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Pay to Play Rounds in Venture Capital - The Bane of the SPV

A pay to play round in venture capital refers to a provision in a term sheet that requires existing investors to participate in subsequent rounds of investment to maintain their ownership percentage; if an investor does not participate, they may face consequences such as outsized dilution of their ownership stake or have their shares relegated to a lower share class (e.g. conversion from preferred to common), among other severe penalties. These provisions are used to incentivize ongoing support from existing investors and ensure commitment to the company in the long term. 

Pay to play provisions typically happen in companies that are substantially underperforming. 

The typical company that puts together a pay to play is likely 1) underperforming, 2) short of cash/runway, 3) having difficulty raising capital. It may and often is a last ditch effort to get a round together and is put into place to basically force the hand of existing investors e.g. if you don’t invest your pro-rata, your preferences (e.g. payout order, liquidation preference, etc.) may be relegated and/or you may be diluted to the point where your ownership stake is a small fraction of what it would be were you to satisfy your pay to play minimum threshold. 

The penalties of these rounds vary substantially. Unfortunately, we were active in 2021 and we are still seeing the effects of that overexuberance with a number of pay to play rounds from that cohort primarily. 

I’ve seen pay to play rounds in which investors are essentially diluted to nothing (e.g. diluted 90%+) if they don’t invest their full pro-rata with no partial benefits. I’ve seen others that are less penalizing e.g. the company will provide investors benefits if they invest their pro-rata (e.g. warrants, increased ownership or other), but if you don’t participate, the investor won’t realize any other penalties outside of standard dilution. 

The worst pay to play round I’ve experienced is happening right now. 

The company in reference did a pay to play less than a year ago that penalized non-participating investors by converting them down 10 to 1 on their share count (e.g. 90% dilution) and converting them from preferred share class (benefits of this class include liquidation preference, dividends, etc.) to common share class (share class subordinate to common) if they don’t invest their pro-rata. That was difficult, but understandable given the environment - many companies needed to adapt to the post zirp world and reset and the VC market was incredibly dire post zirp (zero interest) era. Without these extreme penalties it's possible the company in reference wouldn’t get insider participation and die. 

The inexcusable part is that the company is doing it again, less than a year after that very difficult (but understandable) pay to play - investors are being told if we don’t invest again our pro-rata we’ll be diluted 10 to 1 (90% dilution) and converted to common. And our pro-rata is a lot for an SPV - in the seven figures. I have never seen back to back pay to plays that are this penalizing within months of each other. 

I’m hoping these penalties will change as I’ve explained to the Lead investor dictating that at these terms, there will likely be no opt in from our LPs as trust with the VC/management is completely gone. I know that there will be no way to recover $1M+ from LPs especially with no assurance that the lead VC won’t put forth another highly punitive pay to play months later. If this moves forward it’s also clear that the management team has no interest in protecting small investors. I’m hoping the pay to play in this round changes, but if it doesn’t I’m considering putting this fund on full blast in a future Last Money In post for basically squeezing out all small investors for no reason - more on why this is in a future post.

Why this is so painstaking for an SPV in particular is because unlike a fund, an SPV has to raise capital on a deal by deal basis to fill our pay to play pro-rata amounts. 

A fund typically has part of their fund reserved for pro-rata (20-50% typically) and thus internally has assurance that if they want to participate in a pay to play round, they have the capital reserves to do so without having to go out to market to raise capital.

SPVs don’t have that luxury. Additionally, LPs often either don’t want to invest their pro-rata amount - they’d rather let the investment die because they no longer believe in the company or can’t afford to invest their pro-rata, or may just be too busy with life to care.

This is a huge problem for SPVs as pay to play penalties affect us negatively on the SPV level, not on the LP level. Meaning if half of the SPV LPs want to take their pro-rata and avoid the penalties, but half of the LPs don’t, then the entire SPV vehicle may be subject to the pay to play penalties as pay to play penalties may not have partial benefits, meaning you must take your entire pro-rata or the entire SPV is penalized. Full LP participation is required in these circumstances. 

To use a very simple example - let’s say we have 100 LPs who need to invest $10k each for the SPV to cover their $1M pro-rata (i.e. 100 LPs x $10k = $1M pro-rata for the SPV). 50 LPs invest their $10k and 50 LPs do not, leaving the SPV $500k short of the $1M pro-rata. The entire SPV is penalized with the pay to play penalties despite half the LPs putting up their pro-rata. 

And this really sucks - yes it sucks for the GP, but most importantly it’s horrible for the LPs who want to protect their ownership stake but can’t unless they’re willing to personally put up the capital to cover all of the LPs who don’t want to invest their pro-rata, which understandably LPs don’t want to do… 

My partner Alex can attest to this as he has run multiple pay-to-play rounds via  follow-on SPVs, and it is very rare to get the new buy-in to re-invest and not get heavily diluted. In his P2P rounds, generally speaking, the majority of existing investors do not want to deploy more capital at the current state of the business and there are typically few new investors, even at attractive terms that come into these rounds, making P2P rounds for SPVs a major challenge as it exists today.

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So what are the options for GPs in this situation 

• Try to negotiate better terms with the lead investor dictating terms and/or company (difficult, but sometimes they can be persuaded) 

• Capital raise from external investors - offer them outsized ownership in your vehicle if they can fill the gap on your pro-rata amounts 

• Try to get a few LPs to step up and cover the remaining outstanding pro-rata amounts

• Incentivize participation from LPs by offering them 0% carry on the vehicle - this is something we almost always do on pay to play rounds 

• Fill the pro-rata gap yourself as the GP - unfortunately many will not be able to do that. One of our pro-rata amounts was over $1M that we needed to fill and of course this is not possible for many GPs, ourselves included. 

• I’m open to other options if you have suggestions

The silver lining (if you can call it that) is that almost all of the pay to play rounds I see end up underperforming anyways, but that doesn’t mean the GP shouldn’t evaluate them as there is a small percent that end up figuring out post pay to play. 

One of the worst behaviors I see in this market is that the vast majority of SPV GPs that raised for companies in 2021 aren’t even evaluating those pay to play rounds for their LPs. 

As an LP, how do you know if you fall into this bucket - if your GP isn’t syndicating follow-on rounds from the 2020-2022 cohort or isn’t communicating in general, they’re probably not evaluating your pay to play rounds. This may be very bad as your ownership may be wiped out and you wouldn’t even know it. 

If the company ends up going bust, then it will end up okay, but if they end up figuring out post pay to play and you weren’t offered an opportunity to maintain your pro-rata that may be a tough situation. Just one of the many other reasons why it’s extremely important only to invest in SPVs run by GPs who will stick around!

If you enjoyed this article, check out our past articles discussing GP/LP relationships:

• 🧠 From LP to GP → 10 Valuable Learnings for Success as an LP in VC Syndicates

•  😡 Syndicate GPs – Worst Practices & Concerns

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✍️ Written by Zachary and Alex