Harborco

Milestones or stumbling blocks?

Embarking on a quest for a second round of venture financing in late December, Russ Garcia, an Irvine, Calif., entrepreneur, agonized over an offer. The venture fund would fork out the money if his startup, which makes global-positioning satellite chipsets, met certain goals. The pricing was on a sliding scale -- upward if the goals were met, downward if they weren't.

Fearing that the terms were too stringent, Garcia rejected that first offer. But when u-Nav Microelectronics Corp. finally lined up alternative financing in August, it too, had a milestone structure. It was the only option, Garcia concluded.

"If you can have all the money upfront, obviously that would be preferable because you'd have a lot more flexibility that way," Garcia says. "But if you're looking for funding right now, it's kind of a way of life."

Across the parched early-stage financing landscape, investors are rationing out capital to starving companies in measured doses. Some venture firms hedge their bets by structuring financing terms around performance milestones to mitigate the risks for the investors. But the milestones also can prove to be nasty stumbling blocks for startups when carelessly designed.

"There's such a small base of early-stage funding so it's hard to define a trend, but I do see it more and more often," says Edward Reilly, a partner with Morgan, Lewis & Bockius' New York office. "I think people are considering doing it more frequently."

This certainly wasn't the approach three years ago, when venture capitalists virtually raced each other to a financing event. When the heady days ended, venture capitalists both reduced their investments and imposed more punitive deal terms. Some resorted to super-rich liquidation preference multiples, giving themselves first dibs on the proceeds of a sale or initial public offering, or they ask for provisions that severely diluted the value of the founders' and common stockholders' equity.

In recent months, however, VCs are trying new techniques to manage the technical and financial risks of early-stage rounds and to ensure better performance by their companies.

"So many investors have been burned so badly, they are definitely gun shy," says Stephen Meredith, a partner at Edwards & Angell LLP's Boston office. "The last thing they need now is to have a situation where they've overfunded a bad company."

That's where performance milestones come in: VCs release the funds they've promised in tranches only when explicit benchmarks are met. The milestones may include meeting a budget or revenue target or signing a strategic alliance, marketing relationship or making an acquisition.

"They're trying to moderate the risks by layering in the dollars," says Jay Hachigian, a managing partner at law firm Gunderson Dettmer Stough Villeneuve Franklin & Hachigian LLP in Boston.

Benchmarks have been fairly common in biotech, but they have been relatively rare in IT or other sectors, until recently. For example, u-Nav, Garcia's company, got a $10 million Series B round that was split into two tranches. The first $7 million was available upfront, but the remaining $3 million was predicated on meeting a milestone consisting of revenue, margin and working capital targets.

Garcia elected to go with new investors Shelter Capital Partners of Los Angeles, Denmark's Danske Venture Partners and iSherpa Capital of Denver because they allowed a bit more room for maneuvering. If his company meets the targets, he can demand the money or decide not to call it if it's not needed. On the other hand, if it fails, the investors have 18 months to decide if they want to put in the $3 million.

That was "reasonable," Garcia says, since his company would have those goals anyway. But, he added, "It does force the company to be prudent about how it spends its money to achieve the goal."

However, such conditions complicate financing transactions and can lead to protracted negotiations over interpretation and pricing, so the venture community itself is divided over their wisdom.

On the one hand, the believers say performance milestones keep managers focused on tangible goals while investors minimize the risks. "Are they on their toes? Are they really watching the money carefully? Many times, having that extra financial pressure is a good way to ensure that," observes Michael Feinstein, a partner at Boston's Atlas Venture. "We view this as one more tool in our bag of tricks."

Atlas doesn't insist on milestones in every deal, he says, but finds them useful in many cases. "During the bubble, we lost sight of managing details -- it was all about speed," he admits. "Now people are looking for these types of tools to balance risks."

In a recently completed A round for portfolio company Sandbridge Technologies, a White Plains, N.Y. startup developer of advanced wireless chipsets, Atlas invested $14 million alongside lead investor Bessemer Venture Partners of New York and Columbia Capital of Alexandria, Va. It was divided into two $7 million tranches. The first milestone the company had to pass was resolving an intellectual property issue. "You want to make sure that there's some level of technical risk taken out of the deal," Feinstein explains. Another tranche was tied to a product development goal. The 1-year-old company met both and was rewarded with a $20 million post-money valuation.

Feinstein also thinks the milestones can help ease investor anxiety about pricing. "If they can't hit the milestone, then the deal probably wasn't worth as much as was originally agreed upon and you can change the valuation slightly," he says. In some cases, his firm has negotiated slightly different terms -- "Nothing onerous," he claims -- as an adjustment to compensate for the fact that a company hadn't made as much progress as expected.

Another fan of milestones is Dana Callow, general partner at Boston Millennia Partners. They discipline both the venture partner and the entrepreneur, he says. Currently, he thinks only about one in 20 deals uses milestones, but that's changing.

"If it were up to me, I'd do 50% performance deals or close to it," he adds.

To do it right, Callow explains, one should avoid