Investment in startup businesses is a simple and straightforward concept.
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Venture capitalists and others invest in the fledgling company in exchange for a share of equity. Equity ownership is usually distributed as shares of preferred stock that can be converted to common stock at a later date.
The situation gets more complicated in subsequent investment rounds. As additional investors inject cash and receive equity, the ownership percentages of the original investors are devalued or "diluted". To protect themselves, VCs and other investors require anti-dilution clauses in the investment contract. These clauses preserve their ownership shares despite the equity distributions in later investment rounds.
So what's the problem? For company founders and common stock holders, the issue is that antidilution clauses discourage new investment and force them to carry the burden of dilution. Antidilution clauses also create a scenario in which early investors reap most of the benefits of additional investment, which is sometimes necessary to keep the business afloat.
Pay-to-play provisions can go a long way toward minimizing the negative consequences of anti-dilution clauses for later investors. Although investors may not be keen on the idea, founders and common stockholders feel that pay-to-play antidilution is a fair and equitable investment practice:
- Pay-to-play provisions require investors who are protected by antidilution clauses to participate in subsequent investment rounds or lose their antidilution protection. Frequently, the investor or stockholder is required to purchase a prorated share of stock in the new investment round.
- If the investor refuses to participate at the required pay-to-play level in subsequent investment rounds, his share in the company is significantly diluted. Some play-to-play provisions even require the investor's preferred stock to be converted to common stock, stripping the investor of exit preferences and other advantages.
- There are a number of circumstances that could make it impossible for an investor to fully participate in a subsequent round of investment. Rather than completely eliminating the investor's antidilution protection, pay-to-play provisions typically accommodate partial investments with prorated anti-dilution benefits.