Pay-to-Play Becoming Less Common in Venture Capital

To motivate investors to reinvest in additional rounds of financing at start-up companies, venture capital deals often include “pay-to-play” provisions. Under these provisions, investors that don’t reinvest have their preferred stock converted to common stock or otherwise made less preferential, VC Experts explains.

According to venture capitalist Brad Feld, pay-to-play provisions were rare in the 1990s. But after the Internet bubble popped in 2001, they became very common. New data show that investors have moved away from pay-to-play provisions in recent years.

The figure below shows data on the share of venture capital deals with pay-to-play provisions taken from the Venture Capital Report produced by law firm Cooley LLP. While the data only cover deals for which Cooley did the legal work, they show the frequency with which VCs are using pay-to-play provisions.

While the trend is imprecise, the pattern is clear. Pay-to-play provisions have become less common since the fourth quarter of 2003 when Cooley first began to track this measure.

What does this trend mean for venture capital? Pay-to-play provisions encourage investors to reinvest when the condition of a business isn’t encouraging. If fewer venture capital deals have pay-to-play provisions then VCs will be less likely to put additional money into start-ups in down rounds than they used to be.

Source: Created from data from the Cooley Venture Capital Report, various issues

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.