Pay-to-Play provisions require Investors to keep investing (on a proportional or “pro-rata” basis) in future financing in order to keep the preferential rights and privileges of Preferred Stock. If they choose not to participate in future rounds, their Preferred Stock is automatically converted to Common Stock.

These provisions are generally good for the Company and the other Investors who decide to continue to participate. They require Investors to agree to support the Company during its life cycle, they guarantee that all Investors agree to the same rules, and they ensure that only committed investors continue to hold Preferred Stock. For that reason, many Investors will push back against pay-to-play provisions.

Pay-to-play provisions may not be appropriate in early rounds of financing involving angel investors, family and friends, or other investors that do not participate in subsequent rounds as a matter of practice. A pay-to-play provision in that case would penalize them in the future for supporting the Company at the beginning. A contractual carve-out for these Investors can be negotiated and included in the term sheet.
The Company can choose to apply the pay-to-play requirement on all subsequent rounds or limit it only to down rounds. Down rounds are rounds of financing in which the Company’s valuation is lower than it was in the previous round. Pay-to-play provisions are most useful and most negotiated in these rounds, as Investors may not want to be a part of future financing. This provision therefore creates a strong incentive for investors to continue financially supporting the Company.

Term Sheet Language: Unless the Requisite Holders elect otherwise, on any subsequent [down] round all holders of Series A Preferred Stock are required to purchase their pro rata share of the securities set aside by the Board of Directors for purchase by such holders. [A proportionate amount/all] of the shares of Series A Preferred of any holder failing to do so will automatically convert to Common Stock and lose corresponding Preferred Stock rights, such as the right to a Board seat if applicable.