DVC: The Milestone Investment
One of our common investment techniques is the milestone approach. This approach allows us to invest an initial amount upfront and set up pre-determined milestones for an additional investment amount 4 to 6 months down the line. This is an approach that has been around for quite some time so I will not go into the details but I will explain why it makes sense for both the entrepreneur and the investor as well as explain how it can fail.
For Entrepreneurs – Entrepreneurs have a long list of needs but one of the most important needs is their available cash. Founders should understand how their cash is being spent and how much they have available every day to allocate amongst value add activities. The ultimate complication for an entrepreneur is to hit or surpass projections, but while hitting your stride, take time away from the business to raise capital. Most investment cycles from the first meeting to close take 3 weeks to 2 months, depending on the diligence required and the familiarity the investor has with the product and the market. This means that an entrepreneur could be working with a list of investors and receiving 15 emails a day for different diligence requests (a little less or a little more is possible). The milestone approach solves this dilemma for an entrepreneur.
With the milestones approach, we set up our second round investments as a call option in which the entrepreneur can either choose to accept or deny. We set out pre-determined milestones such as sales, customers, unique visitors, bloggers, etc. That way it is clear at the end of the agreement, usually 4 to 6 months, whether or not the call option is earned. We also set up a pre-determined valuation; however, if you surpass milestones, a higher valuation is warranted.
For Investors - When investors look at an opportunity, they must always ask ‘what if’ to assess the potential risk. What happens if the company builds on a platform and one day the host kicks them off? What if customers will not pay for the product? And obviously the list goes on. Because of these risks, it makes sense for us to invest a smaller amount upfront that allows a company to hit a handful of concrete milestones, proving the strategy of the company. Coincidentally, this time period is usually between 4 to 6 months.
The milestones strategy reduces the risk for an investor. They do not have to commit as much capital upfront and get time to understand and work with the founder. The investor may actually commit additional capital in the next round if they see additional value.
Where the Milestones Approach Becomes Ineffective:
1) If the time between the first round and second round of capital extends to far, then it is tougher to assess reasonable milestones and see whether the company is on track to hit milestones. Four to six months usually makes the most sense for us.
2) Milestones are not clearly defined. For example, add mobile app functionality. While crucial, how do you define functionality. This is where lawyers often get involved to avoid the ambiguity at the option date.
3) Startups pivot…often. What happens if a milestone disappears over the course of the time period? In other words, you say to sell 1,000 widgets, but you actually end up selling 500 widgets and 500 tikes. It can get fuzzy. This is where you have to be clear and make sure each milestone is tested before an agreement is reached.