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 money.
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.