Okay, so you just got told you're getting three million dollars in Series A funding for 20% of the company. Awesome, right? The term sheet is on its way from the lead VC. And the first million will be hitting your bank as soon as the legals are done and the ink is dry. And all you have to do to receive the next two million in funding is... hit the numbers you laid out on page 11 of your pitch deck.
Conservative estimates, or unrealistic expectations?
Courtesy E&Y Ultimate Guide for Startups Kit
Founders, here's the twist. If you don't hit those "investment milestones", you're potentially going to be giving up 20% of your company for USD1M instead of USD3M.
But that's not the end of it. Upon missing that same milestone, you're probably going to need more money. And for that, you're going to have to give up even more equity, and agree a set of new, possibly even tougher incentive-based valuation milestones. Worst case? You may end up with an unwanted co-founder, with loss of control, or be pushed out of your company completely.
Now before you start viewing your investors as evil for causing all of this pain, it needs to be said that none of these outcomes are necessarily good for the investors either - which is why most experienced, professional VCs will go out of their way to avoid their kinds of crushing outcomes, and instead, agree new, more reasonable deadlines and financial incentives.
There's just one problem. Science has shown, almost without a doubt, that this approach doesn't work.Research has proven pretty conclusively that when you marry a financial incentive and a time limit to a task involving creative thinking, you will get a negative result - relative to the result achieved by a non-financially-incentivised person undertaking the same task. As the Harvard Business Review has reported, often when you remove the financial incentives, the results go up, not down.
And this appears to get worse as the tasks become more complex and demanding. As Dan Pink pointed out ten years ago in his famous Ted Talk on The Puzzle of Motivation, the London School of Economics proved that when financial incentives become the central driving force, the field of vision involved in creative thinking literally narrows, and deadlines become counter-productive, as the problem solvers (i.e. founders, in our story) increasingly begin to look for "quick and dirty solutions", rather than complex, innovative solutions based on novel uses of science and technology.
Usually, at the point at which milestones start to be missed, investors will jump in to help. There's just one problem - that "help" often involves some form of co-management, or adoption of "professional development standards". And the data doesn't seem to support this, any more than it supports financial incentives.
In fact, Pink's research shows that better outcomes are achieved not by focusing founders on deadlines, or financial targets or rewards, but by awarding greater, not less, autonomy - and allowing them to be creative, and to simply focus on the object of their intellectual curiosity. Because it turns out that a lot of founders (and, I've found, not a small number of their staff members) are often not driven so much by money or financial gain, as by the thought of achieving a certain goal, such as a new form of drug, molecule, or operating system.
[Note: If you're a non-financial-goal-motivated founder or staff member at a startup, recognise this in yourself, and do yourself a favour and make sure you hire the best lawyer (or mentor) you can find to protect your financial interests. Unscrupulous use of milestones by unethical investors with the ability to spot these personality traits can create much unhappiness down the road. So even if you're not financially-motivated, you will almost certainly be glad you sought advice - a decent financial payoff can fund a lifetime of curiosity-seeking and pure research.]
So where does this leave us, as investors? Should we simply give up on incentive-linked milestones altogether? Should we adapt to more flexible, technology goal-driven milestones? What should we do when these more flexible goals are missed?
I think the first thing we all need to agree is that sometimes, the right kind of professional management can be really useful for all parties - and liberating for the founder. Allowing different kinds of people to each focus on different goals aligned with their individual passions can result in outstanding success (think Google / Eric Schmidt / Larry Page / Sergey Brin).
With regard to financial incentives and milestones, the science says "avoid" - but there are some sensible things we can agree. When you realize that the majority of pivots involve some kind of revenue model adjustment, the adoption of achievable build or user base goals probably makes the most sense for all parties - and in some areas, such as biotech, it's become the norm, so there is a precedent for this.
Bottom line - it's important that we create and agree incentives for the right reasons - because if the science is correct about our upside being correlated to the level of freedom of thought, then it may be possible that will achieve better returns by supporting this kind of activity, rather than artificially growing the level of our upside by hoovering up ever-greater amounts of equity when founders miss their milestones.
John is a serial entrepreneur and investor, and the Founding Partner of Hatcher+, a next-generation, data-driven venture firm that utilises a massive global database in combination with AI and machine learning-based technologies to identify early-stage opportunities in partnership with leading accelerators and investors worldwide.
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