Milestone Funding: The Structure of the Deal, The Dilution and the Valuation of your Company

How do you structure a deal with investors? it's a question for any entrepreneur who needs funding for growth. Here is the answer:

Experienced investors will never offer to invest in one lump sum all the funds that a venture will need to reach breakeven.

An investment deal is typically divided into stages known as funding rounds, which are typically scheduled at intervals of 12 to 18 months. This arrangement:

  1. keeps the entrepreneur focused on achieving set goals (milestones) as a condition for obtaining the next round of funding, and
  2. allows the investors to back out from providing further funding if the venture runs into problems that seem to hail a bad end.

Milestone Funding: What are Concrete value-creating steps?

Evidence of a venture’s likelihood to succeed comes from achieving concrete value-creating steps in the venture journey, such as:

  • Creation of functioning prototypes
  • Successful clinical or product trials and market tests
  • Registration of strong intellectual property rights
  • Partnerships with reputable firms or technical institutes
  • Attainment of required licences or accreditation from government regulators
  • Early sales or large customer orders

Consequently, depending on the type of venture and the strategy foreseen, an investor will structure a funding deal so that, at each round, the venture must achieve a set of objectives that move it closer to the probability of successful growth, thereby also increasing the expected value of the company and the likelihood of an attractive return on investment.

Novice entrepreneurs may understandably prefer the prospect of receiving all the investment in one lump sum and not having to await their investors’ verdict every 18 months.

While milestone funding may at first seem to work primarily in the interests of the investor, it is actually also useful to a venture’s founders because, if all goes well, it makes for a lower rate of dilution of the founders’ ownership stake.

Valuation Controversy

Valuation – the monetary value attributed to a company – is a frequent point of contention between entrepreneurs and investors when trying to agree a deal. Entrepreneurs want a high valuation: the higher the company’s value, the fewer shares the investor will receive for the money she injects into the company; thus the founders keep a large ownership stake in the business in reward for their great idea and hard work, while also maintaining a higher degree of independence.

For their part, an investor wants a low valuation so she can buy more shares and take a sizable stake in the business to compensate for the high risk. If she has a larger stake, she also exerts greater influence as a shareholder over how the company is run, and thus has a better chance (she believes) of safeguarding her investment.

Ultimately, the valuation of an asset is down to what the buyer (investor) is willing to pay, which is usually based on accumulated past experience. Experienced investors can draw on past successes and failures, as well as examples of comparable companies in a similar line of business, and make fairly reliable estimates of a company’s likely exit value in five to seven years if it achieves its value-creating milestones, and consequently what its going rate is likely to be today and in the intervening funding rounds. Keeping in mind that they hope for at least a 10x return on their investment at exit, they work backwards to calculate the ownership stake they’ll demand for their £1 million investment today.

A novice entrepreneur will instinctively lean toward the investor (if she’s lucky enough to have more than one) who offers the highest starting valuation for the lowest ownership stake.

In truth, she should also consider later funding rounds when thinking about valuation. As the company moves into successive rounds of funding, new shares will be issued to the investors putting in new cash, increasing the total number of shares, while the founders will retain the same nominal number of shares as before. The founders’ shares will thus account for a smaller slice of the pie, a process known as ownership dilution. At each round of funding, new shareholders may come in to dilute the ownership even more. If a company needs a lot of equity capital, the founders will inevitably end up with a minority share during the course of several funding rounds.

Figure 32 provides an example of funding rounds and dilution, based on the following information:

  • Round 1: £2m invested at £5m post-money valuation at start of year 1
  • Round 2: £5m at £20m post-money at start of year 3
  • Round 3: £5m at £45m post-money at start of year 4

If the company makes good progress on its business goals and milestones, the perceived value of the company and its share price should increase at each funding round, making for milder dilution. If a founder were to receive all the money needed in a single round at the outset, when risk is highest, she would receive it at the lowest possible valuation and consequently have a lower stake than if she waits for the increase in valuation at each milestone.

However, before you get too excited about milestone revaluations, remember that investors – especially VCs – will structure deals to limit their risk of losing money.

They will also throw in clauses to allow lower valuations and other preventive measures (‘ratchets’, liquidation preferences and other technical devices to be found in term sheets or shareholders’ statements) to limit the dilution of their shares if the company should not achieve its milestones. Furthermore, the higher the stake demanded by an entrepreneur, the more challenging the milestones demanded by an investor will be. Ultimately, accepting a 30 per cent equity stake with achievable milestones and a good exit prospect will probably lead to a better result than taking a 40–50 per cent stake with very difficult milestones that could bring you up short in a future funding round.

This is an excerpt from Sabrina Kiefer's book, The Smart Entrpreneur, which she co-authored with Prof. Bart Clarysse.

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