Milestone Based Investing

Early stage venture capital is by definition milestone based investing. The entrepreneur raises enough capital to get to a significantly different place with his or her business and both the entrepreneur and the investor hope that the next round will be done at a significantly higher price that reflects the progress made.

This is one of the main reasons why I think early stage venture capital is a much less risky form of investing than many outsiders think. Most experienced venture capital investors scale the dollars invested in a startup such that they don’t have much capital at risk when the investment is the most speculative and they increase the capital invested as the risk is mitigated.

But sometimes investors get too cute with this milestone based investing approach and try to build that into the investment round itself. This is called “tranched investing” and serial entrepreneur Chris Dixon has a post on it this morning.

I agree with Chris that tranched investing is a bad idea all around. But first, let me explain how it works.

The entrepreneur will agree to raise a set amount of money, let’s call it $3mm for a set amount of equity, let’s say it is 25% of the company ($9mm pre, $12mm post). If it is three tranches, then $1mm will come in at the first closing and the entrepreneur will dilute 8.33% (1/3 of 25%). There will be a set of agreed upon milestones set in advance. Let’s say tranche two miletstone is the shipping of a product and tranche three is the first contracted revenue for that product. When each of those milestones is hit, the investors will invest the second and third $1mm tranches and the entire round will be completed and the full 25% dilution will have been taken.

Let’s be honest and see this as what it is. It’s an option for the investor to put more money in at the old price as the investment increases in value and the risk is mitigated. It’s a bad deal for the entpreneur and a great deal for the investor.

But as Chris explains, there are other problems with this approach:

Milestones change anyway:  At the early stage you often realize that
what milestones you originally thought were important actually were the
wrong milestones.   So you either have to renegotiate the milestones or
the entrepreneur ends up targeting the wrong things just to get the

The idea that you are going to hard wire the key goals of an early stage company is nutty. The best entpreneurs weave and bob their way into the market, changing things as they go. Setting hard goals is a mistake early on in the life of a company.

The idea behind tranching is right which is to limit the capital at risk (and the dilution) until the business increases in value and risk is mitigated. The right way to do this is raise smaller rounds more frequently and negotiate the prices of each financing as the round is done.

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Comments (Archived):

  1. shafqat

    Interesting post – agreed that milestone based investing is not in the interest of the founders. However, I have some concerns over the idea of raising “smaller, more frequent rounds.” Fundraising is a full-time job for the CEO, and it takes a lot of time, effort and serves as a distraction from developing the product/company. Of course, the upside is huge and being able to run a company while fundraising is a pre-requisite skill for a CEO.But surely frequent rounds is a diversion of scarce resources away from the company? Can you expand on that – how frequent, what size rounds, different investors or the same?We raised a seed round approximately a year ago, and now have built a compelling product (not public yet), have revenues coming in and are close to breakeven. We’re considering another round, but worried about the distraction and loss of momentum it might bring.

    1. fredwilson

      i like the idea of doing smaller more frequent rounds with the existingsyndicate and only going out for new investors when the business has metreally significant milestones and the team can spare the time to do it

      1. Aaron Klein

        I’ll preface this by saying I’ve only done angel deals and have never done a full fledged VC deal before. But it seems to me that it all boils down to trust.You seem like you’re very “real” with your portfolio companies and don’t play cloak and dagger games, but we’ve all heard horror stories (and I’ve seen a few up close). I’ve seen VCs who seem to have an interest in not giving the founder any time to put other options on the table, so they can force a better last minute valuation for themselves when the clock is running out.Of course, if a company is working and things are going well, founders tend to have more options. It’s when it’s still a viable venture, but not everything is perfect, that this scenario presents itself.Maybe you’ve already posted on this before, but I’m curious to know more about your philosophy of how many months of cash a startup should put into the bank for each round, and when you expect them to be looking for the next round. How much time does that leave for contingency if the existing syndicate doesn’t have the resources to follow on, or decides not to?

        1. fredwilson

          ideally, startups should finance for 18 months to 24 months. early on, i like shorter timeframes, like 12 months, to keep the amounts and dilution down.the ideal financing looks like thisfirst round – 12 months (sub $1mm)second round – 18 months (~$2mm)third round – 24 months (~$4mm)fourth round – to profitability ($5mm to $10mm)the amounts depend entirely on how capital efficient the company can be but you get the picture

          1. Aaron Klein

            Makes sense. Thanks.

      2. Aaron Klein

        By the way, I completely agree with your post. With the few VCs I’ve talked with, almost every one liked tranching, and their attitude was “if you believe in your predictions, you won’t have a problem with this. We insist on it.”I think the bottom line of your post is — this isn’t how real partnerships work. Tranche or no tranche, you work with the VC under the same interests throughout that first round and make a business decision together about the second round.Successful VC deals are true partnerships where interests are aligned. That’s a common theme on your and Chris Dixon’s blogs (and thanks for turning me onto a new one).

  2. Peter Cranstone

    As the old saying goes – “No plan survives first contact with the enemy”. Things change (see Ryia) VC’s know this and “smart” Entrepreneurs know this as well. IMO it’s all about engaging, explaining and then aligning expectations. It’s easy to say, much harder to do. Nobody can predict the future, but you can all work together to help it be successful. Trenching funds is out of alignment with that goal. It’s a win – lose deal

  3. robschultz

    The downside of raising smaller more frequent rounds are several fold:1) is that you are constantly fund raising and not focusing on building the business.2) constant fundraising introduces tons of risk out of the control of the entrepreneur like the recession we are going through now when many firms are not investing.I agree that in an ideal world you would exactly align fund raising and milestone generation, but start-up is far from ideal. The best advice I ever got was when a board member told me that the “time to eat appetizers is when they are being passed around”.

    1. fredwilson

      True. But if we have a good syndicate, you can do small internal rounds with them. We do it all the time

  4. dredding

    What about tranched investing without milestones? If there is adequate trust between management and investors, it doesn’t make sense to have a couple million dollars sitting in a bank account earning interest when this lowers a VC’s IRR.

    1. fredwilson

      Tell that to a paranoid entepreneur. And most are paranoid for good reason. Andy Grove said “only the paranoid survive”

      1. kidmercury

        thanks for defending the paranoid boss, much appreciated

  5. MattCope

    To restate your point, tranched investing is a type of milestone-based investing in which milestones are hard coded before the round is closed. And it creates crumby incentives.And since early stage VC is by def milestone-based investing, the alternative is investing later rounds on milestones that are soft-coded or determined during those later rounds, right?Doesn’t the absence of hard goals incentivize weaving and bobbing? Weaving and bobbing is good in moderation, but too much of it creates lost opportunities.

  6. Vladimir Vukicevic

    Interesting post. So can argument be boiled down to: “There are no inevitable or milestones for startups.” ?

    1. David Semeria

      Or alternatively: as the story gets better, so does the valuation.

  7. hendler

    Excellent topic for early stage startups.For our small startup in the education space, goals and milestones have been very helpful – not only for achievement’s sake, but also for measuring progress, and developing language, process, and culture in our company. Milestones lead to dialog and change. Then, a teams ability to adjust to reality is the measure of success during a sprint.There’s Eric Ries’ article – value coming less from cash and more from “number of iterations” remaining in a company. http://startuplessonslearne… . Relatively slow milestones from tranches can slow down iteration cycles for a small startup.Money is fundamental – but there’s also no substitute for a supportive relationship from investors. 🙂

  8. goldwerger

    What’s always troubled me about this type of proposition is that the VC typically presents it as a “benefit” to the entrepreneur while knowing well the benefit is its own. The harsh reality is that the investor in this case is banking on inexperience and for me this should raise a red flag. But it also says something more about the investor… An important educational post!

  9. ErikSchwartz

    The reality is in most cases the idea you’re pitching is not what you’ll end up building. Success is based on how you adjust, not what your initial spreadsheets and pitch deck say.As someone else said, this doesn’t seem like the give and take necessary to make a good partnership.

  10. $3236

    Lots of big companies (including the one I was at – Knight Ridder) did management compensation much the same way with MBOs – Management by Objectives. You figure out in October or November what your objectives should be for the coming year and a large part of the comp was based on whether you hit the objectives. By the middle of the year the real business objectives always had changed so there was regular end-of -year gaming to get the money. It wasn’t such a bad deal for the management team but it did waste tons of time.

    1. fredwilson

      some of our companies do quarterly objectives and that works a lot better. it’s like agile software development. shrink the cycles and you’ll get better results.

      1. Farhan Lalji

        Love the idea of investing like agile development, everything should be agile at the start. Biz dev, sales, marketing as well as development why not agile investing too? Action creates clarity right. Why not assign a pot and after the first traunch, review the investment needs on a frequent schedule, without as much paperwork though

  11. ShanaC

    There sounds like there is a trust problem and not knowing what is flying problem because of quick and ever changing growth in startups in the VC world.This is something that would be so much more easily solved by cutting back on investing in lots of things (invest in less, but invest more of what you believe in) and take time in due diligence. From there, really working with companies to resolve issues as they come up. Since everyone knows that the issues come up. Why bother with the craziness of tranching? Doesn’t it create more stress later on, and actually create more fiduciary headaches- when the contract is voided because it is effectively impossible to live up since the goalpost changes in vague ways? Wouldn’t it be better to try and stay hands on so that the goalpost is firmly intact and a close enough position that the majority of companies that a VC invests in make it to the end… We all know that products and goals change, that’s why the word alpha and beta exist. Why not embrace the goal of changing and take it head on? I don’t get it…It reminds me of non-profit work. If you are not careful, you end up with duplicate, badly run organizations who are run by grants because that’s where the money is, rather than the grants being semi-open ended but asking for say some sort of check-in process. After a while, you find out it is better to turn down the money. Either that, or merge with a bigger non-profit who is doing what you are doing, or at least something similar (I guess the same thing would be said of startups.) Anyone whose been involved though, admits that sort of system is a mess and a half……Remind me never to chase after bad money. I’d rather stay away. Long term, they don’t add value. They take away, because they create artificial constraints that have nothing to do with the work one actually does.

  12. TDKlein

    The only time we’ve ever (very reluctantly) used this structure is to bridge a valuation gap; the entrepreneur wanted one price, we thought it should be lower. If the entrpreneur is right and meets milestones, he/she has a call on the next tranche of capital at the higher price. If not, it’s an opportunity for the investors to try and get the price they orginally thought was fair. Candidly, I think it’s a terrible way to establish a relationship between management and investors, as an investor you have the perverse benefit of doing better from an ownership standpoint if the company does not meet its plan. Unfortunately, there are time that it’s the only way for both parties to get comfortable with the deal. We try to avoid these structures at all costs.

    1. fredwilson

      i agree. bridging valuation gaps is a big problem. everything i’ve tried to address that issue has problems. seems like VCs and entrepreneurs should just walk away if they can’t meet in the middle.

  13. kidmercury

    one of the many problems with investing in our current world is the friction involved in transactions, it is just too much work. entrepreneurs can’t spend all their time raising money and investors need to truly take advantage of the internet by placing lots of bets and scaling in to the ones that work. IMHO microfinance will solve this problem but progress on this front is f’ing slow, slower than i hoped for. but the finance-based economy in the US is collapsing, and this make microfinance as a disruptive opportunity more apparent, so i remain optimistic.

  14. Mark

    However… Tranch based investing has the benefit that it can give investors confidence to make an investment when they otherwise may not. Helping investors to better manage risk isn’t a bad thing.

    1. fredwilson

      i’d rather solve that problem by investing less. it is a better way to manage risk.

  15. nataliehodge

    Thanks 4 the post, it’s nice to see a vc commenting about the perspective of the founder, and what is in their best interest. Come hear me speak at Mayo Clinic about a new tech platform in heathcare at the intersection of Health 2.0 ecommerce and care.http://centerforinnovation….Natalie Hodge MD FAAP

  16. Mark Essel

    Do tranched investments have any up shots for the entrepreneur? Like if there’s an agreed upon time/health to the business funding rounds go quicker. Aka less time worrying about funding and more time producing and team leading?Otherwise it sounds like the investment method is a really crappy straight jacket (the madness reference is intentional 🙂 for the entrepreneurs.

  17. chris dixon

    Hey Fred – Thanks for the comment. Probably obvious but I agree with everything you say here. I tried to follow up with something more constructive today and would love to get your thoughts.

    1. fredwilson

      i left a comment on your post chris. it is such a great topic. i think i’ll take your lead again and follow it up here

  18. Phanio

    If the problem is hard goals – don’t set hard goals. Leave the later tranches open to interpretation by the investors. Base it on growth (whatever growth that has taken place) compared to cash needs.I personally think tranching is good for the entrepreneur as they don’t feel extremely cash rich and over spend on things that do not help growth or development like big campus or increasing products lines with fully developing current offerings. Only give them what they need when they need it – kind of like cpaital calls.

  19. Rick Bodio

    Interesting post re: downsides of tranche investing over at @fredwilson’s blog: