What is Pay to Play clause in Investment Agreement?

Legal clause in Investment Agreement

Pay to Play is a very common clause in any investment agreement and plays a very important role in any down round. Down Round refer to a company issuing shares at a price lower than the price at which it had raised previous financing thus indicating the trouble times of the financial health of the company. While raising finance in the down round, the existing investors generally do not wish to be a part of the future funding due to this company’s ailing condition. Hence, to deal with this issue, a clause Pay to Play has gained great popularity among the company and the investors.

Legal clause in Investment Agreement

Lets discuss this with the help of an example of such clause clause .

“in the event that the Company intends to raise further funding by way of allotment of New Securities of the Company, the Investors shall, on a Pro-Rata Share basis, have the right to invest in and subscribe to these New Securities of the Company proposed to be so issued and allotted. In the event the investors do not participate in the future down rounds of the company, the company reserves the right to convert their existing preferred stock into the equity stock and all the anti dilution rights as mentioned in this clause shall cease to be applicable to the investor”

This part of the clause demonstrates Pay to Play, a financing term that is included as a part of a down round which distinguishes on the basis that whether the existing investor is participating or non participating.  We can say that it encourage investors to participate in future rounds of investments mainly down rounds of the company. Simply going by the name of the clause, it suggest that the investors shall have to pay i.e. contribute in the future financing of the company for the sake of playing i.e. check the preferred stock being converted into the ordinary/equity stock. This clause is generally a penal clause by which the investors are barred from gaining all of the rights and benefits in case they do not participate to their full pro-rata percentage of the ownership and can even lead to losing some privileges like anti-dilution protections.

Pay to Play is highly advantageous for both the company and the investor. This clause is highly beneficial to the company since the company is assured of receiving funds by the investor in the future down rounds of investments as well. The consequences of not participating might lead to loss of several rights and hence the investor becomes responsible to carry out the agreement diligently. For the investor, this clause act as a shield to protect their investments and keeping their rights intact thus ensuring that only investors who continue to participate and who remain committed to the company have preferred stock and the associated rights. Moreover, the investor under this clause is also imparted with the right to make first offer in case the company is to have down rounds or the company is up for sale before any other party comes into picture. This clause addresses the “free-rider” issue wherein one investor continues to support the company while the other investors does not. Thus lead investors want the presence of this clause as they would not want the minor investors to derive benefits from their presence and financing to the company. To sum up, we can say that this clause gives a pre-emptive right to the investor to subscribe to the shares at any time before the company approaches any other party for down rounds.

While discussing the benefits, we cannot ignore the risks that this clause reaps. Now that the investors have agreed to participate in future down rounds basis the pro-rata percentage of shares they hold, in case they are unable to participate even in one down round, they shall lose their rights for all subsequent down rounds say their stock shall get converted, loosing liquidation preference and other special rights. Thus sometimes, investors particularly angel investors are discouraged with the presence of this clause since most of the investors do not want to do away with their rights merely because of non performance in the subsequent down rounds.

Now in this period of uncertainty of liquidity of the company due to the Covid-19, it is expected that pay-to-play provisions shall be a part of discussions among investors, both in later-stage companies and earlier-stage companies. Thus, this clause shall gain huge popularity in the funding ecosystem.


Do you wish to incorporate such protective clause in your agreement? Or do you wish to get your agreement drafted? We at Taxmantra have relevant expertise and experience to help you through. Feel free to reach us over here.

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