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Strategies to Minimise Harm to Investors in Pay-to-Play Financings
Timothy Harris, Partner
Morrison & Foerster LLP
Jan 2011


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.

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