The Staging of Venture Capital Financing: Milestone vs. Rounds

Abstract

Venture capital funding is commonly provided to start-up firms on a piecemeal basis over numerous stages. One way in which this can be implemented is through milestone financing, where a venture capitalist commits upfront to providing additional future funding contingent upon the firm meeting certain conditions, or milestones. Alternately, the firm can operate without a firm commitment in place, still reasonably expecting to be able to receive additional rounds of funding after goals are met (round financing). We identify four dimensions which can affect the optimal contract and choice of financing method: entrepreneurial effort, venture capitalist effort, venture capitalist preference for liquid investments, and heterogeneous expectations about the feasibility of the underlying real technology. The effects of these on the optimal milestone and round financing contracts are examined. Firms that prefer milestone financing to round financing (and conversely) are characterized.