Pay-to-play provisions are most commonly featured in down round financings or recapitalizations. Investors often mandate pay-to-play provisions in order to encourage all existing company investors to participate in the transaction in question and, in some instances, to penalize existing company investors who do not wish to continue investing in the company.
Pay-to-play structures come in a variety of forms but generally feature the same objective: If an investor doesn’t purchase a predetermined allocation of shares in the new investment round, their existing shareholding of the company will suffer a penalty. In other words, existing investors are required to participate in the new financing round (i.e., “pay”) in order to maintain their current position in the company (i.e., “play”).
The most common pay-to-play structure involves a mandatory conversion of outstanding preferred stock held by non-participating investors into common stock. In some cases, the conversion occurs at a ratio that significantly dilutes the relative ownership of the non-participating investor. The higher the ratio, the worse the impact for a non-participating investor subjected to the pay-to-play. For instance, in some cases, an investor who does not participate in the next round of financing will have 10 shares of their preferred stock convert into only one share of common stock. Naturally, the decision to pass on investment in the next round carries much more punitive consequences than in a traditional financing round.
Typically, companies and investors prefer to apply pay-to-play provisions to all preferred stockholders equally and choose not to exclude certain classes or series of preferred stock.
In addition, the timing of when a pay-to-play is adopted (e.g., whether it is adopted prior to or in conjunction with the next round) and the number of investors who approve the terms are significant. Both factors will have an impact on the pay-to-play’s ultimate mechanism and enforceability.
Pay-to-play structures may be implemented contractually through shareholder agreements or by operation of a company’s certificate of incorporation. A pay-to-play may also be implemented through the issuance of hybrid securities with unique features that mimic the dilutive effects of conversion of preferred stock into common stock.
Pay-to-play provisions are fraught with corporate governance and corporate and securities law complexities. Once triggered, pay-to-play provisions may also have tax consequences on existing stockholders of the company. Companies should consult with counsel well in advance of structuring a pay-to-play provision.