The National Venture Capital Association (NVCA) recently updated its model equity financing documents to reflect changes in law and market norms. One update particularly relevant in the life sciences context is the temporary suspension of a preferred stockholder’s right to convert its preferred stock into common stock during the period prior to completion of a financing round with a “pay-to-play” component (see Section 4.1.1 of the model Certificate of Incorporation available here and excerpted below).
A “pay-to-play” provision generally requires existing preferred stockholders to participate in a financing round to maintain their preferred stockholder rights, or they may lose some or all of these rights, typically via conversion of their preferred stock into common stock. In some cases, the non-participating investors may be forced to convert into common stock at a punitive ratio, e.g., receiving one share of common stock for every ten shares of preferred stock. The intent of the new language is to prevent stockholders from circumventing the pay-to-play provision by converting their existing preferred stock into common stock at a 1-to-1 ratio before the preferred stock can be forcibly converted at a more punitive ratio.
We have already observed companies adopting this provision in their governance documents; however, this concept is by no means new for life sciences financings. Life sciences companies often structure their preferred stock financings with multiple planned tranches of funding, with the obligation to fund subsequent tranches generally conditioned on the company meeting specific milestone targets (e.g., successful initiation of a clinical trial or achievement of a successful clinical trial readout). In this context, investors that do not participate in future tranches may be subject to conversion of their preferred stock into common stock at punitive ratios. Therefore, in tranched financings with a punitive pay-to-play provision, investors are often prohibited from converting their existing preferred stock into common stock until the final tranche of the financing has been completed.
The inclusion of this provision in the NVCA forms is both a practical update and a reflection of common market practice, particularly in the context of life sciences financings with multiple tranches.
“Section 4.1.1: …Notwithstanding the foregoing and notwithstanding Section 4.3.1, the optional right to convert shares of Preferred Stock into shares of Common Stock pursuant to the first sentence of this Section 4.1.1 shall be suspended, and no optional conversion may be effective, from and after the date the Corporation delivers (pursuant to Section 5A.1 below) notice of a Qualified Financing (as defined below) until immediately after the earlier of (x) consummation of the Qualified Financing and associated Special Mandatory Conversion or (y) termination of the Qualified Financing; provided, however, that the foregoing limitation on the right to optionally convert shares into Common Stock pursuant to this Section 4.1.1 shall not affect the calculation of the number of shares deemed issuable upon conversion of such shares for purposes of (A) voting rights under this Certificate of Incorporation, or (B) determining amounts payable in respect of shares of Preferred Stock in connection with a dissolution, liquidation, or winding up of the Corporation or pursuant to a Deemed Liquidation Event.”