The Return of 'Pay or Play'

Joseph W. Bartlett, Founder of VC

A recent article by Vyvyan Tenorio in the Daily Deal highlights a situation in which the 'Pay-or-Play provision is appropriate ... and, from my experience in today's private equity financings, 'pay or play' is making a comeback. In the not so distant past, 'pay or play' was a non-starter. But, that was then and this is now. Let me quote briefly from above article:

"But the new money comes at a steep price for Yodlee's previous investors and for the company, which as of late 2000 had a nominal value of $342 million, according to documents filed with the Securities and Exchange Commission. The round significantly dilutes all but two equity holders while buying Warburg an undisclosed majority stake with two board seats.

"Early backer Accel Partners of Palo Alto, Calif., put in $4 million, allowing it to retain its board seat. But all the rest of the company's early investors were washed out. Atlanta-based $1 Corp., which previously owned $33% of the company, did not participate in this round, although it is keeping its board seat. All other investors, including original backer Sequoia Capital of Menlo Park, Calif. Bank of America, J.P. Morgan Chase & Co.; Intel Capital; AOL Time Warner Inc.; Merrill Lynch & Co.; Morgan Stanley and E*Trade, also did not participate, which means their preferred shares became common stock."

There are several possible explanations for what happened in the Yodlee transaction; but, for present purposes, it is not material exactly what went on in the board and conference rooms when the financing was negotiated. What we can conjecture, for purposes of this discussion, is that the investors who did not participate were saddled with a 'pay or play' provision in their various preferred stock agreements ... and the non-players paid.

What the provision means is as follows: An existing holder (and let's use a straight convertible preferred stock, with weighted average anti-dilution protection as our hypothetical) must "play," meaning participate in subsequent rounds of financing, or "pay" a penalty. If the existing holder of, say, Series A convertible preferred participates, i.e., "plays," in the wash-out round, then it protects its percentage interest in two ways. First, by buying new stock at a cheap price up to (presumably) the limit of its pre-emptive rights, it stays abreast of its fellow shareholders percentage-wise when the round is closed. Secondly, because the upcoming round is a "down round," the holder is able to get its conversion formula adjusted so as to entail more conversion shares, presumably at the expense of the common, by virtue of its anti-dilution protection.

Of interest in this context, is the possible impact of the "pay" clause if a given Series A holder does not participate. Typically, the holder "pays" by virtue of the fact that its anti-dilution protection will not operate in the down round ... and, indeed, may be stricken from the governing instruments by virtue of the holder sitting on the sidelines in the face of a round of financing which, all would assume, is badly needed. Perhaps the most Draconian penalty, under the label of "pay," is that the Series A non-participant winds up compelled to convert into common stock, thereby sacrificing not only the liquidation preference and accruing dividends but also all the other special rights which we are accustomed to attach to preferred stock.

In a recent mock negotiation in which I participated at Morrison & Foerster, we talked about 'pay or play.' Fred Wilson, the VC (represented by Jay Rand), made the point that 'pay or play' is a two edged sword; it is either a benefit or a penalty depending on the circumstances. If one's client is either the founder or an investor in the instant round, 'pay or play' can take away a lot of the competing liquidation preferences and other special rights of the non-players and thus, can help clean up the balance sheet for future rounds. (For more on this, see "Crunch Time" in The Daily Deal.) If, on the other hand, a VC has fallen out of love with the company or is winding up its current fund and does not have available capital to play in the current financing, then 'pay or play' (particularly if the 'pay' provision is forced conversion) can be a significant drag on the ultimate outcome. Thus, because of the somewhat aleatory aspect of 'pay or play,' there was a long period of time when it was not popular at all. However, in today's environment, when new investors condition their capital infusions on the ability to cram down the prior shareholders, including not only the common but also the earlier series of preferred, we are seeing 'pay or play' more often in the term sheets of all relevant rounds of financing.