Pay-to-Play

Term sheets have changed in an interesting way

By Frank Demmler

Last week I provided some statistics about venture capital in 2004 as reported by the National Venture Capital Association.

VentureOne, another venture capital “scorekeeper,” also recently released an interesting study. They analyzed a sample of venture capital deals and reported the results. There were two statistics that caught my eye.

· 23% of the transactions were down rounds (with 17% being flat; 41% being up rounds; and 19% being “N/A”), and

· 47% of first rounds included pay-to-play terms.

[I know that these aren’t “apples-to-apples” numbers, but even 27% of later stage deals had pay-to-play provisions.]

Don’t worry; I’m not going to bore you with lots of numbers, like last week. I’m going to provide you with my interpretation of these two statistics, and why they are of extreme interest to you, the first-time entrepreneur.

Investor Protection

As I’ve discussed in previous articles, institutional investors almost always invest in Convertible Preferred Stock. In addition to a variety of “preferences” associated with the stock, there are quite a few protective provisions, i.e., protection for the investors to prevent the company from taking an action that is detrimental to the investors without the investors participating in the decision, or having the right to veto it.

The most notable is anti-dilution protection. This addresses what happens if the company has to sell stock at a price below that of the current investors. Two methods are employed.

• Full-ratchet protection gives the existing investor an adjustment so that it’s the same as if it had invested in the current round; and
• Weighted average protection takes the share base into consideration in the adjustment.

Other protections include such things as:

• Liquidation or sale of the company
• Alter any provision of the corporation would be adverse to the investors
• Create any security that is senior to the investors’ security
• Borrow money greater than some amount.

The common theme of these features is that they are expressed in terms of protections that the investors “need” from the company.

In many cases, their primary purpose is to provide protection from the next round investors. By having these types of rights, the thinking goes, the current investors will have bargaining chips to trade with the follow on investors.

The Golden Rule still prevails, though – he who has the gold rules. In other words, if there’s only one investor interested in the deal, the current investors are likely to have to waive their rights.

Protection Extension

What’s significant about the two statistics that I cited in the introduction is that investors and now seeking protection from one another.

Historically, syndicating a deal (a lead investor with one or more co-investors) has been a staple of the venture capital industry, with few exceptions. Among other reasons, it has been claimed that this mitigates any single investor’s risk by having a broader and deeper pool of capital at the table, so to speak.

In the case of having only one new investor that dictates terms of the next round, the current investors have the “dry powder” to fund the portfolio company themselves, thereby preserving their rights.

This was the norm for quite awhile in the venture capital industry. If faced with a down round, the options were often pretty straightforward.

• Let the company crater.
• Accept the terms of the new investor.
• Do an inside round.

Down rounds were pretty rare [I don’t even remember statistics being reported on them.] If an inside round was the selected path, there was an “understanding” that the current investors would share the round on a pro rata basis.

On those rare occasions that the syndicate didn’t hold together, it was “understood” that you had to “pay-to-play.” In other words, if a current investor would not, or could not, take its share of the next round, their existing investment would be essentially worthless and they would have no rights moving forward.

I remember the first time I was in this situation. The prior round had been done at $1.00 a share, but for a number of reasons no new investor came forward. When one investor balked at putting more money into the company, the next round was priced at $0.05 per share, a 95% write down for the current investors. This is what is known as a “cram down.”

Times Have Changed

The number of down rounds is now significant (23%, according to VentureOne; even higher if you take the “N/A” responses out of the calculation).

Similarly, syndicates are not as strong as they were in the past. As such, “Pay-to-Play” terms are explicit parts of current deals. Similar to anti-dilution, there appear to be two primary mechanisms, and one appears to be harsher than the other. If an existing investor does not take its pro rata share of a down round:

• The investor will automatically lose the right to participate in future rounds, or
• All of the investor’s shares will automatically convert to Common Stock.

Implications for Entrepreneurs

Among the reasons that raising capital is so difficult these days is that your potential investor knows that a down round and/or a disintegrated syndicate are distinct possibilities. Even companies that “do all the right things” are exposed.

• Do everything you can to demonstrate that you will be immune to a down round. [Short of “proving” that you will be cash flow neutral with the existing investment, I’m not sure how you do that, but…]
• Target investors who have sufficiently deep pockets to fund follow on rounds, and a history of doing so. Such investors are few and far between.
• Target those groups of investors who have a history of investing together and have weathered difficult times together.
• When all else fails, if the cash is green and legal, take it.

Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh. An archive of this series of articles can be found at my website.