Financing start-ups and scale ups: milestone financing

In my earlier blog I wrote about what to look out for as a director of a manufacturing or tech startup or scale up when entering into an investment relationship with an investor and referenced what types of financing exist.

Still missing from this overview was the so-called milestone financing. In this blog I elaborate on that. The reason: MT/Sprout challenger Ziel NL BV which, after a short suspension of payments, was declared bankrupt last August 6. Ziel NL BV was financed through milestone financing.

Mile stone funding

A milestone financing involves a large (total) financing that is released in tranches when the company has achieved certain objectives. Legally, it is financing under conditions precedent. The obligation to pay is dormant until a certain condition is fulfilled. 

MT/Sprout asks (rightly) whether such funding is wise.

While it can be argued that milestone funding can absolutely be motivating - after all, not only is a milestone reached, but a funding tranche is released - it remains risky.

Personally, I don't think attracting milestone financing is wise. There are a number of pitfalls that lead to that conclusion:

1. Entrepreneurial optimism; a business owner is quick to think in terms of possibilities, which in itself is a good trait, but that also makes a business owner estimate difficult goals may be easier to achieve just to pull in the funding. Consequence: mile stone is not reached and the money eventually runs out.
2. Formulating mile stones; it sounds so simple, but each mile stone is itself fodder for discussion. When is a mile stone achieved? Whose conclusion is leading therein?
3. Force majeure: you cannot predict all the factors that affect the feasibility of a mile stone. In the case of Ziel NL BV, for example, it seems that the outbreak of COVID-19 made certain mile stones seem unfeasible. Consequence: immediate liquidity problems.
4. Unforeseen circumstance: what if the direction of your business changes? Or when your product might undergo a major modification. Will it still be possible to meet the agreed milestone? Attracting new financing can still be quite a challenge in this case.
5. Investor: you are always dependent on the investor with the payment of tranches and it is difficult to force payment earlier because the claimability of the tranche depends on a suspensive condition. If a liquidity crunch occurs, it is difficult to force the investor to make an additional payment. On the other hand, the investor does get immediate control and shares in the company. Therefore, it does not seem like a completely fair deal.

First suspension and then bankruptcy

Now why file for suspension of payments first and not bankruptcy immediately? Many challenger companies and scale ups have issued substantial equity to their private equity investors. Control based on equity is therefore often in the hands of the investor.

If the board (often the founders) foresees that the company will not be able to fulfill its obligations in the short term (anymore), it can request the general meeting of shareholders to decide in a shareholders' resolution to file its own declaration of bankruptcy. The board cannot do this without the shareholders' resolution.

Director liability?

The question is such mile stone financing beyond the risks to the company also poses risks to the company's management.

The basic principle in the Netherlands is that a business owner is allowed to take certain risks in running a business. If things go wrong, bankruptcy in principle only affects the assets of the company and not the assets of business owner in private. For a more extensive article on directors' liability, see here.

However, in the case of bankruptcy, the board may be liable for the bankruptcy deficit if they have violated the financial statement duty and/or recordkeeping requirements. This claim can only be brought by a trustee.

Individual creditors may be able to bring a claim based on directors' liability if - in short - the board knew or should have known that the company did not have any recourse for the fulfillment of its obligations and the board could be personally blamed in that regard.

If it is foreseeable that certain mile stone will prove unfeasible, but the management board nevertheless enters into new (major) obligations on behalf of the company, it is quite conceivable that it could be blamed in the event of bankruptcy.

Conclusion

Entering into milestone financing can be motivating for the business owner, yet it appears to be primarily a mitigation of risk for the financier. It is therefore not entirely without risk, even for the director in private.

The business owner would therefore do well to spar with a specialist (lawyer) before entering into a financing (relationship) about what risks are involved in certain constructions. This also applies to the (financial) advisors involved in raising (loan) capital.

Whether the management of Ziel NL BV can still be blamed is unclear. The trustee is still investigating and, as far as I can tell, no individual claims have been made against the board.  

Want to know more about this article? Then contact Erik Jansen at e.jansen@pvdb.nl or 024-3810871.