Earlier this year, the law firm Fenwick & West published a report analyzing the financing terms of 37 U.S.-based venture-backed companies that raised money at valuations of $1 billion or more in the 12-month period ending March 31.
The report’s headline-grabbing conclusion was that in all cases, the investors had received significant downside protection in case the companies’ value declines. (Called a liquidation preference, the companies’ later-stage investors basically received the right to get paid ahead of other investors, as well as the companies’ management teams and employees.)
The findings were a revelation, but they didn’t provide a complete picture of what could happen in a downturn. In fact, there’s a giant hitch the report did not touch on, and that’s pay-to-play provisions, which became routine during the dot com bust of 15 years ago and could well become commonplace again if things head south.
“VCs, especially people who’ve been in the business a long time, understand them,” says attorney Barry Kramer, who authored the Fenwick & West report and more recently wrote on Medium about pay-to-play provisions. “It’s part of their calculation. I’m not sure that a good chunk of newer investors, whether non-traditional or because they’re just younger or whatever, have this scenario in mind.”
Pay-to-play provisions mean if a company needs to raise money and resorts to insiders for it, those who can’t or don’t want to contribute their pro rata share will see their preferred shares reduced to either common stock or some other subset of equity with fewer rights. In short, an investor who doesn’t pay up can forget about getting paid before others or guarantees they’ll get all their money back. Those terms and conditions put in place in exchange for a lofty valuation? Gone.
The impact can be far-reaching. Deep-pocketed mutual funds like T. Rowe Price might seem immune to pay-to-play provisions. But if the stock market were to fall broadly, they’d most likely look to reduce their risk exposure. Similarly, in a downturn, corporate VCs could decide, as they have in the past, to shut down their venture arms and write off their losses.
Both would leave earlier-stage investors — who typically have much smaller funds — holding the bag.
Pay-to-play provisions are easier to slap on to a deal than you might think, too. As long as a majority of shareholders gives other investors a reasonable amount of time — 30 to 60 days, typically — they can change earlier agreements that seemed iron-clad previously.
This is especially true in a “disaster scenario,” observes investor Paul Madera, who cofounded the late-stage firm Meritech Capital Partners in 1999 and has seen a tech crash up close.
“Early-stage investors in particular tend to dominate a company’s board [and to] protect their investments,” says Madera. And they can “agree not to vote on a deal unless you modify your terms. These rights in downside cases can go away or get negotiated or changed.”
Luckily for entrepreneurs and investors alike, pay-to-play provisions aren’t an issue right now, says Craig Dauchy, head of the venture capital practice group at the law firm Cooley. In fact, Cooley publishes a quarterly financing report that tracks the deals it does each year, and Dauchy says pay-to-play provisions are appearing in “fewer deals than you might expect.”
Of those companies with which Cooley works, pay-to-play provisions appeared in 11.9 percent in Series D or later deals last year, down from 13.8 percent of deals in 2013.
Still, Dauchy notes that “that could change as you see more of these companies go public at less than their private valuations.”
Kramer is even more sure of it. “We’re still in relatively good times now, so people aren’t focusing on pay-to-plays. If someone were to say it’s a significant issue now, that’s absolutely not true at this moment.”
Kramer is looking to the future, though. And he thinks newer investors would be wise to do the same. “There’s nothing static in this environment. You need to be preparing for the changes.”
Especially investors with a growing number of stakes in so-called unicorns.
“We’re absolutely due for a valuation reset overall,” says Madera. ” I think the most vulnerable companies will be those that have raised the most money and given out these sort of terms in their last round or two. Those that have raised less money, they’ll have fewer issues.