What is Pay to Play in Venture Capital, Especially in a Down Round?

In this video, you'll learn about: what is pay to play in venture capital, especially in a down round? An investor must "Pay to Play" in order to take part in a later investment round, particularly a Down Round.

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The NASDAQ has corrected, the Bessemer Cloud Index is corrected and startup financing is getting a little tougher to come by. And so, what you see in a pay to play is a combination of factors. The first one is maybe the company's doing pretty well, but not a rocket ship.

And so, the company may be going back to existing investors and saying like, "Hey, we need more capital. Can you fund us?" And the second factor here is maybe some of the funds inside the company already invested, are less bullish than some of the others. Also, a third factor could be some of those funds, they may be just as bullish, just as excited, but they're older funds. And so, they have little to no VC fund reserves left. Check out our video on VC fund reserves, where I talk about that. But basically, the piggy bank's empty. They don't have a ton of cash they can put into this deal. And so, the other existing investors who are very excited about the company going forward still they can be a little aggressive here.

Now, if you are in this VC syndicate with people you invest in all the time with, it's less likely a pay to play provision will be brought onto the table, because VCs who work together constantly don't really like to dilute each other. I mean, imagine being in the company for 5 to 8 years, finally getting somewhere, you're out of reserves and your friend, so-called friend, is basically threatening to wash you out. That's what a pay to play provision does. So the pay to play provision is like a term sheet that says like, "Hey, this is gonna be the valuation. Everyone's gonna play on a pro rata basis and participate. However, anyone who doesn't participate will actually be crammed down and lose a good percentage of their ownership.

Because basically, what happens is the valuation gets reset at a much lower number, and there can be some, this is kind of complicated, it'll be its own video, but some stocks, some reverse stocks splits that basically an issuance of a lot of new shares, which basically water down the ownership positions of all the old VCs who are not participating, the old founders, old angel investors, anyone who's not really contributing to the company anymore, they will lose a big percentage of their ownership via the pay to play. This is by design, by the people who are putting in more capital, because their view on it is they don't really wanna carry a lot of so-called dead weight around like the company needs more capital. If they don't give it to them the company probably won't be successful, won't continue.

And if you can't defend your position or you're not important to the company anymore then why should you get a free ride on the new capital coming into the company, right? So you can see both sides of this. The new capital and the people who are still bullish and still have money, they feel like they don't want to give a free ride. The people who have helped build the company help to get to where it is maybe they don't have enough funds to participate, maybe they're angels without funds, maybe they're old VC funds. They feel like, "Hey, I built this company. Why are you penalizing me now? I've been part of the fabric of the company."

And so, sometimes pay to play provisions are introduced not my favorite thing, been a part of this. Unfortunately, I've seen it quite a few times. It does, sometimes it just sinks the whole company and no one can get on the same page and people just get super pissed off. Other times it cleans some stuff up, the company can move forward with a clean cap table and the company can be successful. So the result is probably people have different feelings, depending on which side of the table they're on, if they're getting diluted or not getting diluted. But I really recommend always trying to maintain at least 12, usually 18 months of runway so that you don't end up in this position and your angels and your VCs with low reserves, don't get in this position. So hope that helps. Pay to play provisions are something we are going to see probably a lot this summer in 2022.

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