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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.

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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 structures designed to increase investors' stakes if the milestones aren't met. Instead, he recommends performance-based conditions that encourage the investors and the entrepreneur to build a business over a stretch of time.

"If a deal is focused only on the venture guys, it's going to fail," he says. "We don't want to win this as venture guys. I want the entrepreneur to win it so I end up owning less but my relative value goes up."

Callow says his firm typically sets three types of targets: budgets; nonfinancial, strategic acquisition, partnership or marketing alliance goals; and a third tactical target that's relatively easy to achieve. "As long as it's thought of from a corporate director's standpoint, as opposed to a VC's, I think they're good."

On the other hand, says Manu Rana, vice president at New York's Lazard Technology Partners, there is a risk that the company could only focus on those agreed upon metrics, when other things could happen that require the company to deviate and they can't.

"Then it becomes a lawyer issue and you end up running a company through contracts, which isn't the most constructive way to run a company," Rana says. "The board and management need flexibility." Ultimately, he says it comes down to: "if you don't trust the management, don't invest in the company."

Some lawyers say that difficulties often arise in the IT field where setting the milestones can be a complicated process for startups. For example, he says that rigid sales milestones may not make sense when a company is trying to line up customers for a new product where customers won't buy until other companies have.

"To some extent, milestones could involve an arbitrary set of numbers designed to gauge the acceptability of a product," Reilly says.

In addition, having a staged financing can add an element of uncertainty, potentially prompting concerns among suppliers and customers over a company's balance sheet and long-term viability. "Having fewer dollars in the company upfront implies there's some ambivalence in the support from the investor group," Reilly adds.

Lawyers for startups often argue against milestones because of the additional time and money spent negotiating over what should be achieved. Management can also be distracted by periodic closings, not to mention protracted renegotiations when milestones are not met.

For milestones to work, investors really need to get into a business and understand what makes sense operationally, says Michael Littenberg, a partner at New York's Schulte Roth & Zabel, who says about one-third of his deals this past year have had milestones.

What happens when milestones are not reached? Usually, it's the kiss of death for a company — except where the VCs decide to ignore the missed target.

Littenberg cites the example of an unnamed infrastructure provider where a VC put in $4 million with two milestones to meet: a development target and a revenue goal. The company missed both, but the VCs ultimately released the second tranche anyway because they agreed that milestones were never really attainable. "It engendered a lot of bad feelings all around, and it resulted in a lower degree of confidence in management," he recalls.

Moreover, situations aren't always cut-and-dried, lawyers say. Sometimes, there are material adverse changes that make it impossible for a company to meet an objective but which could lead to disagreements over the VC's obligations. For example, a company gets some customer acceptance, but it's not growing as quickly as expected. Or, a company needs to have hired a new CFO or completed a strategic alliance on terms satisfactory to the investors.

In such cases, the parties usually have to restructure a deal with the VCs increasing their stakes, if they didn't already own majority control. Or investors could demand management changes.

"There's always one or more goal that is squishy in nature and subject to disagreement as to whether it's been met," Meredith says. "Those gray areas have always been there, but the problem now is that investors are more likely to think long and hard about providing the subsequent investments."

That means more potential disputes and some difficult conflicts of interest. If a company's board is controlled by VCs whose funds have promised milestone-based financing and the funds don't want to sink more money in the company, the VC directors face a dilemma.

"The directors have a duty to the company to ask for the money, but at the same time, those same people are also general partners of a fund with a fiduciary duty to the fund's investors," Meredith notes.

Gregory Smith, a partner at Skadden, Arps, Slate, Meagher & Flom LLP, sees a broader reason for avoiding specific targets and multiple tranches: "As a general rule, people do better when they can make the decision and their investment now and not try to crystal ball everything."

U-Nav's Garcia, for one, admits that he ended up agreeing to a "brutal deal" compared to the terms startups could strike 18 months ago. Still, he is confident of making his targets and reaching cash-flow positive status by end-2003.

And what if his company doesn't make the milestone? Garcia says he also has faith in his investors.

"I don't think any good investor will let their money go to waste by not keeping a company funded properly," he says. "From that standpoint, I don't worry about it too much."
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