

These rights allow investors to buy additional shares in future rounds before anybody else has the chance. The National Venture Capital Association (NVCA) term sheet includes a preemptive rights provision, titled “Right to Participate Pro Rata in Future Rounds.”  The preemptive right is possibly the most favorable provision from the entrepreneur’s perspective. The addition of this clause indicates that your investors are not only pleased with how you have performed so far, but that their interest is strong enough to warrant first dibs on more shares.

Speak the VC Language

One of the biggest mistakes entrepreneurs make when they’re shopping their company or concept is not understanding in any detail the way institutional investor’s work. Look at it this way — you expect anyone investing in your business to have a solid grasp of what you’re doing, so in turn, VCs respond much more positively to a founder who has at least some clue how VC deals work. Nobody expects you to walk in the room sounding like Warren Buffet. But when you can discuss the relevant parts of the deal with some fluency, that will make a positive impression on the VCs. Get a solid foundation in the terminology by reading more about VC deal term changes:

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