Milestones or stumbling blocks? Russ Garcia, an entrepreneur from Irvine, Calif., was faced with a difficult decision when he sought a second round of venture financing in late December. In order to secure the funds for his startup that produces global-positioning satellite chipsets, the venture fund required his company to achieve specific goals.
The initial offer had a pricing structure that increased if the goals were achieved and decreased if they were not. Garcia refused the offer because they believed the terms were too strict. However, in August, when u-Nav Microelectronics Corp. secured alternative funding, they also implemented a milestone structure.
Garcia determined that receiving all the money at once is the optimal choice because it offers greater flexibility. However, in today’s funding landscape, it is typical for companies to continuously pursue funding. Investors are selectively allocating capital to struggling companies due to the limited availability of early-stage financing opportunities.
Some venture firms mitigate risks for investors by structuring financing terms around performance milestones. However, when carelessly designed, these milestones can prove to be obstacles for startups. Edward Reilly, a partner with Morgan, Lewis & Bockius’ New York office, states that although the trend is difficult to define due to limited early-stage funding, he is increasingly seeing this approach being considered. Three years ago, venture capitalists eagerly competed in financing events.
During the decline of prosperous times, venture capitalists minimized their investments and enforced more severe deal terms. Certain individuals turned to high liquidation preference multiples, which allowed them to claim the majority of proceeds from a sale or initial public offering. Alternatively, they demanded provisions that significantly devalued the equity of both founders and common stockholders.
Recently, venture capitalists (VCs) are experimenting with new approaches to mitigate the technical and financial risks associated with early-stage funding rounds and to enhance the performance of their portfolio companies. According to Stephen Meredith, a partner at Edwards & Angell LLP in Boston, many investors have suffered significant losses and are now cautious. Avoiding situations where they have invested too much money in underperforming companies is their top priority. This is where performance milestones become crucial: VCs disburse the promised funds gradually, contingent upon meeting specific predetermined goals.
The text suggests that milestones such as achieving a financial target or forming strategic partnerships are important in mitigating risks. Jay Hachigian, a managing partner at Gunderson Dettmer Stough Villeneuve Franklin & Hachigian LLP, explains that companies are implementing these benchmarks to minimize potential drawbacks. While milestones have traditionally been prevalent in the biotech industry, they have recently become more common in IT and other sectors as well. For instance, Garcia’s company u-Nav received a $10 million Series B round which was divided into two tranches.
The initial $7 million was immediately accessible, while the remaining $3 million was contingent upon achieving specific benchmarks related to revenue, margin, and working capital. Garcia opted to partner with new investors, namely Shelter Capital Partners from Los Angeles, Danske Venture Partners from Denmark, and iSherpa Capital from Denver, as they provided greater flexibility. If his company successfully meets the specified targets, he has the option to request the funds or forego them if unnecessary.
However, if the investment fails, investors are given a period of 18 months to make a decision regarding their $3 million investment. Garcia considers this to be a “reasonable” condition as his company would have these goals regardless. However, he acknowledges that it does encourage the company to spend its money wisely in pursuit of these goals. Nevertheless, these conditions can make financing transactions more complex and can result in prolonged negotiations over interpretation and pricing. As a result, the venture community is divided on the wisdom of such conditions.
According to believers, performance milestones are beneficial for managers as they help them stay focused on concrete goals, while also reducing risks for investors. Michael Feinstein, a partner at Boston’s Atlas Venture, suggests that having financial pressure can be a motivating factor for managers to handle money carefully. He views milestones as an additional tool that can be effective in certain cases. Feinstein acknowledges that during the bubble period, managing details took a back seat to speed. However, now there is a demand for tools like milestones to ensure risk management.
In the A round funding for Sandbridge Technologies, a startup based in White Plains, NY that specializes in developing advanced wireless chipsets, Atlas invested $14 million. Bessemer Venture Partners of New York and Columbia Capital of Alexandria, VA also participated as lead investors. The funding was divided into two tranches of $7 million each.
The company faced its first challenge in resolving an intellectual property issue, which was an important milestone. According to Feinstein, it is essential to mitigate technical risks in the deal. Additionally, there was another milestone related to achieving a product development goal. The company, despite being only one year old, successfully met both milestones, resulting in a post-money valuation of $20 million. Feinstein believes that milestones can help alleviate investor concerns about pricing. If a milestone is not achieved, it indicates that the initial agreed value may have been overestimated, allowing for a slight adjustment in valuation. He assures that the adjustment terms negotiated are not burdensome and are meant to compensate for lower-than-expected progress. Dana Callow, a general partner at Boston Millennia Partners, also favors the use of milestones.
According to Callow, both the venture partner and the entrepreneur are subjected to discipline. He believes that currently only 5% of deals use milestones, but this is gradually changing. He emphasizes that he would prefer to have 50% or more deals structured based on performance. Callow advises against using structures that would increase investors’ stakes if the milestones are not achieved.
Instead of solely focusing on the venture capitalists, the author recommends using performance-based conditions to encourage both investors and entrepreneurs to establish a business over time. He emphasizes the importance of the entrepreneur winning and his firm owning less, but increasing in relative value. Typically, Callow’s firm establishes three types of targets: budgets, nonfinancial strategic goals such as acquisitions, partnerships or marketing alliances, and a relatively easy tactical target to accomplish.
From a corporate director’s perspective, it is believed that establishing agreed upon metrics for a company is advantageous. However, there is concern that solely focusing on these metrics may impede the company’s ability to adapt to unforeseen circumstances. Manu Rana, vice president at Lazard Technology Partners, cautions that over-reliance on contracts can hinder effective operation of the company. Thus, it is crucial for the board and management to maintain decision-making flexibility. Ultimately, Rana advises against investing in a mistrusted management team. In the realm of IT startups, lawyers acknowledge the complexity of establishing milestones.
According to Reilly, rigid sales milestones may not be appropriate in situations where a company is attempting to attract customers for a new product, as these customers may only make a purchase once they see other companies doing so. Reilly suggests that milestones could potentially be arbitrary numbers created to assess the viability of a product.
Furthermore, the presence of staged financing can introduce uncertainty, potentially causing suppliers and customers to worry about a company’s financial situation and long-term sustainability. “When the investor group provides fewer funds initially, it may signal some uncertainty in their support,” Reilly explains. Lawyers representing startups often oppose the use of milestones due to the added expenses and time involved in negotiating what accomplishments should be attained.
Management can become distracted by periodic closings and lengthy renegotiations when milestones are not achieved. According to Michael Littenberg, a partner at New York’s Schulte Roth & Zabel, it is crucial for investors to thoroughly understand a business and its operational logic for milestones to be effective. Littenberg reveals that approximately one-third of his deals in the past year involved milestones. When milestones are not reached, it usually has severe consequences for a company unless the venture capitalists decide to overlook the failed target. Littenberg gives the example of an infrastructure provider that received $4 million investment from a VC, contingent on meeting two milestones: a development target and a revenue goal.
The company failed to meet both milestones, but the VCs decided to release the second tranche regardless, as they acknowledged that the milestones were unattainable. This led to negative sentiments and reduced trust in the management, according to the person recalling the incident. Additionally, lawyers note that situations are not always straightforward. There are instances where material adverse changes occur, rendering it impossible for a company to achieve an objective and potentially causing disagreements regarding the VC’s responsibilities.
When a company doesn’t meet growth expectations or requires significant new hires or alliances, they frequently must renegotiate agreements with venture capitalists (VCs), who may choose to increase their ownership shares. Alternatively, investors might request changes in management. According to Meredith, there is always at least one objective that can be interpreted differently, causing disagreements on its achievement. Nevertheless, currently investors are more hesitant to provide additional investments, resulting in an increased likelihood of disputes and conflicts of interest.
If a company’s board is controlled by venture capitalists (VCs) whose funds have committed to providing financing based on specific milestones, but the funds do not want to invest more money in the company, the VC directors are faced with a dilemma. According to Meredith, these directors have a responsibility to request the money on behalf of the company. However, they also have a fiduciary duty to the investors of the fund and serve as general partners in that fund.
Gregory Smith, a partner at Skadden, Arps, Slate, Meagher & Flom LLP, believes that it is preferable for individuals to make investment decisions in the present rather than attempting to anticipate future outcomes.
One executive from U-Nav named Garcia acknowledges that he eventually agreed to an agreement that he considers unfavorable compared to what startups could negotiate eighteen months ago.
Despite any concerns, the speaker remains confident about meeting their goals and becoming cash-flow positive by the end of 2003. They also express trust in their investors, believing that responsible investors would not allow their investment to be squandered by not providing sufficient funding to the company. As a result, they do not have significant worries about the possibility of not achieving their milestone.
