Bildnachweis: YPOG.
A tranche payment that is conditional on the achievement of specific milestones is a common instrument in venture capital financing for life sciences because it addresses an uncertainty that is inherent to this space. At the same time, it ensures that both the start-up and the investors can rely on sufficient funding of the company as long as its development stays on track. Milestone payments can therefore be a driver for a company’s growth and success if they are well-structured.
Life sciences start-ups typically face a long road to exit with various hurdles along the way. Every hurdle that is overcome significantly reduces the risk of failure in developing a drug, therapy, or medical device. Accordingly, the likelihood of a start-up delivering on its value proposition sharply increases after each hurdle. Milestone-based tranche investment addresses the significance of these hurdles, which are particularly relevant in the life sciences space. Further, life sciences is a capitalintensive business, and it is often easier to find investors (as part of a consortium) for smaller tickets and tranches rather than one investor with a huge lump sum upfront. For all these reasons, milestone-based payments in tranches are well-suited to venture capital financing in the life sciences sector.
A double-edged sword
Milestone investments can create certainty both for the company and the investors: the company has secured long-term funding, which reduces fundraising pressure and ensures that management can focus on development. Similarly, investors have reduced their risk exposure by making a certain portion of their overall investment subject to the achievement of milestones. In addition, investors acting as part of a consortium have certainty that, once the milestones are fulfilled, they do not have to reach out to new co-investors, but can rely on the existing consortium, which is committed to further capital injections in accordance with the agreed milestone schedule. The flip side is that milestones can present real bet the company moments, where the outcome is binary success or failure. Furthermore, milestone agreements add significant pressure on the company to work towards very specific targets. And while milestone targets are typically defined as static benchmarks, they may extend over a considerable period of time. Should the company’s business environment or strategic priorities evolve during that period, the milestone structure may create misaligned incentives. This could encourage the pursuit of milestone achievement to secure the next funding tranche rather than the strategy that would best serve the company’s development.
Defining Milestones
Milestones can fall into the following buckets: science and technology (e.g., initiating or completing clinical studies and trials, or demonstrating certain technological capabilities); commercial (e.g., winning (government) contracts, reaching specific revenue targets); and operational (e.g., hiring science and management experts). The definition of the milestones requires tailoring to the individual case, and their content depends very much on the sector and the development stage of the company. In any case, milestones should be clearly defined and objectively measurable. Where milestones include subjective elements or terms which do not have a commonly accepted specific meaning, the risk of disputes and litigation increases. Milestones usually also include a long-stop date by which the targets must be met.
Determining milestone achievement
Investment agreements typically include a mechanism for determining whether a milestone has been achieved. Where milestones are only considered to be achieved if their achievement has been approved by the advisory board, the milestone determination becomes subjective and, depending on the composition of the advisory board, decisions may be driven by the individual interests of certain board members. Therefore, investment agreements often provide that milestones are fulfilled once the objective milestone criteria have been met, whereas the advisory board merely confirms such achievement. Where the company and the investor-dominated advisory board do not agree on the achievement of a milestone, the documentation should provide for a swift dispute resolution mechanism, including the appointment of an expert in the relevant field who has the power to decide the matter with binding effect for all parties.
Waiving milestone satisfaction
The milestone framework should be designed to provide sufficient flexibility to accommodate changing circumstances. For example, a milestone may be only partially achieved, or the company may fail to meet a milestone while nevertheless exceeding expectations in other areas. In such cases, investors may have a commercial interest in advancing the next tranche despite the failure to satisfy the agreed milestone. Accordingly, the investment documentation should include a waiver mechanism. Typically, the financing documents allow each investor, for a certain period, to elect individually to waive the relevant milestone condition and fund its tranche. Furthermore, a qualified majority of investors can usually waive the milestone condition with binding effect for all investors, allowing the tranche to be drawn notwithstanding the milestone’s non-fulfilment.
Consequences of a missed milestone
If a milestone is not achieved or waived within the applicable timeframe, investors are generally not obliged to fund the corresponding tranche. Accordingly, they lose subscription rights pertaining to that tranche. However, in some cases, milestones are intended not only to structure the investment by way of tranches, but also to serve as a mechanism for adjusting the valuation if a milestone is missed. In such cases, the investors remain entitled to receive the relevant shares (or a portion thereof) even if the milestone is not achieved, with the result that they effectively pay a lower price per share in the company. It is key to clearly define the consequences of a missed milestone in the term sheet to avoid misunderstandings, which can have a significant economic impact.
Milestone achievement
If a milestone has been achieved or waived, the investors will fund the respective tranche and receive newly issued shares in return. To facilitate the issuance of shares, a sufficiently large authorised capital (‘genehmigtes Kapital’ in German) should be created in connection with the equity financing round, such that the capital increase can be conducted without an additional shareholders’ meeting. Since the terms and conditions of the newly issued shares are usually set out in the investment documentation, no changes to the shareholders’ agreement are needed, and the implementation is quite straightforward. Occasionally, the investors receive all shares (for all tranches) up-front at first closing, and a portion of these shares must be re-transferred to the company or redeemed if a milestone has been missed. However, this structure is rarely used, as it does not align with the principle of ‘equity in exchange for investment’.
Investor default and Pay-to-Play clauses
Non-payment of a milestone tranche may lead to substantial practical and legal issues not only for the start-up, which needs the additional funding to continue operating according to its business plan, but also for the other consortium members, who rely on prorata participation by all investors. To create a strong disincentive against any form of opportunistic behaviour, all milestone-based payment agreements should therefore be accompanied by pay to play mechanisms. The default rules must be penalising, e.g., by converting the preferred shares which have been paid for in prior tranches into common shares (often at a ratio of five to one or ten to one) and by a forfeiture of any preferential rights (e.g., board appointment rights). These consequences usually become effective after a grace period of ten to 20 working days from the receipt of a default notice.
About the author:
Dr Martin Schaper, LL.M. (Cambridge), is a partner at YPOG advising investors, growth companies and corporates on venture capital, M&A and private equity transactions, with a focus on biotech and healthtech deals.
