A Founder's Guide To SAFEs & Pay-to-Play Down Rounds

There is no universal definition, but a down round is – roughly – a situation where the pre-money valuation of a financing round is lower than the post-money valuation of the previous financing round.

Factors that can lead to a down round include:

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• Poor macroeconomic / fundraising conditions
• Negative changes in industry sentiment
• Company underperformance

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Down rounds are often viewed as a negative signal by employees. Fundraising for a down-round valuation can also make it more difficult to attract investors.

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One strategy to incentivize existing investors to further invest in the company during a down round is to implement pay-to-play provisions.

A pay-to-play provision refers to an investment term that incentivizes existing investors in a company to participate in a new financing round.

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Pay-to-play provisions can either be punitive or rewarding to investors. Punitive provisions penalize investors that don’t participate in the new financing round; rewarding provisions grant benefits to investors that participate in the new financing round. Sometimes, both punitive and rewarding provisions are implemented in the same round – the economic impact can often be the same whether structured as a penalty or award.

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Most pay-to-play provisions are contingent on the investor participating their full pro-rata amount in the new financing round, but some only require partial investor participation.        

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Pay-to-play provisions can strain relationships between investors and the company. As a result, pay-to-play provisions typically arise only when companies have challenges raising capital - as is frequently the case in a down round.    

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Common forms of pay-to-play provisions include:

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• Punitive provisions
  • Conversion of shares to an inferior share class: for example, if an investor doesn’t invest in the new round, all or some of their preferred shares convert to common shares.
  • Inferior conversion terms: If the investor doesn’t invest in the new round, their existing convertible investments (such as via a SAFE or convertible note) are amended to contain worse terms (like a higher valuation cap or lower discount rate).  
  • Loss of investor rights: Investors who don’t participate in the new round may lose certain rights such as preemptive rights to participate in future rounds, voting approvals, or board participation.
• Rewarding provisions (also often referred to as “pull-through” or “pull-up” provisions)
  • Conversion of shares to a superior share class: If the investor invests in the new round, all or some of their company shares convert to a new class of preferred shares with superior terms to the existing class of preferred shares.
  • Superior conversion terms: If the investor invests in the new round, their existing convertible investments (such as via a SAFE or convertible note) are amended to contain better terms (like a lower valuation cap or higher discount rate).

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The remainder of this article focuses on pay-to-play provisions as applied to existing SAFEs during down rounds.

Take as an example the following scenario:

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• The company raised significant capital via SAFEs at valuation caps that are higher than they expect to be able to raise in a new round.
• The company needs to raise additional capital.
• The company will raise a down round.
  • If it is a SAFE round, the new valuation caps will be less than those of the existing SAFEs.
  • If it is a priced round, the pre-money valuation will be less than the post-money valuation caps of existing SAFEs.
• New and existing investors are expected to be less likely to invest in the down round, interpreting the reduced valuation as a negative signal of company trajectory.
• The company implements pay-to-play provisions as part of the new round to incentivize existing investors to further invest in the company.
• These pay-to-play provisions impact existing SAFE holders either favorably or unfavorably - see the mechanics of how in the next section.

As a reminder, the underlying goal of the pay-to-play is to incentivize existing investors to participate in the new round.

You can create incentives through implementing one or several of the following provisions:

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• If existing investors don’t participate in the new round, their SAFEs could:
  • Lose certain investor rights (such as voting or pro rata rights)
  • Convert to common shares or a less favorable class of preferred shares
  • Get unfavorable amended terms (such as a higher valuation cap, lower discount rate, and/or lower principal investment amount - note amending the principal will likely require meeting a higher investor approval threshold)
• If existing investors participate in the new round, their existing SAFEs could:
  • Convert to a more favorable class of preferred shares
  • Get favorable amended terms (such as a lower valuation cap or higher discount rate)

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Without careful communication, punitive pay-to-play provisions may sour relationships between investors and a company. Rewarding pay-to-play provisions may be less likely to jeopardize investor relationships, but may still raise investor concerns about the company’s health.

Effective investor communications generally include:

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• Why the company needs further capital
• Business context for the down round
• An explanation of the pay-to-play provisions and how they will impact existing investors

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It’s often useful to approach key investors privately for their buy-in before informing other existing investors. Depending on the investor relationships, founders can either enter these private discussions with a fixed proposal or with several options to discuss together with the key investors.

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Existing investors will likely be more open to participating in the new round if they have a clear understanding of how participation (or lack thereof) will impact their ownership stake in the company.

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For example, let’s say Company A currently has 5 investors who invested via SAFEs with post-money valuation caps ranging from $1M-$20M (see screenshot below).

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Company A offers investors with valuation caps greater than $5M the chance to get their existing SAFE valuation caps amended down to $5M if they participate in the new round (a “rewarding” pay-to-play provision).

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As demonstrated in the sample screenshot from our model, Post-Money SAFE investors 3, 4, and 5 would receive a greater number of shares from their existing SAFEs upon a future conversion event if they participate.

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Sharing a similar model or otherwise communicating to investors with clear numbers how they would be affected by the pay-to-play provisions may increase the likelihood of their participation.

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