A worked down round in which one Series A investor takes its allocation and the other does not, with the exit waterfall run for both.
A pay-to-play provision requires existing preferred investors to buy their share of a new round, usually a down round, or lose their preferred rights: their shares are converted to common, stripping the liquidation preference and the anti-dilution adjustment. In the example below, a Series A investor holding 4,000,000 shares declines a $1,200,000 allocation. At a $15,000,000 exit it receives $631,579 instead of $4,800,000: playing would have returned 3.47 times the cheque more than declining.
Worked in full in The Venture Capital Associate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A company that raises at a lower price needs its insiders to support it, and a new lead does not want to fund a company whose earlier investors keep senior preferences and a repriced conversion ratio while contributing nothing. A pay-to-play clause makes the deal explicit: keep your preferred terms by taking your allocation, or step down to common with the founders. Below, the mechanics are run on a fictional company, with every preference 1x non-participating and the Series B senior to the Series A.
| Input | Value |
|---|---|
| Common, founders and option pool (fully diluted) | 15,000,000 |
| Series A shares at $1.00, investor X | 6,000,000 |
| Series A shares at $1.00, investor Y | 4,000,000 |
| Fully diluted shares before the round | 25,000,000 |
| Series B raised | $6,000,000 |
| Series B price (pre-money $12,500,000) | $0.50 |
| Series B shares issued | 12,000,000 |
| Reserved for Series A holders, pro rata | $3,000,000 |
| Anti-dilution for those who play | Broad-based weighted average |
The $3,000,000 reserved for insiders is split by Series A holding: X is offered $1,800,000 and Y $1,200,000. X plays. Y has to decide. If Y declines, the new lead takes Y's allocation and invests $4,200,000 rather than $3,000,000.
Step 1: the anti-dilution adjustment that playing keeps. The Series A conversion price falls under the broad-based weighted average formula.
CP2 = CP1 × (A + B) ÷ (A + C)
= $1.00 × (25,000,000 + 6,000,000) ÷ (25,000,000 + 12,000,000) = $0.8378
Conversion ratio = 1.00 ÷ 0.8378 = 1.1935
In Excel: =B1*(B2+B3/B1)/(B2+B4)
X's 6,000,000 Series A shares now convert into 7,161,290 common. Y's would convert into 4,774,194 if Y plays. The formula itself is explained in how broad-based weighted average anti-dilution works.
Step 2: the two cap tables. If Y plays it holds 4,000,000 Series A shares convertible into 4,774,194, plus 2,400,000 Series B shares, with preferences of $5,200,000 in total: 18.43 per cent of 38,935,484 fully diluted shares. If Y declines, its Series A shares become 4,000,000 common, with no preference and no adjustment: 10.48 per cent of 38,161,290 shares.
Step 3: run the waterfall. At a $15,000,000 exit, the Series B takes its $6,000,000 first. The remaining $9,000,000 goes to the Series A preferences.
| Holder | Y plays | Y declines |
|---|---|---|
| Series B, new lead | 3,000,000 | 4,200,000 |
| Series B, X | 1,800,000 | 1,800,000 |
| Series B, Y | 1,200,000 | 0 |
| Series A preference, X | 5,400,000 | 6,000,000 |
| Series A preference, Y | 3,600,000 | 0 |
| Common, founders and pool | 0 | 2,368,421 |
| Common, Y (former Series A) | 0 | 631,579 |
| Total | 15,000,000 | 15,000,000 |
When Y plays, the $10,000,000 of Series A preferences exceed the $9,000,000 left, so X and Y share it pro rata and common gets nothing. When Y declines, X's $6,000,000 preference is paid in full and $3,000,000 is left for 19,000,000 common shares, $0.1579 each. Y's 4,000,000 shares receive $631,579.
Playing costs Y $1,200,000 and returns $4,800,000 at this exit, or $3,600,000 net of the new cheque, against $631,579 for declining. Y is $2,968,421 better off for having played.
| Exit value | Y plays | Y plays, net of $1,200,000 | Y declines | Cost of declining |
|---|---|---|---|---|
| 8,000,000 | 2,000,000 | 800,000 | 0 | 800,000 |
| 15,000,000 | 4,800,000 | 3,600,000 | 631,579 | 2,968,421 |
| 30,000,000 | 5,777,778 | 4,577,778 | 3,096,774 | 1,481,004 |
| 60,000,000 | 11,055,510 | 9,855,510 | 6,289,096 | 3,566,414 |
| 150,000,000 | 27,638,774 | 26,438,774 | 15,722,739 | 10,716,035 |
The penalty has two sources. Around a $15,000,000 exit it is the lost preference: Y gives up a senior claim on the little that is left after the Series B. In a large exit, where every preferred holder converts, it is the lost ownership: 10.48 per cent of the company instead of 18.43, made up of the anti-dilution shares and the Series B shares Y did not buy. At $30,000,000 the penalty dips: the Series B has converted, enough now reaches common for Y's converted shares to recover much of what the lost preference was worth, and the Series A still takes its preference rather than converting, so its anti-dilution shares are not yet paying. Below $15,000,000 the penalty is capped by how little reaches the Series A at all.
Treating the pay-to-play decision as a fresh investment decision on the Series B alone: is $1,200,000 at $0.50 a good price? That ignores what the cheque buys back. The relevant comparison is the whole position with and without the cheque, as in the table above. An investor that thinks the company will be sold for a modest sum has the strongest reason to play, not the weakest, because that is the outcome in which the preference it would lose is worth most.
Clauses vary: some convert non-participating holders only partly, some to a shadow series without anti-dilution, and some apply only to holders who fall short of a minimum. Read the conversion mechanics before running the numbers.
A pay-to-play provision turns a follow-on cheque into the price of keeping your seat in the preference stack. Price it as the difference between two waterfalls, at the exit values you actually believe, and compare that with the cheque. The book treats follow-on decisions as a fight for a limited reserve pool; the free reserve workbook shows how few companies that pool can defend, which is why a pay-to-play call is often the first time a fund has to choose.
Their preferred shares are converted into common, usually one for one, so they lose the liquidation preference, the anti-dilution adjustment and often their protective votes. In the example the non-participating investor's 4,000,000 Series A shares stay 4,000,000 common shares, where playing would have made them convertible into 4,774,194 with a $4,000,000 preference ahead of the founders.
Usually yes in a small exit. Every preference stripped from a non-participating investor moves value down the stack. In the example, at a $15,000,000 exit the common holders receive $3,000,000 when one Series A investor declines and nothing when both play, because the preferences then absorb the whole exit.
When the new cheque buys back more than it costs. Here $1,200,000 protects a position worth $4,800,000 at a $15,000,000 exit against $631,579 without it, 3.47 times the cheque. The gap narrows around a $30,000,000 exit, where the preference matters less, then widens again: at $150,000,000 playing is ahead by $10,716,035 net, because the investor keeps its anti-dilution shares and its Series B stake.
This article is one calculation from The Venture Capital Associate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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