Anatomy of a Term Sheet 9 — Pay-To-Play

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth. The goal is to give startup founders a solid understanding of the complex provisions of the term sheet. We have had 8 installments so far, covering topics like the option pool, voting rights, the liquidation preference, dividends, conversion, and anti-dilution. The next item in our Anatomy of a Term Sheet series is the pay-to-play term.

The pay-to-play term is a departure from the previous terms, because it is typically requested by the startup company, rather than the investors. Here’s what the provision looks like:

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].

The pay-to-play concept is that if the Series A investors don’t participate in later funding rounds, they will lose certain benefits of being preferred stockholders. For example, a Series A investor that doesn’t invest in later rounds may lose its anti-dilution rights. The goal is to keep the Series A investors around for the long haul, and in particular, during a down round.

A typical pay-to-play clause might require each Series A investor to participate on a pro rata basis in later rounds. As a practical matter, however, if every Series A investor contributes its pro rata share of the new investment, there won’t be room for any new investors. A way to work around this is to set aside a portion of the total new investment, and reserve that portion for the Series A investors. For example, if the total new investment is for $2 million, half of that might be set aside for the Series A investors, and they would participate in that half on a proportionate basis.

If the pay-to-play term provides for non-participating Series A investors to lose some of their preferred stockholder rights, there will need to be a provision in the company charter for a shadow class of preferred stock with diminished rights, like a Series A-1 class of preferred. An easier solution is to have some or all of the non-participating preferred stock convert to common stock.

Next installment: Redemption Rights.

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