Term Sheet Template - National Venture Capital Association (Page 14 of 25) in pdf

should lose at least some privileges thereafter. However, many larger Investors may require that a pay-to-play provision

apply in any future financings, including up rounds. This seems to rely less on policy and more on self-interest of the

larger Investors to ensure that their syndicates contain only sufficiently capitalized members committed to providing the

funding required to achieve a successful exit.

For the pay-to-play to apply to only Major Investors, pay-to-play provisions need to be contractual

outside of the Certificate of Incorporation; within the Certificate of Incorporation, all shareholders holding the same

class of shares need to be treated in the same manner. Having the pay-to-play apply only to “Major” Investors (or any

subset of Investors for that matter) is relatively uncommon at this time. However, when negotiating the term sheet,

Company counsel should take into account whether there are existing groups of Investors who will have Preferred Stock

(i.e., if this is a Series B round, or if earlier Investors with convertible notes will convert into Series A as part of the

financing under negotiation) who will object to pay-to-play provisions. There may be good policy reasons for giving an

“out” of the pay-to-play provisions to angel groups and certain early stage Investors who fill a crucial funding gap in

seeding start-up companies (e.g., these types of Investors have fulfilled their ‘mission’ in providing the early stage

capital, and they often don’t have the capital or the contractual ability to invest in increasingly large future rounds).

This being said, larger venture funds are often unwilling to allow for any such exceptions. Additional exceptions

commonly discussed include exceptions for corporate venture funds (i.e., Intel Capital) or an institution that is receiving

or purchasing Preferred Stock as part of a spin-out of the Company’s core technology.

Company counsel (in its role as advisor to the Board) should keep in mind the conflict of interest this

particular provision may cause in the common situation where the Series A Directors are designated/elected by the

largest Series A Stockholders which will also be the Investors who are most likely to participate in a future financing

(and thus avoid the negative consequences of the pay-to-play provision). Including the requirement that the Series A

Directors consent to waiving the pay-to-play may mean, in effect, that the pay-to-play provision may never be waived,

since these designated Series A Directors may feel the need to abstain from any such vote, consent or waiver on such a

topic, potentially leaving the Company unable to meet this requirement.

Company counsel or the non-lead Investors may consider negotiating some additional exceptions or

limitations to the pay-to-play provisions. There are many types of exceptions and limitations that may be negotiated,

including:

•

A provision that after any Series A Stockholder (together with its affiliates) has invested a

certain amount in future financings, the pay-to-play provision will no longer apply to such

Series A stockholder (and its affiliates). This could be expressed as a certain dollar amount,

but may make more sense expressed as a multiple of the original Series A investment made

by such Investor (i.e., after any Investor and its affiliates have made additional investments

of 1x, 1.5x, 2x, etc. times their original Series A investments, then the pay-to-play no longer

applies).

•

A provision that there may be only one dilutive financing triggering the pay-to-play

financing in any twelve-month period.

•

A provision that if a dilutive financing is in excess of a certain amount (i.e., $10,000,000),

then each [Major] Investor is only required to invest its Pro Rata portion of such threshold

amount in order to avoid being punished by the pay-to-play provisions.

•

Carve-outs for angel Investors, angel funds, seed stage Investors, institutions or corporate

Investors.

•

Provisions that the pay-to-play only applies to certain series of Preferred Stock.

In negotiating carve-outs, as with all portions of the pay-to-play, keep in mind the general rule that each

share of stock of the same series must have the same rights, preferences and privileges as other shares of the same series

– so that the more specific a carve-out becomes, the more thought needs to go into how to appropriately draft such

carve-outs. Disparate treatment among holders of the same series should be address through contractual provisions

outside the Charter. See discussion in footnote 18, supra.

Alternatively, this provision could apply on a proportionate basis (e.g., if Investor plays for ½ of pro rata

share, receives ½ of anti-dilution adjustment). Note that the pay-to-play provision upheld in Watchmark provided for

such proportionate application.

If the punishment for failure to participate is losing some but not all rights of the Preferred Stock (e.g.,

anything other than a forced conversion to common), the Charter will need to have so-called “blank check preferred”

provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished

ABA Comments to NVCA Term Sheet - Final Version.DOC

Term Sheet Template - National Venture Capital Association Page 14

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