Deal contributors Jonathan M.A. Melmed (left) and J. Allen Miller, Chadbourne & Parke LLP private equity transactions partners, take up the comeback of the "pay-to-play" provision in a Judgment Call item Tuesday -- the contractual obligation that forces investors to put additional money into existing portfolio companies, or else, and one that enjoyed its heyday after the 2001 bubble implosion.
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"The justification for pay-to-play provisions is that in a difficult capital-raising environment such provisions are necessary to raise capital and, in some cases avoid bankruptcy," they write. "In the current economic climate, such provisions have been reappearing with significant consequences for the unwary."
Given the resurgence, a quick refresher is in order. Melmed and Miller (right) remind us that provisions vary by contract, but all say that investors must participate on a pro-rata basis in follow-on funding rounds, while consequences of failing to do so include losing liquidation preferences or board seats or the conversion of preferred stock into common stock.
By example, the column addresses the formal approach the Delaware courts have taken via WatchMark Corp. v. Argo Global Capital and Benchmark Capital Partners IV LP v. Vague, focusing on procedural fairness and contract construction rather than equitable arguments and notions of fiduciary duty owed early-round minority investors.
Melmed and Miller also offer advice on how companies should best protect their interests, like appointing an independent committee of directors to advise on valuation and mind of stockholders' best interests, and provisions like early-round preferred stockholders' certificates of designation calling for the conversion of the preferred stock into common stock only upon a majority class-based vote, not a series-based vote. And investors, they write, should, if possible, set aside enough in reserves for additional rounds at the time of a first investment, and from a legal perspective, focus on the absence procedural protections.
- Carolyn MurphyRead the full atricle on TheDeal.com
