My colleague Jordan Koss recently wrote a good piece warning entrepreneurs of milestone-based vesting of incentive compensation (Milestone Vesting – Generally Avoid for the Good of the Team, Jordan Koss). His reasoning is solid, and his conclusion sound.
Jordan’s take on milestone vesting got me thinking about another aspect of high risk/reward entrepreneurship: milestone financing. It’s a financing structure sometimes employed when high risk/reward entrepreneurs and their investors have trouble agreeing on a valuation. Resolving those differences is often contentious, and setting up a milestone financing structure can seem an effective way to get the job done. As with milestone-based vesting, though, milestone-based financings are best given a wide berth.
With milestone financings, the parties might agree that an initial tranche of financing will be followed by a subsequent tranche based on the company achieving (or not) some milestone. The second tranche might be contingent on achieving the milestone; alternatively, the valuation of the second tranche might be contingent on whether the milestone is achieved. Sophisticated readers (as mine) can imagine a variety of variations on the milestone financing theme.
Milestone-based financing has been around for quite a while, and why not? In theory, it seems like the kind of creative approach to problem-solving that high-impact entrepreneurs and investors pride themselves on. That said, milestone-based financing usually causes more problems than it solves, for one or more of the following reasons.
First, defining milestones is not always as easy as it might seem. Too often, in the interest of getting the deal closed, entrepreneurs and investors set milestones that they “agree” on but have different interpretations of. This is among the lesser of problems with milestone financing, but one that has tripped up more than a few startups.
A more problematic aspect of milestone-based financing manifests itself when a milestone is set too far in the future. “Too far” can be not very far at all. Entrepreneurs and investors may think they know what they want the enterprise to be when it grows up, and all the key steps between now and then, but experienced folks well know that startups seldom stay on the same path for very long. Tying future financings to today’s milestones seriously impairs management's flexibility to adapt to changing circumstances.
Finally, milestones are useful on routes that are well marked and durable (thus the term’s roots in the road networks of ancient Rome). Having been in and around high-risk/reward entrepreneurship and investing for close to 35 years, I can’t recall the last startup that followed a well-marked and durable route from conception to exit. Rather, these are businesses where today’s best take on how to apply limited resources to achieve success will likely change, if not tomorrow, surely before the next year goes by. But once a milestone is set, and something as crucial as the next critical slug of capital is tied to it, it will take on a life of its own; a life that will likely be a significant management distraction at best, and a company killer at worst.
Now, there are cases, I suppose, where milestone-based financing works. In my experience, though, they are few and far between. If you think your deal is one of the exceptions where milestone financing makes sense, be sure and pick a near-term milestone that can be very precisely defined – and then cross your fingers that your startup’s growth trajectory stays aligned with the milestone until it is achieved.