Why milestone-based agreements are bad for early stage startups
The pace in which startups progress is very fast, which makes it difficult to set up an accurate long-term plan. Therefore, startups often use milestones to plan and measure their progress. These milestones are usually defining points in a company’s life, such as a financing round, a product launch, signing a commercial agreement, etc.
The problem I often encounter is when these milestones are used in contracts and agreements related to the startup. This can be milestone-based funding from VCs (also known as “tranched investing”), milestone-based compensation for senior execs and advisors, or even Milestone-based vesting for founders shares.
The problem I find with basing agreements on milestones for early stage startups is that too often they will change along the way, making it difficult to use those milestones as a concrete baseline. What seemed to be an important target only a year ago, might seem completely irrelevant a year later. This doesn’t mean that anything went wrong, it is just that the targets were changed as the startup progressed, a natural evolution in the life of a startup. Another issue is that milestones for early stage startups tend to be quite vague and it’s often difficult to decide whether they have been met or not (e.g., “does this qualify as a large customer or not?”).
What ends up happening because of changing milestones, is that signed contracts often become irrelevant. This puts all sides in the agreement in an awkward situation and forces them to renegotiate what was already signed. Making things worse is that unlike the previous negotiation which was mainly theoretical (“you will get $10K if we achieve this milestone”), the negotiating is now much more concrete and is often a zero-sum game (“I want my $10K although we didn’t meet the original target”).
For example, an investor who tried to be too cute and tranche their investment based on milestones (e.g. “you will get the second half of my investment after you land a paying customer”) will likely have to renegotiate the current investment with the entrepreneur or force him to hit a milestone which is not necessarily the right one for the company; or a CEO who agreed on milestone-based compensation for senior execs will need to ignore the contracts and still compensate his management or risk losing them when the company goals change; or a founder who has milestone based vesting will need to go back to investors and explain why he should still be vested. Re-opening these discussions can be detrimental to the company as often one side ends up feeling like they got screwed.
So how can we avoid this predicament all together?
It is typically better for early stage startups to avoid relying on milestones in agreements as these milestones often change. The amount raised in a funding round hedges the risk for an investor and should suffice to hit an accretive milestone that should allow the company to raise an outside round at a higher valuation. When hiring executives, it is better to agree on a range for compensation without tying it to specific milestones, and then agree on the exact targets to hit the bonus on a on a yearly basis (or even change throughout the year). Founders’ shares should vest over time even though it is not always fair since the alternative is worse.
There are, however, times when it is reasonable to use a milestone-based contract. This can work when the milestones are relatively short term, predictable, and extremely clear such as revenue growth, FDA approval, or raising a round. In addition, as the company matures, the targets are more likely to hold over time, and therefore can be used in agreements.