Milestone or Millstone? Financing, that is.

As a lawyer, I’ve counseled many an entrepreneur, and even an occasional angel or venture investor, who thought so-called milestone-based financing rounds might bridge an especially irksome entrepreneur-investor gulf on valuation.  And, indeed, if you’ve been around the high-impact startup game awhile, you are bound to have seen some of these deals done.  You might even have seen some of them work out.  But as attractive as the idea of punting on valuation and/or funding timing pending the future achievement (or not) of some pre-defined milestone can be, more than a few words of caution are in order.

The kind of milestone financing I am talking about typically looks something like the following.  An investor agrees to put in some money up front, with the valuation thereof, and/or the provision of an additional sum of money, determined at some later time, when the company has (or has not) accomplished some defined milestone(s).  In theory, this structure can be a good mechanism for bridging otherwise intractable differences about valuation and funding requirements between entrepreneurs and investors.  In practice, though, this approach can be quite problematic.

The problems with milestone funding are basically as follows.  First, the parties too often leave the definition of what constitutes achieving the milestone subject to interpretation.  Some milestones are in fact hard to define with precision.  Beyond that, precision itself in terms of defining a milestone can be problematic if, as is often the case, success or failure in achieving a milestone can take forms not contemplated at the beginning of the enterprise.  Second, and particularly where the milestone is more distant in time, market conditions can change so that one party or the other inevitably ends up feeling like they are being held to a deal that no longer makes sense.  Finally – and this, for me, is the biggest issue with milestone funding – is that what seem like the best/most pressing milestones today might be overtaken by events before they are achieved.  Most technology-based startups evolve rapidly: what looks like the best use of limited resources at, say, the first closing of a milestone financing, might look like a less than optimal use of resources a day, week, month or quarter later.  But with a milestone financing clock ticking, the various parties – founders, managers and investors – can find themselves with confused and conflicting priorities.  At best, in this situation, you will have a serious management distraction on your hands.

Milestone financing structures can be good tools in the right situations.  Considering the real world risks, however, they should be considered as if not last at least late-in-the-day resorts.  And, when used, both sides should be careful to pick milestones that can be achieved sooner, rather than later, and defined, appropriately, with precision.  And then everyone should still cross their respective fingers that the business – technology, markets, competition, etc. – stays reasonably stable at least until the milestone is achieved.