Avoiding Harsh Pay to Plays

I am looking to raise some money from insiders in a Series A-1 deal to see if we can get traction for a pivot we just did. My lead investor is proposing a traditional “pay to play” which converts all my earlier investors to common if they do not invest their pro rata in the Series A-1. Many of the early investors are my friends and family and I would like to find a solution which is less harsh. Have you seen anything else work?

The classic problem with early investors is they do not reserve capital for subsequent rounds. And even if they did, they usually do not want to participate in financings which are “down rounds” or flat to the last valuation. These realities often leave later stage investors feeling sour, as they are fronting the capital to keep the company alive and preserve the economics for those who are no longer helping. Non-participants are “free riding” on the capital of later investors when times get tough, which is why so many funds insist on classic, punitive pay to play terms. Plus, pay to play provisions eliminate a great deal of liquidation preference, which makes the deal more potentially lucrative for the new investors and founders alike.

Your goals are to maximize participation from insiders — ideally without ruining any relationships — and perhaps induce a few new investors to join. You can motivate existing investors with carrots or sticks. Traditional play to play provisions are a blunt force stick: participate or lose all your preferred rights and liquidation preference.

One strategy we use in my fund is an incentive-based pay to play structure. In your situation, if an investor puts in its pro rata, that investor not only buys new Series A-1, but is also able to exchange some or all of its old invested amount for new Series A-1 shares, perhaps $2 for every new $1 invested (but the exchange amount cannot exceed the original investment). Because this structure does not eliminate existing preferred rights and occurs in a flat or down situation, it often requires an enhanced liquidation preference to compensate for the risk, as well as a waiver of all the anti-dilution protections for the junior rounds. It can sometimes require some additional option pool or incentive structure for management, depending on the severity of the dilution.

For example, an investor previously invested $60,000 in the Series A. The company creates a new Series A-1 with a 1.5x liquidation preference, often at a reduced price to the Series A. The investor’s pro rata amount is $30,000 with an exchange of 2:1. In this scenario, the investor purchases $30,000 of new Series A-1. As a reward, the old $60,000 is exchanged into the new Series A-1 (meaning the investor no longer owns any Series A). For the additional $30,000, the investor now holds $135,000 of liquidation preference ($90,000 x 1.5) which is senior to the Series A. Series A holders who pass do not lose their liquidation preferences or other rights, but are diluted and junior to the Series A-1.

In my experience, such incentive-based pay to play provisions usually attract sufficient capital from existing investors. They also rarely alienate these investors who, after all, helped get you to your current state. I think it optimal to avoid making enemies of seed and early stage investors. Some funds take the opposite view and even insert mandatory pay to play provisions in Series A term sheets. If an early stage investor knows it could be forced into a punitive pay to play later, it rationally should invest less now to reserve funds for the future. Less investment, however, lowers the chances the company will succeed, so this is not the optimal outcome.

All of this said, each time I have been involved in a gentle recap based upon positive incentives, a few early investors who are not participating (and therefore have everything to gain) show their “gratitude” by haranguing the management and our fund, and sometimes creating hostage negotiations by withholding consents. Why? Because they want even better terms despite their abject uselessness to the company. If you have ever negotiated with an over-tired toddler about bedtime when you already extended bedtime once, you have lived this story.

While no good deed goes unpunished, I still think the good will gained with kindness toward early investors goes a long way. Good investors have long memories and will repay harshness or generosity later.

See also: 4.110: Down Rounds  

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