Let’s take the following hypo: you are the CEO of Company XYZ, and you just raised $2mm in a Series A financing. In the financing there are 3 institutional investors and 4 high net worth individuals.
When a company has a bunch of investors (like the above hypo), it is important to understand that it is likely that not all of them will want to invest in future rounds (and this is particularly true with a mix of institutional and individual investors). Let’s assume that future equity financings will be needed as usually is the case.
If Company XYZ is performing really well at the time the next financing is needed, then it is likely that the existing investors will want to support the company by participating in the Series B round, but that is not always the case. Even is the Series B is an “up” round (simply meaning that the per share price of the Series B is higher than that of the Series A), some investors might not want to participate. An investor might not have sufficient available cash or there might be discord inside an institutional investor about Company XYZ.
If the company is performing well, and there are one or 2 existing investors that don’t participate in the Series B, this probably not very problematic – the other investors will invest a bit more than their pro rata or a new investor will show up.
If Company XYZ has not yet hit its stride, however, then the situation has the potential to get a little ugly. The participating investors might want to “punish” the non participants. You could replace “punish” with “make them feel some pain”. There are a variety of ways to dish out some pain in this context. Here are few:
1. Pay to play provisions: simply stated, pay to play provisions provide that unless existing shareholders participate in the subsequent financing unfavorable things happen to their existing stock. So, if a shareholder did not participate in the Series B, the holder’s Series A stock might convert to common stock or lose certain key provisions like liquidation preference. The impact to the non-participating shareholder can be quite dramatic. There are many (many many) ways to slice pay to play provisions.
2. Warrant kickers: A warrant kicker is a reward for participation. A warrant is the right to buy stock in the future as a set price (usually called a strike price). For example, participants in the Series B financing might receive warrants to purchase additional shares of Series B stock based on their level of participation. For instance, participants could get a warrant for 50% of the stock they actually purchased exercisable within the next 7 years. The impact of the warrant kicker is to dilute non-participants. As with pay to play, there are many (I will say it again “many many”) ways to slice warrant kickers too (for example, the strike price might be the same price per share as the Series B stock or might be one penny per share; or the warrant might be for common stock and not Series B).
3. Stock kickers: Stock kickers are very similar to warrant kickers except that actual additional shares are issued at the time of the given investment. So, if a shareholder participating in the Series B purchases $500,000 of Series B shares, the stock kicker might provide for the issuance of any additional $250,000 of Series B shares to the participant. In effect, the stock kicker lowers the immediate price of the Series B shares and immediately dilutes non-participating shareholders.
I want to reiterate that the “pain” devices come in many flavors and many variants inside each flavor. The composition of the given company’s shareholder base will also influence what strategies are most appropriate. This area is a potential mine field so make sure to get good advice before driving through it. The battles are typically between investors and do not involve the management team directly – so there is a silver lining for the CEO…..