Term Sheet Template - National Venture Capital Association (Page 13 of 25) in pdf

provision. The contractual (vs. Charter) approach is important in the event not all holders of the same series will be

treated in an identical manner (e.g., strategic corporate Investors) (see footnote 20). For an example of a contractual

waiver model of a pay-to-play provision, please see Venture Capital & Public Offering Negotiation (3

ed.), Holloran et

al, Aspen Law & Business (pp. 8-47 through 8-50). See also drafting considerations discussed in footnotes 10-14, infra.

There are many points in the Term Sheet where Company counsel can (and in some cases, should) solicit

the assistance or counsel of other Investors in the Company before the Term Sheet is signed. The pay-to-play provision

is of particular importance to non-lead Investors. Even if the Company itself may be in favor of a pay-to-play provision

(e.g., future funding incentive, possible preferred overhang reduction, etc.), if the Company has had prior Investors (i.e.,

angel rounds, convertible debt rounds, etc.) or if the Company and/or its officers have been the main point of contact

with some of the non-lead Investors in the financing under negotiation, Company counsel should make sure to point out

to these non-lead Investors the likely consequences of this particular term and allow them the opportunity to have input

on either negotiating the pay-to-play out of the Term Sheet or negotiating limitations and exceptions.

Note that the legality of a pay-to-play provision is arguably more certain following the recent Watchmark

case in Delaware. Watchmark Corp. v. Argo Global Capital, LLC et al, 2004 Del. Ch. LEXIS 168; app. denied by

Watchmark Corp. v. ARGO Global Capital, LLC et al, 2004 Del. LEXIS 175 (Del., Nov. 15, 2004); app. denied by

ARGO Global Capital, LLC et al v. Watchmark Corp. et al, 2004 Del. LEXIS 551 (Del., Nov. 23, 2004). This case held

that, at least in certain circumstances, a pay-to-play provision will be enforceable. Since pay-to-play provisions are

often adopted in connection with a down round financing (including being put in place on the eve of such a financing),

similar considerations apply to the adoption of pay-to-play provisions as apply to other terms of such a financing (e.g.,

whether the Board complied with fiduciary duties owed to its current shareholders in accepting terms which may cause

certain shareholders to lose rights as a result of the pay-to-play). This is particularly true where the Company is

negotiating with a subset of its current Investors who are providing the new capital, and the pay-to-play affects other

Investors who are not in a position to participate or negotiate the terms. Company counsel should advise the Board to

specifically consider the pay-to-play provisions when making its decision on whether the terms of the financing are in

the best interest of the Company and its stockholders.

In some circumstances, particularly in Series B or later rounds where a subset of prior Investors is leading

the new round, the participating Investors expect that the pay-to-play provision being adopted in connection with the

financing under negotiation will apply to non-participants in that same financing. In other words, the pay-to-play isn’t

being adopted merely to provide incentive to participate in financings that may occur at some time in the future, but it is

to be applied immediately as a punishment (or, in the eyes of participating Investors, an appropriate incentive to

participate and adjustment for not) to those not participating in the current financing. This is sometimes referred to this

as an ‘eve of financing’ pay-to-play, and the Company’s board of directors should be particularly mindful of its

fiduciary duties (and possible self-interest in the case of certain directors) in such cases.

In some Series B or later rounds, participating Investors want to provide strong incentive for prior

Investors to participate in the current round but do not have the voting power that would be necessary to alter the terms

of the currently outstanding series of Preferred Stock (i.e., in order to put an eve-of-financing pay-to-play in place with

respect to already outstanding shares). In these cases, Investors will often achieve a similar result to an eve-of-financing

pay-to-play by structuring the financing as a “pull-through” financing. In a pull-through financing, those holders of the

existing Preferred Stock (let’s say there are Series A Preferred Stock outstanding and the Company is negotiating a

Series B financing) who elect to participate in the Series B financing are allowed to “pull through” or exchange or

convert shares of their Series A stock for shares of either the new Series B or, more often, shares of a new series of

Preferred Stock (i.e., Series A-1 or Series B-1) which is similar to the Series A, but senior in liquidation and convertible

at a much better rate. The purchase price of the Series B financing (and the conversion rate of the new Series A-1) is set

in such a manner as to reflect what the new Investors perceive to be a correct valuation of the Company, taking into

account any anti-dilution adjustments that the non-participating Series A stockholders will experience upon issuance of

the Series B and the new Series A-1, which may be significant. This usually results in a dramatic change in the number

of shares outstanding and can be demoralizing for management, unless the financing is accompanied by a new set of

option grants based on the new fully-diluted capitalization. The new option grants would not remedy the situation of

those Common Stockholders who are not current employees, so the potentially drastic dilution such non-employee

Common Stockholders will face should be considered by the board of directors when considering whether to accept the

terms of such a financing.

Note that the rationale for having a pay-to-play is stronger in “down rounds” (or “Dilutive Issuances” in

more common Charter parlance), reasoning that those who aren’t willing to back the Company when its outlook

becomes bleaker should not get the benefit of any price protection adjustments arising in the down round financing, and

ABA Comments to NVCA Term Sheet - Final Version.DOC

Term Sheet Template - National Venture Capital Association Page 13

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