Case 078Down rounds, distress and runwayHard
Sanchavik Energy Systems needs Rs 40 crore and the lead insists on pay-to-play. Fund P will take its pro rata and Fund Q will not. Show the cap table and the payout at a Rs 200 crore exit, before and after the recap.
1The situation
Sanchavik Energy Systems makes battery management hardware for grid storage. It has 100 crore shares: Fund P holds 24 crore (it invested Rs 60 crore), Fund Q holds 16 crore (it invested Rs 40 crore), and founders and staff hold 60 crore of common. Both funds hold 1x non-participating preferred shares that rank equally.
A pilot slipped and the company needs Rs 40 crore. A new lead will invest at a Rs 60 crore pre-money valuation with a 2x non-participating preference, senior to the old preferred, but only with a pay-to-play clause: any existing investor that does not buy its pro rata share of the round converts its preferred shares to common, one for one, and loses its preference. Fund P will take its pro rata. Fund Q, near the end of its fund life, will not. The lead takes whatever is left of the Rs 40 crore.
2Your task
Build the post-round cap table and the payout at a Rs 200 crore exit, before and after the recap. What does Fund Q's refusal cost it?
Quick check
At a Rs 200 crore exit, roughly what does Fund Q receive after the recap?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Fund Q's refusal cuts its payout at a Rs 200 crore exit from Rs 40 crore to about Rs 12.6 crore. Before the recap each fund takes its 1x preference and common shares Rs 100 crore. After it, the new money takes a Rs 80 crore 2x preference and Fund P keeps its Rs 60 crore preference, leaving Rs 60 crore for 76 crore common shares. Fund Q saved Rs 6.4 crore by not paying and gave up about Rs 40 crore.
Step 1Why would a lead insist on pay-to-play?
Think of a housing society that needs money to repair the roof. If some flat owners refuse to pay but still expect the same vote and the same share of any future sale, the ones who pay are subsidising them. A pay-to-playA clause that strips preferred rights, usually by forced conversion to common, from existing investors who do not invest their share of a new round. clause makes existing investors choose: fund the company alongside the new money, or give up the preference that protected them. The lead wants to know the insiders still believe; the clause turns that belief into a cheque.
Step 2What does the cap table look like after the round?
The pre-money of Rs 60 crore on 100 crore shares prices the round at 60 paise a share. Fund P's pro rata is 24% of Rs 40 crore, Rs 9.6 crore, which buys 16 crore shares; the lead's Rs 30.4 crore buys 50.67 crore. The company now has 166.67 crore shares. Fund P holds 40 crore, exactly 24.0% again. Fund Q still holds 16 crore, but that is now 9.6%, and they are common shares.
Step 3How does Rs 200 crore get paid out before and after?
Before the recap, the preferences total Rs 100 crore. At Rs 200 crore, converting would give Fund P only about Rs 46 crore and Fund Q about Rs 30 crore, so both take their 1x. Fund P gets Rs 60 crore, Fund Q Rs 40 crore, and founders and staff share the remaining Rs 100 crore. After the recap, pay the senior money first: the 2x preference on Rs 40 crore is Rs 80 crore, split Rs 60.8 crore to the lead and Rs 19.2 crore to Fund P. Fund P's old Rs 60 crore preference comes next. Only Rs 60 crore reaches the common, shared by Fund Q's 16 crore shares and the founders' 60 crore.
| Rs crore at a Rs 200 crore exit | Before recap | After recap | If Q had also paid |
|---|---|---|---|
| Lead | 60.8 | 48.0 | |
| Fund P | 60.0 | 79.2 | 79.2 |
| Fund Q | 40.0 | 12.6 | 52.8 |
| Founders and staff | 100.0 | 47.4 | 20.0 |
| Total | 200.0 | 200.0 | 200.0 |
Step 4What is the judgement for each party?
For Fund Q, Rs 6.4 crore would have protected about Rs 40 crore of value at a middling exit, a trade most funds should take if they have the money. A fund near the end of its life may not, which is exactly the investor pay-to-play is designed to flush out. For the founders the recap is painful either way: their Rs 100 crore at this exit falls to about Rs 47 crore, because Rs 140 crore of preferences now sit ahead of them. A board would normally pair a recap like this with a fresh option pool for the team, or the people building the product have little reason to stay.
Where candidates lose it
Candidates keep Fund Q's Rs 40 crore preference in the after waterfall. The whole point of pay-to-play is that the preference is lost on refusal, and forgetting that overstates Q's payout by about three times.
The second slip is pricing the new round on the post-money. Rs 60 crore is the pre-money, so the share price is 60 paise and the Rs 40 crore buys two-fifths of the company, not two-thirds.
What the interviewer asks next
- At what exit value does Fund Q's refusal stop mattering?
- The pay-to-play converts refusers at ten old shares for one common share. What does Q get now?
- Why might the founders support pay-to-play even though it adds a 2x preference ahead of them?
- How much option pool would you create to keep the team, and who should bear the dilution?
Company names and figures are illustrative.