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“Pay-to-Play” Provisions Making a Return in Venture Financing

April 12, 2023

In recent months, we have begun to see venture financing rounds that include the negotiation of “pay-to-play” provisions. These provisions have been largely absent in recent years due to the buoyant financing environment. However, at times when companies face greater challenges in raising funds under their current capital structure, these powerful recapitalization tools may be deployed to encourage reinvestment and new investment into a company. “Pay-to-play” provisions can help deliver the necessary funds, but it is important that companies evaluate and implement them in a manner that anticipates and mitigates the associated risks.


In financing rounds that include some element of recapitalization, a company will seek to attract new financing by modifying the economic rights of prior investment rounds, including the priorities, liquidation preferences or valuations of one or more classes or series of preferred shares.

“Pay-to-play” provisions take different forms, but their fundamental purpose is to incentivize existing investors to continue to support the company. These terms can be presented to investors as a carrot or a stick (or both together) and may have been incorporated into a company’s governance documents during a prior financing round or, as we are now seeing more frequently, introduced in the context of a new round of investment where subscriptions are falling short of the company’s needs.


A common “pay-to-play” approach is to punish existing investors who fail to take up their pro rata share of a new financing round by compelling the conversion of some or all of their prior investment into either common shares or a newly created class of preferred shares having reduced economic entitlements.

In the case of a conversion to a new class of preferred shares, other rights associated with the existing class of preferred shares, such as voting approvals, board participation entitlements, pre-emptive rights to participate in future financing rounds and other rights provided only to so-called “major investors” may be adversely altered. The conversion can be imposed on all shares held by an investor that does not subscribe for its full entitlement in the new financing. Alternately, only a portion of the investor’s existing shares may be converted, in a manner that correlates to the proportionate participation in the new round. The distinctions among classes and series of existing preferred shares may be preserved by conversion into distinct new classes or series, or all converted shares may be consolidated into a single class. There is a broad range of possibilities.


“Pull-through” or “pull-up” transactions, by contrast, offer existing investors a reward for participating in the new financing round. While they take various forms, the general idea is that an investor has the opportunity to exchange existing preferred shares for a new class of preferred shares, based on the degree of their participation in the new financing.

The new preferred shares may be identical to the investor’s existing preferred shares but superior in priority or may include other superior terms. Existing preferred shares that remain unexchanged may merely be disadvantaged by being subordinate in priority to the new preferred shares or may face compulsory conversion into common shares or a class of preferred shares having reduced rights. In the latter circumstances, the reward of a beneficial share exchange offered to participating investors is coupled with the punishment of an adverse share conversion imposed on investors who do not adequately participate in the current financing — the carrot and the stick.  


Earlier this year, it was reported that Silicon Valley heavyweight Sequoia Capital declined to participate in a “pay-to-play” financing proposed by one of its portfolio companies. Faced with the decision to either reinvest or suffer a level of dilution that would largely eliminate its existing investment, Sequoia walked away, and its representative resigned from the company’s board. While the company succeeded in raising the necessary funding from other existing investors, this is a cautionary tale for companies pursuing a recapitalization. In other cases, existing investors have successfully pushed back on proposed financing terms that they felt were overly punitive.

While investors recognize that companies require adequate funding to execute their business plans, they may feel that their continued financial support requires not just some form of recapitalization but also that the company identify and implement operational and other changes. Absent such changes, investors may elect to opt out and face the consequences. Conversely, we have recently seen some dramatic recapitalization transactions in which existing shareholders saw most of their existing investment wiped out. However, where the proposal process was transparent and the company clearly communicated its belief that the terms of its recapitalization represented the best path forward, the proposal received strong support. In most cases, a broad range of scenarios will be evaluated in an effort to identify the combination of factors that will result in a sufficiently acceptable outcome for both the company and its investors.


Under Canadian corporate statutes, implementing a recapitalization, including “pay-to-play” provisions, will generally require shareholder approval on a class-by-class basis. While the transaction may receive sufficient shareholder support to enable its implementation, it is important to keep in mind that Canadian corporate statutes (unlike their Delaware counterpart) provide a broad remedy to shareholders who feel slighted. This includes shareholders who feel a corporate action or omission effects or threatens to effect a result that is oppressive or unfairly prejudicial to them, or that unfairly disregards their interests.

In considering and implementing any “pay-to-play” transaction (particularly where the proposed transaction is not provided for in the company’s governance documents and share terms) companies should follow a process that helps mitigate any risk of adverse claims by objecting minority shareholders. This includes carefully evaluating options and making informed decisions, seeking professional advice where relevant, carefully identifying and managing potential conflicts of interest, adequately communicating with shareholders in a timely manner and maintaining a record that evidences the process.

For further information, please contact:

Christopher Jones         +1-416-863-2704

or any other member of our Emerging Companies & Venture Capital group.