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Milestone Based Financing – Access to Capital

In “Raising Capital: The Value to Raising Less Capital“, we discussed why raising less can be more for the entrepreneur.  In part two, we will discuss how this can positively affect how much of the company the entrepreneur ends up owning, but also how milestone based financing can be challenging.

The Challenge with Milestones

  • Defining milestones is not always easy 

At the earliest stages, milestones are incredibly tough to define. A working prototype is likely to be incredibly flawed, and will likely be buggy, and / or incredibly limited in scope. But, does what gets delivered meet the threshold of a minimal viable product (MVP) to satisfy both parties as a milestone? Depending on how expectations are managed, it may. Setting these expectations is key to the entrepreneur’s success in raising capital through the company’s growth. Too often based on the urgency and necessity of closing a financing deal, terms and expectations are too loosely defined. Accordingly, the entrepreneurs and investors discover this after the fact. Investors who are habituated to the milestone-financing model are accustomed to this, ask a lot of questions to become comfortable and define personal expectations, and they are best prepared for a surprise.

When the entrepreneur reports that the first milestone is met becomes the moment of reckoning. At this point the investor and entrepreneur discover whether or not they really see things the same way. It also offers an opportunity to validate whether the assumptions made are aligning with the reality of what is occurring. Knowing and not assuming means the subsequent funding is lower in risk.

  • Long Term Milestones are like Horoscopes

A milestone that is set too far in the future is highly unreliable. With hindsight, everything is easy, but just like a horoscope, predicting milestones too far into the future requires varying degrees of fuzzy logic and mental gymnastics to reconcile events with predictions.

Entrepreneurs and their investors start on a journey together based on certain assumptions as to how the technology, company, and market may develop. But, it is very rare that a startup develops and matures along a straight line path that closely matches with everyone’s earliest ideas. As the business develops, long-term milestones can become a burden. They define a path to a presumed success which may become less than optimal based on market evolution. Basing a future tranche of funding on incorrect goals makes it impossible to reconcile the correct business decisions and the committed strategy.

  • Milestone Financing is Not for Everyone

Some will argue that milestone based financing does not work for everyone. And they are correct. The IT startup world is highly dynamic and the only thing predictable is change. Some will say that milestone financing is the antithesis of what is required in this type of fast paced environment. If the milestones are too big, or would qualify as a BHAG (Big Hairy Audacious Goal), then milestone financing is unrealistic, and would sink the company. This is why it is really only best for the very-early stage companies, and tied to very specific short-term goals. If the goal(s) cannot be met within 3 months, they probably are too big for this model.

A very early stage company likely and hopefully has a BHAG. After all, you as the entrepreneur are trying to change the world! But in the early days, you are really testing a lot of ideas to see which ones work, and is it possible to establish a path to actually accomplishing your goal. At these stages, if you base financing on accomplishing these goals, then milestones make sense.

Milestones that only take you a very limited distance make sense for Minimum Viable Products, and even for proof-of-concept stage companies. Later stage companies will still have milestones, and their ability to attract financing will still be predicated in some part by their proven ability to execute against established milestones. But, for later stage companies to based their financing solely on short-term milestones would be suicidal.

  • Milestones are Great for the Entrepreneur Who Executes

Milestones are suicidal for the entrepreneur who fails to execute. If you follow the path of milestone based financing, you are committing yourself, and your company to your ability to execute. If you miss a target the question becomes 1) Did you forecast improperly, and is the problem you?; 2) Did you misjudge the market?, and then the problem is you; 3) Did you overpromise on either a) what you could deliver within scope, or; b) what was possible to achieve with the resources within the timeframe?, and then why? Were you unrealistic (not good), or was the investor unrealistic? In either case managing the expectations is the responsibility of the entrepreneur. Tempering their expectations is the responsibility of the more experienced investor.

If your company meets expectations, then the subsequent financing is on better terms. Hurrah! If not, then the questions are whether the business is solving a real problem; whether you are the right person / team to tackle the problem; whether the solution is ready before the market, (always possible); or if the solution is more difficult than forecast, and thus will take more effort. If it’s the latter, this means an early reset on expectations. As an investor, and an entrepreneur, I prefer this early reset. It means I am forced to reassess and pivot quickly, and hopefully choose a better path sooner.

For the entrepreneur who misses because they could not execute, the lack of follow-on funding means a quick end. But, less time and money wasted by everyone in this culmination of events is in everyone’s best interest, no matter how painful it may seem at the time.

  • Milestones Do Not Work for Institutional Investors

Milestone based financing simply does not work for a standard Venture Capital firm or other institutional investor.  Their model is predicated on placing larger investments in companies and teams with match with their investment profiles, and align with their commitments.  These firms’ commitments to their investors require an amount of due diligence that simply cannot be reconciled with the milestone model.  These firms are ready and available to invest in your BHAG.  Meaning they look to the long term potential, and judge progress on different terms.  They are highly unlikely to invest in the very-early stage company which is better suited to the seed and angel investors.  Because they tend to invest in companies that are more developed, or for which there is less uncertainty, milestone based financing is less applicable.

For the early-stage entrepreneur, this model works better with private equity financiers, seed and angel investors, and family offices.  The model works well to help the early stage entrepreneur achieve on a set of defined milestones early on, and this establishes credibility for these VC’s judging your opportunity.  The less uncertainty, the higher your value, and thus the better your valuation.  Achieving milestones means there is less uncertainty on your ability to execute, and possibly on the market opportunity.  This means everyone can have a better defined sense of market size, and potential value.

The Unconventional Benefit to Raising Less

I am arguing that if you raise less capital, you are constrained in what you can do. This is a good thing! It means you have to have control on what you do, and you need to keep tightly focused on what you need to do, versus what you would like to do.

With limited capital, every choice will be weighed and decided based on value to the customer, which intuitively results in value to the company and shareholders. Do you need to add a feature? Do you need an API? Do you need a more senior team member? Do you need a PR agency? Do you need to do anything other than X to reach the goal / milestone you have committed to? Using your capital effectively is a signal to investors; you want it to be a positive signal. Every company is capital constrained. Even Apple operates as if capital constrained. If they didn’t, they would not have so much cash in the bank!

Valuation

As mentioned in the prior piece and above, in the early stages your company’s valuation is tough to determine. In many cases, the valuation is actually determined by how much money you raise, not on basic business fundamentals; after all, how can fundamentals apply to a bunch of unknowns?   Unfortunately, it is what comes next that hurts.

If you raise $4MM, and give up 40% of your company that seems great, and in line with many financing deals. But would it not be better to raise $1MM under terms that meant you only gave up 10% of your company if you met the agreed to milestones? If you meet the milestones, you will be raising the next $3MM at a higher valuation. Let’s say the valuation is now $15MM. That’s 20% dilution.

    • Round 1 : 10% dilution
    • Round 2: 20% dilution
    • Result: 28% dilution (20% +(10% – (10% x 20%))

You now have your $4MM for 28% instead of 40%. This makes a huge difference during future rounds, and when you sell the company!

Yes, raising less means you will have less room for mistakes in execution, and you will spend more time fundraising, and you will get rejected more often. But it also means you and your entire team is incented to focus on the most immediate goals. Properly managed, this means the risks are lower for everyone.  This is a good thing for future funding, whether things go well, or less well. If they go very poorly and you lose the company, then the point is moot…

The Mother of Invention

If you raise too much capital too soon, urgency is removed, and things can seem comfortable. Comfortable is bad…

Necessity is the Mother of Invention, and being capital constrained means not having enough cash in the bank to do all the things you might want to. It means the company remains focused on what needs to be done versus what could be done. ie: need to have v. nice to have. In this scenario, everyone in the organization is focused on making progress, and making existing capital go further. If everyone recognizes that delivering on milestones are the proof-points critical to getting the next round of funding, then everyone is focused on the same objective: achieve the milestones on or ahead of target. The rewards are obvious!

The “feet to the fire” mentality should become part of your company’s culture, and it should persist long past the point you are profitable and no longer in the routine of raising capital. In fact, if you and your team do not question “why” money is being spent a certain way, then it is pretty certain there is some waste happening.

Even if you raise a big round early on, having a culture focused on “necessary” v. “optional” expenditures, and benefits v. features will serve everyone well. If you do not make this mentality a core value within your organization, then you are likely to seek out capital before you want to, or worse before you have achieved the goals set out in your prior round. If you see out capital before you have met the promised goals, you will be at high risk of rejection, or worse subjecting your early-stage investors to a downround.

Use whatever capital you raise wisely, and you will be rewarded. Raise less and prove the value early on means you’ll end up retaining more later.

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