Setting up and running a startup requires knowledge of the industry that you are in.
It also requires knowledge about finance, marketing, customer service, management, and legal matters.
There is no way of knowing everything you need to know, which is why the network that supports you becomes a valuable tool and asset.
Funding and milestones
As an entrepreneur, your goal is to create value — and your company is your vessel to do so.
The long and winding road towards that goal requires resources: primarily money. Most likely you don’t have that money readily available yourself, so you’ll need to convince investors to give you money.
And what do investors want? A decent return on investment, obviously.
But they are also keen to mitigate their risks. Which is why investors may make their investment conditional on milestones.
In fundraising, you show investors your business plan or pitch deck. Your plan contains the goals and the estimated resources needed to reach them.
Based on your own plans and forecasts, you now convince an investor to invest, say, £600,000 in your company.
However, let’s assume the investor proposes to structure the investment in tranches, based on the goals (milestones) you yourself outlined in your plan.
The investor will in principle invest a total amount of £600,000, but will only actually make that investment available in three tranches of £200,000.
Each tranche will be conditional upon reaching a milestone. The size of each tranche will be based on your own estimation of resources needed.
Should you accept the offer?
If you’re anxious to secure the funding — as a lot of entrepreneurs are — this may sound tempting.
Accepting the offer means the deal gets done quicker, which means less risk for the investor.
One way or another you need to give the investor some control over how the money is spent anyway.
Tranche-based investing allows you to do so without extensive provisions on governance.
Plus, you did your homework with the numbers, right? So, what can possibly go wrong?
Well, quite a lot.
Downsides of funding with milestones
Focus on milestone-seeking instead of long-term value-creation.
You are locked-in with a short runway, which will only be extended if you reach the next milestone.
Your company will therefore be inclined to focus on reaching milestones, to the point where this is not — or no longer — in the long-term interest of the company.
Your focus should be on value-maximisation in the long-term and not milestone-seeking in the short-term.
Milestones limit flexibility
Your stellar plan is usually outdated the moment it lands in the investor’s inbox.
Along the way, you will need to continuously modify your plan and such modifications would lead to missing your milestones.
This means re-negotiating with your investor in order to secure funding, and this becomes far more difficult when you’re in a bad bargaining position and at a moment when time and energy is better spent on the business.
Milestones may encourage the concealment of setbacks
Because of your short runway, you may be tempted to obfuscate or conceal setbacks or change of plans in order to secure the next tranche, instead of building a long-term relationship based on trust.
Short runways scare off top talent
New (potential) elite team members will be aware of risk and will (or should) therefore ask you about your runway to assess whether he or she should hop on board.
You will have to admit that runway is short and conditional… and the potential team member will sign up with a competitor.
Milestones may lead to unfair outcomes
Last but not least: you are, in fact, allowing an investor to keep investing in your company at the initial valuation even though that valuation increasingly becomes off-the-mark when you progressively reach your milestones.
Having said that, tranche-investing based on milestones is not always a bad thing.
If you do decide to accept milestones, or simply have no choice, keep in mind the following:
Be sure that milestones are SMART: Specific, Measurable, Attainable, Relevant and Time-related.
Milestones that are not SMART are prone to leading to disagreements on whether they have been met.
The investor generally has the upper hand here because the money you need badly is in his pocket, and you will need to go to court to force him to give it to you.
So generally speaking, quantitative milestones such as financial metrics or (unique) users are to be preferred over qualitative milestones.
The latter are, by their nature, more fuzzy/vague. Should you nonetheless consider qualitative milestones, you should agree to regularly evaluate if, and to what extent, they are met, and to have parties sign a document containing joint findings and action points in order to avoid surprises.
To partially mitigate the downsides mentioned above, limit the amount of milestones and make sure that each tranche provides you with sufficient runway, allowing for change of plans and a margin of error.
You don’t want to be on continuous life-support.
Agree with the investor that you have the right but not the obligation to draw down another tranche if a milestone is met.
In other words, if the investor is unwilling to provide you with all the money upfront, why should you be required to accept all that money upfront?
If you can get a better deal along the way, you should be able to go for it.
A potential alternative
Find an investor who trusts you will spend his money wisely and who acknowledges that you shouldn’t put an entrepreneur on a leash too tight.
Preferably, an investor who invests unconditionally upfront and only request a limited amount of control to protect their investment.
For example, if the investor invests in equity, we advise that you enter into a shareholders’ agreement, in which you agree that a limited number of decisions require the investor’s approval.
If they invest in (convertible) debt, ensure that the loan agreement includes covenants with the same effect.
But obviously as an entrepreneur you don’t want to be hampered too much in working your entrepreneurial magic.