Pay-to-Play

What does pay-to-play mean?

Pay-to-Play (participation as a condition of preferential rights) denotes a rule under which investors keep their preferential rights only if they take at least their pro rata share in a future financing round. An investor who does not participate loses, depending on the design, anti-dilution protection, liquidation preference or consent rights, and is afterwards in the position of a shareholder without preferential rights. In the contract it is usually called a pay-to-play clause or pay-to-play rule.

Pay-to-play rules appear in the term sheet and in the shareholders' agreement, occasionally also in the articles of association where preferential rights are anchored there. They occur above all in down rounds (rounds at a lower price per share than before), in bridge financings until the next larger round (bridge financing) and in restructurings. The typical situation is one in which the company needs capital from its existing investors and the burden is to be spread evenly. They are often linked to anti-dilution protection (anti-dilution protection): compensation shares are received only by those who themselves invest in the down round. Outside corporate financing, the expression denotes models in which participation or access costs money, for example in online games, club sports or political donations. They share only the name with the financing clause.

How a pay-to-play rule works

The pro rata amount

The rule determines what amount counts as a pro rata participation. Customary is a share of the volume of the new round that corresponds to the investor's ownership percentage, measured on the fully diluted basis or against the group of existing investors. In some cases only a part of the round is reserved for existing investors and the obligation relates to that part. If an investor participates only in part, it loses its preferential rights proportionately under some rules and completely under others.

Formula: pro rata amount = volume of the new round × the investor's fully diluted ownership percentage before the round

Consequences of non-participation

• Loss of anti-dilution protection: the widespread and mildest form. The investor receives no compensation shares in the down round.
• Loss of liquidation preference: The shares participate in the proceeds only in proportion to the ownership percentage, without a preferential amount.
• Loss of consent and appointment rights: The investor loses, for example, its veto rights (veto rights) or the right to nominate a member of the advisory board.
• Conversion into common shares: The shares become shares without special rights, as the founders also hold them. All preferences lapse at once. The shares themselves, with voting right and share of profit, remain.

In every case the investor keeps its shares. Common shares are not worthless; economically they rank equally with the founders' shares. What is lost are the preferences, not the shareholding.

Pay-to-play in a GmbH: implementation and enforceability

In a GmbH (German limited liability company), preferential rights are mostly set out in the shareholders' agreement and so take effect under the law of obligations. Their lapse on non-participation can be agreed there as a condition that occurs when the subscription period expires. If preferential rights are additionally anchored in the articles of association, for example a preference in the distribution of liquidation proceeds, their lapse requires an amendment of the articles with a three-quarters majority and notarial certification (Section 53 of the German Limited Liability Companies Act, GmbHG). Because interference with special rights in principle requires the consent of the person affected, the shareholders' agreement as a rule provides that the investors consent to such an amendment already on entry.

An enforceable obligation to participate in future rounds is rarely agreed. The amount, price and conditions of the future round are not fixed when the contract is concluded, and funds are bound by the investment limits of their own contracts. Pay-to-play therefore generally operates as a burden that the investor bears in its own interest (Obliegenheit): participation is voluntary, non-participation has agreed consequences. An obligation of the shareholders to make additional contributions (Nachschusspflicht) under Section 26 GmbHG requires an express rule in the articles of association and is unusual in financing rounds.

Company law sets limits on sanctions that go beyond the lapse of preferential rights. An obligation to assign shares below value on non-participation raises questions of validity and in any case requires notarial certification under Section 15(4) GmbHG. In addition, the rule should apply equally to all investors of the same group. Under the principle of equal treatment in company law, unequal treatment needs an objective justification or the consent of those affected.

Pay-to-play in a down round and restructuring

In a down round, pay-to-play spreads the burden of the financing across the existing investors. A new lead investor, who leads the round and negotiates its terms, often makes its commitment dependent on other investors bearing their share or giving up their preferential rights. The same applies to the largest existing investor if it leads the round. Without such a rule, investors who do not invest would benefit from the financing without making a contribution. In a comprehensive reorganisation of the capital structure (recapitalization), the rule is therefore a frequent building block.

For founders, pay-to-play can be advantageous, because the preferences of non-participating investors, which would be served ahead of the common shares, lapse. A rule agreed already in an early round, by contrast, can deter investors who hold no reserves for follow-on investments (follow-on investment). New investors examine in due diligence whether earlier pay-to-play rules have already caused preferential rights to lapse and whether the list of shareholders and the contractual position reflect that status accurately.

Worked example: pay-to-play in a down round

A GmbH has 90,000 shares: the founders hold 50,000, and the Series A investors A and B hold 20,000 each, for which they each paid EUR 2 million. The virtual pool comprises 10,000 shares. Both Series A investors have a simple, non-participating liquidation preference: on a sale they receive first the amount they paid in or, if that is more, their share by ownership percentage, but not both. There is no anti-dilution protection. A down round of EUR 5 million at EUR 50 per share is combined with a pay-to-play rule. The preference of the new round ranks first and is likewise simple and non-participating.

• New shares: EUR 5 million / EUR 50 = 100,000; fully diluted ownership percentage of A and B before the round, 20,000 / 100,000 = 20% each
• Pro rata amount per Series A investor: 20% of EUR 5 million = EUR 1 million; if related only to the group of Series A investors, in which each holds half, it would be EUR 2.5 million
• A invests EUR 1 million and receives 20,000 new shares; B does not invest, the new lead investor takes EUR 4 million for 80,000 shares
• Ownership percentages after the round at 200,000 shares: founders 25%, virtual shares 5%, A 40,000 / 200,000 = 20%, B 20,000 / 200,000 = 10%, lead investor 40%
• Consequence for B: its preference of EUR 2 million lapses; its 20,000 shares remain in place as common shares
• Sale for EUR 6 million with preference for B: first EUR 5 million to the lead investor and A from the new round, the remaining EUR 1 million in equal parts to A and B, that is, EUR 0.5 million each
• Sale for EUR 6 million after lapse: the remaining EUR 1 million goes to A alone, whose preference of EUR 2 million it does not exhaust; B receives nothing
• Sale for EUR 40 million: for all investors, participating pro rata is more favourable than their preference; B therefore receives 10% of EUR 40 million = EUR 4 million in both cases

Non-participation halves B's ownership percentage, while A stays at 20% through its pro rata participation. The loss of the preference matters only at low sale proceeds: at EUR 6 million, B loses EUR 0.5 million to A, at EUR 40 million nothing. The rule thus shifts above all the risk of a weak exit.

Distinctions: pay-to-play, anti-dilution protection and pre-emption right

• Anti-dilution protection: compensates for a fallen issue price. Pay-to-play governs who may keep this compensation.
• Pre-emption right (pre-emptive rights): the right to participate pro rata in a capital increase. Pay-to-play makes the exercise of this right a condition for preferential rights being retained.
• Cramdown: a financing whose low price greatly reduces the stake of non-participating shareholders. Pay-to-play, by contrast, works through the withdrawal of rights.
• Obligation to make additional contributions: an obligation to make further payments regulated in the articles of association. It is regulated by statute and enforceable, whereas pay-to-play is usually voluntary participation with agreed consequences.

Common mistakes

• Pro rata amount unclear. If it remains open to which base the percentage relates, the investors argue over the amount of their contribution while the round waits to close.
• Articles of association overlooked. Preferential rights in the articles of association do not lapse through a rule in the shareholders' agreement alone. Without consent to the amendment of the articles agreed in advance, the lapse remains incomplete.
• Partial participation not regulated. Without a rule it is unclear whether an investor who subscribes half of its amount keeps its rights entirely, in part or not at all.
• Sanction drafted too widely. Consequences such as an assignment of shares below value go beyond the loss of preferences and jeopardise the validity of the rule.
• Deadline and proof missing. Without a fixed subscription period and a clear rule on when a participation counts as made, it remains open when the consequences occur.

Frequently asked questions

Is an investor obliged under pay-to-play to invest in the next round?

As a rule not. The rule usually creates no enforceable payment obligation but attaches the loss of preferential rights to non-participation. Whether to invest is for the investor to decide.

How high is the pro rata amount under pay-to-play?

Usually the volume of the new round multiplied by the investor's own fully diluted ownership percentage. An investor holding 20% before the round must take EUR 1 million in a round of EUR 5 million to keep its preferential rights. If the rule relates the percentage only to the group of existing investors, the amount is higher, in the worked example EUR 2.5 million instead of EUR 1 million.

Do the shares of a non-participating investor become worthless?

No. The investor keeps its shares with voting rights and its entitlement to its share of the proceeds. It loses only the preferential rights that went beyond the founders' rights.

Does pay-to-play also apply to business angels?

That depends on the rule. In some cases participations below a threshold are excepted; in others the rule applies equally to all holders of preferential rights.

Is pay-to-play already agreed in the first financing round?

As a comprehensive rule for all preferential rights, rather rarely. A narrow form is, however, widespread: anti-dilution protection is tied already on entry to the investor taking its pro rata share in a later down round. Further-reaching consequences such as the loss of the liquidation preference are usually introduced only in a down round or bridge financing, once it is clear that the company needs further capital from its existing investors.

The Roemer Capital view

When a round at a lower price is coming, Roemer Capital talks early with the existing investors: who participates, in what amount and which preferential rights are on the table in return. Roemer Capital calculates the pro rata amounts and the consequences of non-participation for each investor, including the distribution of proceeds at several sale prices.

For Roemer Capital, a pay-to-play rule is not an end in itself but a means of placing a round in full and keeping the preference structure comprehensible for future investors. The legal implementation in the shareholders' agreement and articles of association rests with the company's law firm.