Venture Capital Term Sheet: Pay-to-Play Anti-Dilution
Recap: What are Anti-Dilution Provisions?Dilution prevention provisions are designed to protect the investor from dilution that may occur in subsequent financings where stock is sold at a price lower than the investor originally paid. The anti-dilution formula provides for an increase in the conversion rate of the preferred stock (and therefore a lower effective per share price on a common stock equivalent basis) in the event of a subsequent financing at a price less than that paid for the preferred stock being adjusted. A future financing sold at a price lower than in the prior round is called a "down round" or a "washout financing" (see the box at the end of the chapter discussing washout financings). Down rounds occur more frequently than you might think (approximately 20% of financings each year are down rounds). As a result, investors will generally insist on anti-dilution provisions to prevent dilution in the event of a future down round.
What are Pay-to-Play Provisions?One other wrinkle on anti-dilution clauses is the so-called "pay-to-play" provisions, which require the investors to participate in the dilutive round in order to receive anti-dilution protection with respect to their higher-priced preferred stock.
What percentage of financings have "Pay-to-Play" Provisions?Series A 13% Series B 15% Series C 22% Series D 27%
% with Pay-to-Play by Quarter
Q2 2007 14%
Q1 2007 9%
Q4 2006 11%
Q3 2006 8%
Q2 2006 11%
Q1 2006 13%
Source: Private Company Financing Report, Cooley Godward Kronish LLP, November 2007 (By Quarter), April 2006 (By Series, transactions from 2004-2005).