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For companies that raised substantial capital on SAFEs and aren’t tracking towards their original valuation goals, a new round with pay-to-play provisions may be an effective way to raise necessary capital.
In this article, we discuss down rounds, pay-to-play provisions, and how they apply within the context of outstanding SAFEs.
Like with most fundraising scenarios, the pay-to-play down round’s impact on existing SAFEs is best understood with concrete numbers rather than theoretically.
You can plug in your own startup’s fundraising details in this template model.
There is no universal definition, but a down round is – roughly – a situation where the pre-money valuation of a financing round is lower than the post-money valuation of the previous financing round.
Factors that can lead to a down round include:
Down rounds are often viewed as a negative signal by employees. Fundraising for a down-round valuation can also make it more difficult to attract investors.
One strategy to incentivize existing investors to further invest in the company during a down round is to implement pay-to-play provisions.
A pay-to-play provision refers to an investment term that incentivizes existing investors in a company to participate in a new financing round.
Pay-to-play provisions can either be punitive or rewarding to investors. Punitive provisions penalize investors that don’t participate in the new financing round; rewarding provisions grant benefits to investors that participate in the new financing round. Sometimes, both punitive and rewarding provisions are implemented in the same round – the economic impact can often be the same whether structured as a penalty or award.
Most pay-to-play provisions are contingent on the investor participating their full pro-rata amount in the new financing round, but some only require partial investor participation.
Pay-to-play provisions can strain relationships between investors and the company. As a result, pay-to-play provisions typically arise only when companies have challenges raising capital - as is frequently the case in a down round.
Common forms of pay-to-play provisions include:
The remainder of this article focuses on pay-to-play provisions as applied to existing SAFEs during down rounds.
Take as an example the following scenario:
As a reminder, the underlying goal of the pay-to-play is to incentivize existing investors to participate in the new round.
You can create incentives through implementing one or several of the following provisions:
Without careful communication, punitive pay-to-play provisions may sour relationships between investors and a company. Rewarding pay-to-play provisions may be less likely to jeopardize investor relationships, but may still raise investor concerns about the company’s health.
Effective investor communications generally include:
It’s often useful to approach key investors privately for their buy-in before informing other existing investors. Depending on the investor relationships, founders can either enter these private discussions with a fixed proposal or with several options to discuss together with the key investors.
Existing investors will likely be more open to participating in the new round if they have a clear understanding of how participation (or lack thereof) will impact their ownership stake in the company.
For example, let’s say Company A currently has 5 investors who invested via SAFEs with post-money valuation caps ranging from $1M-$20M (see screenshot below).
Company A offers investors with valuation caps greater than $5M the chance to get their existing SAFE valuation caps amended down to $5M if they participate in the new round (a “rewarding” pay-to-play provision).
As demonstrated in the sample screenshot from our model, Post-Money SAFE investors 3, 4, and 5 would receive a greater number of shares from their existing SAFEs upon a future conversion event if they participate.
Sharing a similar model or otherwise communicating to investors with clear numbers how they would be affected by the pay-to-play provisions may increase the likelihood of their participation.