Pay to play provisions encourage investors to participate in subsequent rounds of investment. Such provisions provide incentive to continue investing by providing that if investors don’t participate in subsequent rounds proportionally to their investment, their preferred stock will automatically convert to common stock.
From an economics standpoint the pay to play provisions motivate investors to continue financial support by eliminating the liquidation preference that generally goes along with preferred stock. If an investor wants to keep their right to a 3X preference, they need to continue investing in the company. As one might expect, this can be a powerful incentive. Conversion from preferred to common stock would also eliminate an investor’s rights in any other benefits that came with preferred stock.
These provisions are generally viewed as good for both the company and key investors. Agreeing to terms on continued financial support is a healthy matter for investors to be upfront about. If the company and investors carefully negotiate a pay-to-play provision, the parties will be less likely to be upset about future troubles with reinvestment because these scenarios were already contemplated, and the appropriate remedies were provided for in the pay-to-play provision.
Pay to play provisions are generally welcomed by the company because it encourages investors to financially support the company on an on-going basis. These provisions allow companies to gauge an investor’s commitment to the company. And as the company receives subsequent financing rounds, pay-to-play provisions ensure that only committed investors have preferred stock and the rights that go with it.
Key investors also often favor these provisions because they provide an incentive for other investors to continue supporting the company. Pay to Play provisions address the “free-rider” problem—where one investor continues to support the company while the other investors stand on the sidelines. Moreover, in the event an investor’s preferred stock is converted to common, the conversion is often not overly harsh for investors as they retain an interest in the company in the form of common stock, which can still be valuable.
Not everybody loves pay-to-play provisions, which can sometimes be harsh on angel investors that don’t have adequate capital to continue financially supporting a company.
One variation of the pay-to-play provision provides that if investors are only able to reinvest a portion of their pro-rata share, they will retain a corresponding portion of their preferred stock.
Another variation—a “pull up” provision—provides an encouraging rather than discouraging incentive: the preferred stock of investors who reinvest in the company is converted to another series of preferred stock that has even more favorable terms than their original preferred series.