What is a “Pay-to-Play” Financing?

Let’s start with a hypothetical: Tough Times, Inc. is in the market for another round of financing. By “in the market,” we mean they have spoken to dozens of ventures funds, have had first meetings with many and second meetings with some—via Zoom, of course. Tough Times has raised prior rounds of financing at very favorable terms and valuations over the course of the past three years, has double-digit revenue and before the COVID-19 pandemic was looking at a stellar 2020. Then in March things started to go sideways for Tough Times—some clients cancelled, some prospects didn’t sign their contracts, their revenue forecast needed to be changed, they had to lay off some people, they reduced salaries… Sound familiar? Now, in order to stay alive, Tough Times needs an infusion of capital. What are they in for?

The past 10 years have seen largely favorable terms for many startups raising capital. Many rounds are closed quickly with what we all have come to accept as “typical” terms, such as 1x non-participating liquidation preference, dividends only upon an exit (if declared), broad-based weighted-average anti-dilution protection, simple and standard protective provisions and increases in valuation from round to round. That may change, however, as this economy starts to show additional signs of weakness that extend deeper into the private funding market.

Back to our company: Tough Times does not receive a term sheet. They continue to tighten their belt and look at ways to extend runway, including adjusting payables and reducing costs everywhere. Then, they get a term sheet from Opportunity Ventures (this is a fictional name so apologies if there is an actual “Opportunity Ventures”). The founders think it looks a little “off,” so they send it to their lawyer for a look. She says, “This is a cram down, with a pull-up.” Huh? Not knowing what these terms mean, they jump on a call with their lawyer and she walks them through the terms of the proposed “cram down” (also called a “pay-to-play”) as follows:

1. All current preferred stock is converted to common stock at a 1:1 ratio. That ratio can be negotiated but it is meant to “wipe out the preferred.” Typically, this is already provided for in the charter, so there is no need for a charter amendment unless the financing imposes a harsher ratio, such as a 10:1, or worse. It will, however, require a vote of the stockholder, so they need to be on board.
2. Opportunity Ventures proposes that immediately after the forced conversion, they will lead a preferred stock financing at a valuation of roughly 25% of that of the last round. Again, this valuation is negotiated, but the concept here is a “reset.” This is clearly a “down round.”
3. As part of their proposal, Tough Times suggests that the company hold a “rights offering,” whereby all preferred stock that was just converted to common stock will be given the opportunity to participate in the financing led by Opportunity Ventures. If they participate at their pro rata level then the common stock that was just converted from their preferred stock will be “pulled up” and re-converted to a new series of preferred that sits just below (in liquidation preference priority) the new preferred stock that Opportunity Ventures is buying. The “pulled up” preferred stock will have a liquidation preference of 25% (negotiated) of the prior preference, and will represent the same number of shares prior to the preferred stock conversion (depending on the ratio at which the preferred was just converted). The level of participation that will trigger the “pull-up” is also negotiated, but it often starts with full pro rata.
4. Opportunity Ventures will “back stop” the rights offerings by covering any former stockholders’ pro rata investment. That way, the company can be assured of raising a certain amount of funds. This is ideal for Tough Times, but does not always happen.
5. Certain members of management are being granted equity in the form of options after the closing of the financing at the new post-closing 409A price to account for the dilution and keep them incentivized. The approval of this needs to be carefully considered.
6. All outstanding options will be “repriced” down to the new 409A that will be obtained after the closing of the financing. This is often done so that the employee equity maintains some of its value and does not get wiped out.
7. Opportunity Ventures includes the following terms for the new preferred:
1. 2x senior liquidation preferred (but not participating). This may not be too bad depending on round size, but Tough Times should ask for 1.5x.
2. 8% accruing and compounding dividends. On a large round these could add up fast, so let’s push back here.
3. Full ratchet anti-dilution protection. This kind of protection is sought so that in the event of another down round, the investors’ share price gets adjusted to that new, lower price. This is also negotiable and sometimes we ask it to sunset after 12-18 months.
4. Veto on M&A that returns them less than 3x their money. As a reset financing, a multiple may be acceptable for a finite period of time, so let’s ask for 1.5x.
5. Heavy handed protective provisions—actions for which you need investor consent. Let’s see if we can push back as much as possible here.

This is a fairly standard cram-down or pay-to-play financing. Sometimes it’s called a recap. They can get a lot more onerous, as well as complicated. Currently, we are not seeing a lot of financings like this, but it is still early days and they may start to pop up more and more. Some would say that the venture capital industry was due for a valuation reset, and we are surely seeing that. Valuations are coming down. But deals are getting done. We have also seen some equity term sheets shift to convertible debt term sheets. Debt is treated differently, and with higher priority in a bankruptcy scenario, so some investors may feel more comfortable in that position right now.

Key takeaways:

1. Venture capital will be flowing but terms may shift so start talking to your advisors that are familiar with these types of scenarios and have been through other down cycles.
2. There are some important corporate governance aspects to these financings which need special attention, so founders should lean on board members and investor board members should seek guidance when making decisions. Close attention needs to be paid to the fair treatment of all similarly situated stockholders, and treatment of the common stock in particular.
3. VC funds are in the business of investing and many of them have raised new funds recently, so they will need to deploy that capital; strong and seasoned funds will be less harsh with their terms than newer, less experienced funds.
4. Deals may take longer to close as funds may take a wait-and-see approach at certain inflection points such as the end of a quarter.
5. Particular industry sectors may not see terms like this at all and may in fact experience growth.

Given the current economic uncertainty and complexity surrounding cram-down deals, it is highly recommended that you first discuss your approach to such financings with your legal counsel. Fenwick's legal team addresses these issues for clients on a daily basis, so if you have questions, please contact us at your convenience.