When it comes to venture capital dealings, there are many terms and nomenclature that are unique to this part of the business world. Terms such as “Post-Money Valuation,” “Letter of Intent (LOI),” and “Memorandum of Understanding (MOU)” are typically used and probably make no sense to anybody outside of the industry. Another term that is commonly used (in at least 5% of all deals) is “Pay-To-Play.” Anybody involved in the venture capital world should be familiar with this term, which will be described below.
What Is Venture Capital?
Venture capital (or abbreviated as VC) is a private equity investor that provides funds for a growing company in exchange for an equity stake. Typically, these are startup ventures trying to launch, but often are smaller companies looking to grow. VC firms are usually founded as limited partnerships, where the partners themselves invest in the fund.
And the endgame of the financing usually isn’t to launch startups; in most instances, the companies that receive VC funding have been established and are looking to make it to the next level. Investing in a company isn’t a guaranteed success, but many of today’s most prestigious firms were funded by venture capitalists, including Facebook, Groupon, Zoom, AirBNB and Google, among many others.
How Does A VC Deal Typically Work?
There are four players in a standard VC deal, including:
- The Entrepreneur: The company that is looking for funding to grow to the next level.
- The Investor: The money people who are looking for high returns on their investment.
- The Investment Banker: The institutions that need companies to sell.
- The Venture Capitalist: Those who make their profit by creating a market for the other three players.
Typically, a VC firm isn’t alone when it comes to investing in one company. In most instances, there is a “lead” investor and one (or more) “followers” – companies that invest less into the startup. The goal is to get an attractive return for the VC firm – most VC firms seek to expect a 10X return on the original capital investment over the next five years.
Similar to other types of business transactions (particularly in the M&A space), VC deals usually include a “term sheet.” A term sheet is an agreement that spells out the terms and conditions of an investment. Though it’s a non-binding agreement, it is a template for more detailed documents, some of which are legally binding. In short, it’s a blueprint for the entire deal.
A Pay-To-Play Provision in VC
In short, a pay-to-play provision is a mandate that an investor continues to participate in the funding of a company. While not exactly old-school investment terminology (it has gained popularity post-year 2000), it has caught on and is now a mainstream investing instrument and not fringe ideology. Pay-to-play requires that an investor must continue investing (where “pay” comes in) in order to “play” (meaning to avoid having its preferred stock holdings converted into common stock or otherwise diluted).
This is an important concept, as investors will agree from the outset that they will maintain their investment commitments that were agreed upon. If they don’t continue their investment as originally stated, then they risk losing the right bestowed upon them stemming from their allocation of preferred stock. Simply put, it’s presenting a penalty to those investors who don’t fund an agreed-upon pro rata percentage of funding invested.
Why Is Pay-To-Play Important in the VC World?
Pay-to-play VC is important because it usually means that if the original investors continue to fund the startup, the others will take the cue from them and follow suit with future investments. However, as mentioned earlier, those that don’t continue with the pay-to-play scenario will find that their stock (and share of the company) will get diluted over time. Of course, the terms of pay-to-play are clearly stipulated in the rules of engagement.
Predicting the Future
Pay-to-play provisions help impact investment rounds in the future by ensuring that the early-stage investors will continue investing through the lifecycle of the company. Having this “safety net” ensures that the company being funded by the VCs will continue to receive funding in the long term.
How a Virtual Data Room Can Help
A virtual data room (VDR) is a vital tool in any sort of VC activity. A VDR is a highly secure online location where all parties involved in venture funding, due diligence or working on a term sheet can safely and securely share and store the documentation required.
A sophisticated VDR has multiple features that allow this, including secure access, which includes enterprise-level encryption, multiple layers of security and user-friendly admin controls that allow you to seamlessly upload and download documents, protected by version control and allows only certain parties access to certain documents.
CapLinked, an industry leader in the VDR space, delivers secure online workspaces that are secure yet simple to manage. To see how robust its secure VDR is, sign up for a free trial that will allow you to see its management features, document collaboration controls, customizable permissions and more.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
Forbes – How Venture Capital Works
Venture Beat – Demystifying the VC term sheet: Pay-to-play provisions
Harvard Business Review – How Venture Capital Works
Investopedia – Pro Rata