investment
Pay-to-Play & Pull-Up: How to Get Investors to Invest MORE | Top Business Lawyer Strategies
How to ensure that your investor is committed long-term. Pay-to-play, pull up and control rights as incentives for further investments explained.
Introduction
There are mechanisms that will function as to create a strong incentive for current investors in a company to participate and invest more in future funding rounds. Such mechanisms can be negotiated and implemented in situations where a company is in a strong position visa vi investors. This will often be situations where the company and its founders are choosing between investors, and they want to ensure that the investor they go with really intends to participate and support the company in the future funding round(s)) also. However, the mechanisms can also be negotiated in situations where the markets are on a down turning curve and the current investors in the company are negotiating mostly between themselves as regards if, and how, to support the struggling company that they are invested in.
In this article we explain the fundamentals you need to know, and what the results can be for you and the other stakeholders involved.
Pay to Play
Pay-to play clauses are clauses that impose negative economic consequenses for existing investors if they do not participate in future funding round(s). The imposed punishment will create a strong incentive for the existing investor to participate in future rounds, and thereby also creating a greater deal of certainty for the company in relation to its ability to fill the anticipated future funding round.
Such clauses may in particular be negotiated when a company is struggling and only some of the current investors are willing to support the company with more funding.
Pay-to-play - how they work
Pay to play is condition that punishes investors that do not participate in a future funding round by taking away economic rights that they gained in the prior funding round. You can impose a pay-to-play mechanism in the investment agreement (or shareholders agreement) or it can be negotiated the final night before a new funding round - both versions are as frequently seen on the market.
What will happen is that the investors preference shares will - if the investor does not particpate - be subject to compulsary conversion into common shares. So the investor must take its pro rata share in the future funding round to safe guard its preference shares (they can either be converted into common shares or to a less favoured class of preference shares).
Hence it can be an attractive clause for the company and the founder to have in the investment agreement as the consequenses for the investor that does not participate are severe.
Trigger – most often the pay to play will stipulate that the investor must take its pro rata share in the next funding round in order not to lose an economic it gained when investing the first time around. But it can also be a smaller requirement/ hurdle for the investor to not lose the relevant economic right. For example it can be that the investor must at least take 50 % of its pro-rata share in the future funding round in order for it not to lose its economic right that are at risk.
Other economic rights that could be subject to a pay-to-play (broadly defined as any lose of economic rights):
A) If investor Y falls under 10 % ownership then Investor Y will lose its right to pro rata participation in future funding rounds.
B) If Investor K does not participate in future funding rounds but co-investors I and J do, then only J and I will keep the already awareded anti-dilution protection.
Pull-up
A pull-up is similar to a pay-to-play, but its a mechanism that incentivices an investor to invest in future funding rounds by way of rewarding the investor that takes its pro rata (or other hurdle that has been set) in the next funding round.
The pull-up will mean that the investors shares are subject to a conversion to a better share class - i.e. a better class of preference shares if it invests more.
Notably, this pull-up will not only serve to reward the participating investor but will most likely also function to punish other investor that hold common shares or preference share as they will become subordinate to the class of preference shares that the participating investor gets bumped-up to.
Control rights
Pay-to-play and pull-up will most often be used to refer to the above mentioned economic right or other economic mechanisms (it can be that a liq.pref is adjusted from x3 to x2 or something similar).
Another incentive to get the investor to participate will be to either punish it if it does not participate, by having it lose control rights, or to reward it with more control rights if it contributes in the future funding round(s).
Examples
A) If investor X does not take its pro rata in the future funding round it will lose its right to participate as one of the three investors that jointly has reserved matters.
B) If investor F falls under 10 % ownership stake then it will lose its board position.
C) If Investor U does not participate pro rata in the next tunding round then it will lose its right to invoke an exit provision.
Summary
Having an understanding of the mechanisms typically negotiated and imposed when the company or an investor collective wants to ensure that an investor is committed long-term is key to optimize the process and to be able to seek all the business law tools you need in the fundrasing journey of the company.
London, 2024-09-08
Author: Kat Strandberg
Email: Kat@stgcommerciallaw.com
Introduction
There are mechanisms that will function as to create a strong incentive for current investors in a company to participate and invest more in future funding rounds. Such mechanisms can be negotiated and implemented in situations where a company is in a strong position visa vi investors. This will often be situations where the company and its founders are choosing between investors, and they want to ensure that the investor they go with really intends to participate and support the company in the future funding round(s)) also. However, the mechanisms can also be negotiated in situations where the markets are on a down turning curve and the current investors in the company are negotiating mostly between themselves as regards if, and how, to support the struggling company that they are invested in.
In this article we explain the fundamentals you need to know, and what the results can be for you and the other stakeholders involved.
Pay to Play
Pay-to play clauses are clauses that impose negative economic consequenses for existing investors if they do not participate in future funding round(s). The imposed punishment will create a strong incentive for the existing investor to participate in future rounds, and thereby also creating a greater deal of certainty for the company in relation to its ability to fill the anticipated future funding round.
Such clauses may in particular be negotiated when a company is struggling and only some of the current investors are willing to support the company with more funding.
Pay-to-play - how they work
Pay to play is condition that punishes investors that do not participate in a future funding round by taking away economic rights that they gained in the prior funding round. You can impose a pay-to-play mechanism in the investment agreement (or shareholders agreement) or it can be negotiated the final night before a new funding round - both versions are as frequently seen on the market.
What will happen is that the investors preference shares will - if the investor does not particpate - be subject to compulsary conversion into common shares. So the investor must take its pro rata share in the future funding round to safe guard its preference shares (they can either be converted into common shares or to a less favoured class of preference shares).
Hence it can be an attractive clause for the company and the founder to have in the investment agreement as the consequenses for the investor that does not participate are severe.
Trigger – most often the pay to play will stipulate that the investor must take its pro rata share in the next funding round in order not to lose an economic it gained when investing the first time around. But it can also be a smaller requirement/ hurdle for the investor to not lose the relevant economic right. For example it can be that the investor must at least take 50 % of its pro-rata share in the future funding round in order for it not to lose its economic right that are at risk.
Other economic rights that could be subject to a pay-to-play (broadly defined as any lose of economic rights):
A) If investor Y falls under 10 % ownership then Investor Y will lose its right to pro rata participation in future funding rounds.
B) If Investor K does not participate in future funding rounds but co-investors I and J do, then only J and I will keep the already awareded anti-dilution protection.
Pull-up
A pull-up is similar to a pay-to-play, but its a mechanism that incentivices an investor to invest in future funding rounds by way of rewarding the investor that takes its pro rata (or other hurdle that has been set) in the next funding round.
The pull-up will mean that the investors shares are subject to a conversion to a better share class - i.e. a better class of preference shares if it invests more.
Notably, this pull-up will not only serve to reward the participating investor but will most likely also function to punish other investor that hold common shares or preference share as they will become subordinate to the class of preference shares that the participating investor gets bumped-up to.
Control rights
Pay-to-play and pull-up will most often be used to refer to the above mentioned economic right or other economic mechanisms (it can be that a liq.pref is adjusted from x3 to x2 or something similar).
Another incentive to get the investor to participate will be to either punish it if it does not participate, by having it lose control rights, or to reward it with more control rights if it contributes in the future funding round(s).
Examples
A) If investor X does not take its pro rata in the future funding round it will lose its right to participate as one of the three investors that jointly has reserved matters.
B) If investor F falls under 10 % ownership stake then it will lose its board position.
C) If Investor U does not participate pro rata in the next tunding round then it will lose its right to invoke an exit provision.
Summary
Having an understanding of the mechanisms typically negotiated and imposed when the company or an investor collective wants to ensure that an investor is committed long-term is key to optimize the process and to be able to seek all the business law tools you need in the fundrasing journey of the company.
London, 2024-09-08
Author: Kat Strandberg
Email: Kat@stgcommerciallaw.com