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Pay-to-Play refers to conditions imposed by lead investors in venture financings that motivate investors to invest more money in future fundraisings. The motivation to reinvest is the prospect of forfeiting value in their existing shares if they do not participate in future investments. The value forfeiture is frequently built into terms of the security they purchase. The feature might reduce the value of the security purchased by reducing the number of shares of common stock that their security stock can convert into if the investor does not “play” in the future round or it might reduce other preferences. Pay-to-pay also refers to conditions imposed in down round financings by the new investor that cause existing investors to forfeit value if they do not reinvest in the current down round. The lead investor imposes the conditions by refusing to fund unless the conditions are met. The new investor’s conditions work with the issuance of large numbers of shares in the new funding to remove much of the value from existing shareholdings. The company and prior investors concede to the conditions because other funding opportunities are unavailable and funding is needed to continue operations. Pay-to-play financings of the this second sort typically involve the issuance of large numbers of shares at low prices to new investors that effectively dilute the percentage ownership of existing investors to very small percentages. The incentive for existing investors to reinvest in the new round is the ability granted to those who reinvest to convert the stock the purchased earlier into a new class of stock with preferences that give it greater value. The provisions have the effect of punishing existing investors who do not participate in the new financing by further reducing the value of their existing shareholdings. One pay-to-play approach has the company amend its charter to create a new series of convertible preferred stock into which shareholders who invest in the down round may convert their existing convertible preferred stock. The amended series of stock allows holders to convert their shares of preferred stock into more shares of common stock than the preexisting preferred stock. Existing investors who participate purchase stock with the new investors in a convertible preferred stock created for their investment and obtain this additional right convert their existing shares of preferred stock into the new enhanced preferred stock. Existing investors who do not put new money into the company are left with their original, now devalued, convertible preferred stock. For example, participating investors in a new Series B round might be allowed as a part of their purchase of Series B stock to convert their existing Series A into a newly created preferential Series A-2 stock. The preference might be a revised conversion formula that increases the number of shares of common stock they are entitled to receive on conversion by a factor of five, where the new conversion more closely resembles the value afforded in the subsequent Series B down round. Nonparticipating investors are left with the original Series A stock. In the example, two Series A investors who invested $1 million each for 500,000 shares at $2.00 each representing a total of 40% of a company each might see the value of their investment largely wiped-out by a new Series B investment. If the Series B investor invests $4 million at $.10 per share, he will receive 40 million shares for his investment, dramatically reducing the ownership percentage represented by the Series A stock. By participating in the Series B round, a Series A investor might not only receive $.10 stock but also be allowed to convert his Series A stock into a newly created Series A-2 stock that converts into 4 million shares instead of 500,000. The resulting capitalization of the company before and after the down round might look like this.
In the foregoing example, the Series B down round effectively dilutes the ownership of the nonparticipating preferred investor 1 from 20% to less than 1% of the fully diluted outstanding shares. The second preferred investor who participates by investing $500,000 in the Series B round sees his Series A investment convert into a Series A-2 stock that converts into 7.8% of the outstanding stock and acquires new stock representing 9.8% of the outstanding stock for a total holding of 17.6%. Common shareholders see their 20% holding reduced to less than 2%, with employee option holders falling below 1%. See: Antidilution Provisions, Convertible Preferred Stock, Dilution (Percentage), Dilution (Value), Down Round, Convertible Securities, Follow-on Fundings, Participating Preferred Stock, Preferred Stock Umbrella. |