Milestones, the mother of all pitfalls in venture capital term sheets

What exactly is a milestone?

Milestones are pre-agreed targets that are crucial to the valuation of the company from the perspective of the investor (definition borrowed from the book ‘Venture Capital Deal Terms – a guide to negotiating and structuring venture capital transactions’ by Sjoerd Mol of Benvalor and others, see: http://www.venturecapitaldealterms.com/). Looking at the ‘technique’ behind them, milestones can be split in two different types: investment milestones and valuation milestones.

With investment milestones, a certain amount of the investment is postponed until the milestones are fulfilled. If all shares to be issued to the investor are issued upon payment of the first tranche, the company is in serious trouble if the milestones are not fulfilled. Not only will the company not receive the second tranche of the investment, the valuation against which the shares were issued changes.

Valuation milestones do not affect the height of the total investment, but are used to adjust the valuation of that investment. Investments with valuation milestones are usually split in several tranches, the number of shares to be issued for each tranche then depends on the fulfillment of a milestone.

This is a very high-level breakdown of milestones, but what’s important to comprehend is what all milestones boil down to: a possible re-evaluation of the price per share or the equity interest the investor gets in the company for the amount invested.

Apart from the obvious interest investors have in milestones, they can be very useful for founders as well: it helps founders break down their master plan for the future growth and success of the company into the smaller and more practical steps necessary to achieve their goals.

Some common examples of milestones are: the release of the 2.0 version of the product in app stores, a minimum amount of sales of the product of EUR [amount] or a certain number of users of the product. All of them of course prior to a date agreed upon by the parties.

How does a milestone become a pitfall?

If the milestone can benefit both the investor and the founder, you might wonder what could possibly go wrong. Here goes.

• In general, founders are glass-half-full kind of people. This is good when faced with all kinds of different challenges in starting a business, but in combination with trying to impress an investor it might prove to be counterproductive in the end. This positive attitude, perhaps increased with a little bluffing on the side of the founder to impress the investor, can result in unrealistic milestones.
• The milestone that seemed perfectly clear on signing may actually be very vague when the deadline comes up and both sides might argue it has respectively has not been met.
• In almost all cases, there are some unexpected hitches that result in the realization of certain goals taking longer than expected.

Now we’ve come to the deadline of the vague or un-met milestone. At this point, the company needs the money, so the founder is in no position to make any demands from the investor or to go to court to settle the matter. The founder can only stand idly by while the equity interest of the investor increases.

Milestones, keep calm and …

Of course you can do your best to avoid a milestone becoming the tomb- or headstone of your company. Keep calm and:

• be specific – when negotiating milestones in a term sheet, it is very important to make them as concrete or detailed as possible. It should also be very clear when a milestone is met or who decides on this if a decision is required.
• calculate – work through the worst-case scenario to see what happens if the milestone is not met. Consider that the company will probably need a new investment at this point, so it is important to know what position you will be in when looking for a new investor.
• ask for help – ask someone else to read the term sheet and discuss it with them. Preferably your (venture capital) lawyer or a fellow entrepreneur with some experience on the topic.

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