Reading: Protection and Participation

The previous sections have shown that investors use many different types of deal elements to extract more favorable deal terms, including liquidation preference, redeemability, anti-dilution provisions, and participation rights. All these rights and preferences help the VC to limit the financial risk that is associated with direct investments into new venture. We have also seen that these elements help the parties bridge valuation gaps and align incentives. So there are many good reasons why such deal structures exist.

Still, one concern of the entrepreneur could be that all these deal elements are good for the current investors. At the same time, they limit the firm's financial flexibility and might make it more difficult to tap into new sources of external capital. 

This is why in most instances, all the rights and privileges of the Preferred investors are not unconditional. They are usually tied to a so-called Pay-to-Play Provision. This provision stipulates that investors only receive the aforementioned special treatment if they participate in future rounds of financing and purchase their pro rata share of newly issued securities. Investors who fail to do so, will automatically lose some or all of their privileges.

The specific characteristics of the pay-to-play provision are subject to negotiations between the founders and the investors. There is no universally valid formulation.

• Some term sheets apply Pay-to-Play to all future rounds of financing whereas others only apply it to down rounds. 
• And then, term sheets differ greatly with respect to the privileges that are turned off if the investor fails to participate. Usually, these privileges are a selection or all of the following:

• loss of anti-dilution rights
• loss of right to participate in future rounds
• automatic conversion to Common Stock
• loss of right to appoint Board member.

A typical formulation from a term sheet that includes all of these privileges could be:

On any subsequent 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.