[Startup Must-Know Laws] The Rise of Down Round Investments and Pay-to-Play Clauses

Startup Law Essentials by Heecheol Ahn

Heecheol Ahn, Attorney at Law at DLG Law Firm

In recent years, as down rounds among startups have rapidly increased in South Korea, the "Pay-to-Play" provision-previously regarded as a uniquely American investment term-has begun to appear in Korean investment contracts. This signals that the entire investment ecosystem has entered a structural inflection point. Recent cases of domestic startups raising capital through down rounds show that Pay-to-Play clauses are actually being implemented, with preferred shares being converted to common shares or certain rights being forfeited depending on whether existing investors participate in follow-on investments.

The purpose of the Pay-to-Play provision is clear: it rewards investors who share responsibility during difficult times for the company and imposes penalties on those who do not. Legally, this is typically achieved by tying the retention of preferred share rights to participation in subsequent funding rounds. If an investor does not participate in the follow-on investment, their preferred shares are converted to common shares, causing them to lose key rights they previously held. Furthermore, in down rounds where new investors invest at a lower valuation, the Pay-to-Play clause may be structured so that existing investors who do not participate face significant dilution of their equity.

The increasing inclusion of this provision in Korean investment contracts is due to shifts in the startup investment environment and the deterioration of investor sentiment. With global interest rate hikes and economic downturns occurring simultaneously, the startup ecosystem has shifted from a focus on growth to concerns about survival. During periods when investors seek to avoid risk, new investors may find themselves at a disadvantage compared to existing investors-this is precisely where the Pay-to-Play provision comes into play.

The issue is that this clause does not always function as a fair risk-sharing mechanism among investors. Early-stage or angel investors, who have supported the company by taking on significant risks, often lack sufficient capital. If they are unable to participate in follow-on investments, their previous risk-taking and contributions may be disregarded, effectively rendering their equity worthless.

After 2025, the Pay-to-Play provision is no longer just an American investment contract condition; it has become a realistic option that can be thoroughly discussed in Korean investment contracts as well. It is essential for both investors and founders to fully understand the structure and legal implications of this provision and to carefully review their rights and risks during negotiations. As the market continues to change rapidly, the Pay-to-Play clause will become an increasingly important issue at the intersection of startup survival and investor protection.