Strategies to Minimise Harm to Investors in Pay-to-Play Financings
Timothy Harris, Partner
Morrison & Foerster LLP
To incentivise prior investors to participate in a current round of financing, many financing transactions in the current capital raising environment employ a 'pay-to-play' mechanism, whereby prior investors who do not participate in the current round of financing suffer a punishment. Typical punishments imposed upon non-participating investors include automatic conversion of their preferred stock to common stock, on a 1-for-1 or less than 1-for-1 basis; automatic conversion of their preferred stock to a shadow-series of preferred stock that lacks one or more significant rights, privileges, or preferences (eg, anti-dilution protection or protective voting rights); or reclassification of their preferred stock to a new series of preferred stock with a liquidation preference that is either smaller in amount or lower in priority than their previously issued preferred stock, or a new series of preferred stock that eliminates the valuation differentials among previously issued series of preferred stock.
The processes pursuant to which pay-to-plays are proposed, approved and implemented are fraught with legal peril arising from the conflicts of interest between participating investors (who may control the board of directors) and non-participating investors. Such perils tend to dominate the attention of the transaction participants and their respective counsel. For this reason, the mechanics considered often include limiting the application of the pay-to-play to investors with a specified threshold of ownership, third-party valuation setting (or at least establishing a clear record of a thorough search for a third-party valuation), disinterested director approval, disinterested stockholder approval, robust stockholder disclosure, and rights offerings to accredited investors.
The legal structures pursuant to which pay-to-play provisions are implemented also vary, depending upon the subject company's existing charter, its existing contractual pre-emptive rights and its jurisdiction of formation. But common to all structures is the definition of the required level of participation in the financing to avoid the punishment. Most typical is a provision that obligates an investor to invest some or all of its 'pro rata share' in the new financing. In one formulation, the pro rata share is computed as the investor's fully diluted percentage ownership interest in the company. In another formulation, the pro rata share is based upon the investor's proportionate share of the outstanding preferred stockholdings.
Regardless of the formulation used to compute an investor's 'pro rata share', implicit in the calculation is the notion of a date upon which an investor's stockholdings are used to compute the threshold investment amount to avoid the specified punishment. This date is similar to the record date for a stock split, dividend payment or stockholder vote, and thus can be thought of as the 'effective record date' for the application of the pay-to-play provision. Careful consideration should be given to this effective record date and its consequences on the impact of pay-to-play provisions. An investor may be able to influence the impact of the pay-to-play provision on the investor by adjusting its ownership position in advance of the effective record date.
Reduction in Shares – Pro Rata Participation
For example, consider a pay-to-play mechanism that converts all of an investor's shares of preferred stock into common stock if the investor fails to invest its pro rata share in a new financing. If the pro rata share is computed based upon the investor's fully diluted percentage ownership interest in the company, an investor that is only willing or able to invest a portion of its pro rata share could avoid the conversion of all of its preferred stock by reducing its ownership interest in the company, reducing its pro rata share, and participating in the financing to the extent of this reduced pro rata share to avoid the conversion punishment. The reduction in ownership interest can be achieved by surrendering shares to the company or selling the shares at a nominal price to another stockholder or a third party. Any proposed disposition of shares must comply with all bylaws and contractual restrictions on dispositions; many rights of first refusal include exceptions for sales to the corporation or to another stockholder.
Consider instead a similar pay-to-play mechanism that computes pro rata share based upon the investor's proportionate share of the outstanding preferred stockholdings. Here again, an investor that is only willing or able to invest a portion of its pro rata share could avoid the conversion of all of its preferred stock by voluntarily converting a portion of its preferred stock into common stock to reduce its proportionate share of the outstanding preferred stockholdings, reducing its pro rata share and participating in the financing to the extent of this reduced pro rata share to avoid the punishment. If possible, the voluntary conversion should be made subject to, conditioned upon, and effective immediately prior to the consummation of the financing (and the application of the pay-to-play) so as to avoid the unintended result of an investor having sacrificed a portion of its preferred stockholdings to protect the remainder of its preferred stockholdings from a pay-to-play that is never applied.
Consider further a pay-to-play mechanism that an investor's shares of preferred stock into common stock on a less than 1-for-1 basis as a punishment for insufficient participation. An investor who does not intend to participate in the financing can avoid the loss in ownership interest that would result from a less than 1-for-1 conversion rate by voluntarily converting all of its preferred stock into common stock at a 1-for-1 conversion rate before the effectiveness of the pay-to-play. It is, of course, possible for a corporation to amend its charter to provide for a less than 1-for-1 conversion rate with less than unanimous stockholder approval (subject to an obligation to provide notice after the fact to any non-consenting stockholder).
Divestiture of Stockholdings
An investor with a limited willingness or ability to participate in a financing should maximise the protective benefit of its limited participation by strategically adjusting its ownership position in advance of the effective record date. For example, an investor who holds shares of multiple series of preferred stock may wish to segregate its stockholdings into separate legal entities, each of which would be subject to its own pro rata share computation based upon its ownership position on the effective record date so as to isolate its highest value holdings into an entity that participates in the financing to the full extent of its pro rata share. This strategy provides the greatest benefit in the case of pay-to-play provisions that apply the punishment rateably across a non-participating investor's holdings. In using this approach, an investor should be aware of any aggregation rules for purposes of determining what constitutes an investor's pro rata share (eg, are all affiliates included?).
An investor with no willingness or ability to participate in the financing may attempt to sell its shares of preferred stock prior to the effective record date to a participating investor who is willing and able to increase its participation in the financing and preserve the value of the transferred shares.
Key to an investor's ability to achieve the desired outcome in any of the scenarios described above is the ability of the investor to change its pro rata share by adjusting its ownership position in advance of the date upon which the investor's stockholdings are used to compute the threshold investment amount to avoid the specified punishment. If an effective record date in the past is used, investors will have no ability to adjust their ownership positions and pro rata shares. Given the tension inherent in pay-to-play financings and heightened risk of claims of unfairness and self-dealing, it may be prudent in a particular situation to give stockholders adequate advance warning of an impending pay-to-play mechanism and avoid use of an effective record date in the past.
Some pay-to-play provisions expressly identify the effective record date upon which an investor's stockholdings are used to compute the threshold investment amount to avoid the specified punishment. In the absence of an express identification of the effective record date, most provisions defining an investor's pro rata share are interpreted as speaking as of the date of the financing event that triggers the pay-to-play mechanism, thereby providing investors with an opportunity to employ the strategies described above.
Although there may be no absolute protections available, this article proposes some strategies that may minimise the potential draconian impact of pay-to-plays on an investor who is either unwilling or unable to participate in a new financing at the level needed to fully protect its investment.
Mr Harris is a partner in Morrison & Foerster LLP's Corporate Group, where he represents emerging companies and the investors who fund them.
This article first appeared in NVCA Today (4th Quarter 2010). For more details, please visit nvcatoday.nvca.org