The startup ecosystem fuels America’s economy in ways few other sectors can match. It has also ridden waves of boom and bust, with periods of explosive growth followed by cool-downs. During these market downturns, capital becomes scarce and investors must make difficult decisions about which startups in their portfolios deserve continued support. In a new paper, I examine one mechanism that can help startups survive these periods of contraction – pay-to-play clauses, which law and finance scholars have so far given little attention.

Pay-to-play provisions are designed  to induce investors to provide a startup with fresh capital, as necessary. Their operating mechanism is simple but painful for investors: decline to participate in future financing when called to, and penalties will follow. A pay-to-play clause would typically force the conversion of the non-participating investors’ shares into a junior class, stripping them of economic privileges such as antidilution protections and liquidation preference, decreasing their voting power or ownership stake, or causing the loss of their control-related privileges such as secured board seats or veto rights. Having reached all-time highs in the aftermath of the dot-com bubble crash in the early 2000s, the prevalence of pay-to-play clauses in venture deals serves as a barometer for the VC market’s health. They tend to fade during bull markets and resurge during downturns – with the current VC winter (or at least, outside of AI investments) being no exception. VC-focused law firms tracking trends in VC-deal structuring have reported that the rate of deals including pay-to-play clauses is the highest it has been in years.

My paper discusses pay-to-play clauses, examining their construction, their role in shaping efficient governance and capital structures in VC-backed startups, and their standing under Delaware law. The paper opens with an empirical study to of pay-to-play clause design, based on a survey of a novel dataset of 150 pay-to-play provisions hand-collected from U.S. startup charters. Prior research touching on pay-to-play variations has mostly focused on a single feature: Whether non-participating investors saw their preferred stock converted to common stock or to a new class of “shadow” preferred stock with diminished rights. This study goes further by analyzing these clauses across additional dimensions, while also taking a closer look at clauses’ penalty aspect – examining not just the conversion of their shares into a junior class, but also whether that conversion applies to their entire holdings, and whether a punitive conversion ratio is applied, leaving them with fewer shares compared withj other, “benign” conversion scenarios.

The survey reveals several patterns that challenge conventional wisdom. First, only slightly more than half of pay-to-play  clauses in my dataset targeted “down round” financings (where new shares are priced below previous rounds). Second, many pay-to-play clauses discriminate among investors based on ownership thresholds or other characteristics, even though Delaware courts have suggested that they may be more likely to uphold clauses that apply equally to all investors. Lastly, while investor syndicates have traditionally used the clauses to resolve or prevent disputes within investor syndicates, startup boards are often given the power to trigger or disarm the clauses at their discretion – regardless of investor consent.

As my paper discusses, pay-to-play clauses can play a role in solving startup governance problems. First, they can help create and stabilize investor syndicates by deterring free-riding. When, for example, a startup needs more funding to survive – and all investors would benefit from its survival – but the investors willing to put up the money needed would be economically worse off compared whith those who did not, negotiations among the investors can be difficult or even fail, leading to inadvertent underfinancing of viable startups. Pay-to-play clauses can help by requiring all investors in advance to pony up in that situation or face economic penalties, which encourages, when appropriate, the investors’ long-term commitment.

Second, pay-to-play provisions can help optimize staged-financing structures by startup investors to discourage entrepreneurs from creating agency costs. For example, when  entrepreneurs seek large upfront investments to maintain control, but investors prefer smaller, staged investments to enhance monitoring, pay-to-play provisions can help bridge the gap. By making it possible but costly for investors not to invest more money in the future, the provisions allow startups to proceed with smaller initial investments that satisfy investors’ monitoring needs, while assuring entrepreneurs that investors have stronger incentives to maintain support in future rounds. This feature is, I argue, what made pay-to-play provisions particularly useful in sectors such as life sciences, where information asymmetries between entrepreneurs and investors are extreme and reaching an agreement over the initial investment amount is particularly difficult.

Lastly, the paper examines how Delaware law shapes and potentially constrains the use of pay-to-play provisions. The provisions are potentially vulnerable to two main legal challenges: questions about their disparate treatment of investors in the same stock class, and heightened judicial scrutiny of the approval of financings by boards that include directors whose interests may conflict with the company’s because they were appointed by investors. The Court of Chancery’s WatchMark opinion offered some comfort by validating an investor-controlled board’s decision to trigger a pay-to-play provision under the business judgment rule. However, it left many questions unanswered as it dealt with a simple case – one where the pay-to-play clause treated all investors equally and affected investors of similar financial means. The WatchMark court’s reasoning, as well as that of subsequent Delaware cases, suggest that pay-to-play provisions might face greater scrutiny when investors are treated equally under the corporate charter but have grossly disparate financial abilities to participate in future rounds.

This uncertainty imposes costs by making pay-to-play provisions less reliable and more expensive to implement and adjust. However, perhaps surprisingly, my survey data shows that the industry’s response has not been for drafters to adopt the court-validated WatchMark template. Lawyers frequently deviate from it – using more aggressive terms and selective application – while also resorting to functionally-equivalent mechanisms outside the charter when legal risks seem high. As the paper points out, this trend toward “stealth governance” may reduce transparency and make it harder for startup stakeholders to assess these mechanisms’ role and effect.

This post comes to us from Gad Weiss, a Wagner Fellow at NYU’s Pollack Center for Law & Business. It is based on his recent paper, “Pay-to-Play,” forthcoming in the BYU Law Review and available here.