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.
Article Contents
Template model
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.
Key Terms
What is a down round?
What is a pay-to-play provision?
How do pay-to-play down rounds affect existing SAFEs?
Take as an example the following scenario:
The company raised significant capital via SAFEs at valuation caps that are higher than they expect to be able to raise in a new round.
The company needs to raise additional capital.
The company will raise a down round.
If it is a SAFE round, the new valuation caps will be less than those of the existing SAFEs.
If it is a priced round, the pre-money valuation will be less than the post-money valuation caps of existing SAFEs.
New and existing investors are expected to be less likely to invest in the down round, interpreting the reduced valuation as a negative signal of company trajectory.
The company implements pay-to-play provisions as part of the new round to incentivize existing investors to further invest in the company.
These pay-to-play provisions impact existing SAFE holders either favorably or unfavorably - see the mechanics of how in the next section.
What are the potential pay-to-play provisions to address a down round scenario after raising on SAFEs?
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:
If existing investors don’t participate in the new round, their SAFEs could:
Lose certain investor rights (such as voting or pro rata rights)
Convert to common shares or a less favorable class of preferred shares
Get unfavorable amended terms (such as a higher valuation cap, lower discount rate, and/or lower principal investment amount - note amending the principal will likely require meeting a higher investor approval threshold)
If existing investors participate in the new round, their existing SAFEs could:
Convert to a more favorable class of preferred shares
Get favorable amended terms (such as a lower valuation cap or higher discount rate)
Communication with existing investors
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.
General best practices
Effective investor communications generally include:
Why the company needs further capital
Business context for the down round
An explanation of the pay-to-play provisions and how they will impact existing investors
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.
Tactical tips
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.