Over the past year I’ve seen a little-used investment strategy come up a few times: the tranche. With a tranche, money is typically invested over two or three milestones based on the progress of the company (often at the will of the investor, and sometimes contingent on the entrepreneur’s approval). As an example, $250,000 might be put in immediately, and within the next six months, the investor has the option to put in an additional $250,000 at the same terms.
Clearly, this is a nice benefit for the investor as they can see how the company performs before putting in the additional money, and if the company does well, the second part of the tranche investment is a better deal because the company is worth more as the investor is buying the equity at the previous valuation. Only, there are a few more nuances at play as well. Here are some thoughts on tranche investments:
- Entrepreneurs almost always operate, and spend, as if the later round(s) of the tranche are going to come in, creating challenges if the business doesn’t perform as expected
- Tranches often make the entrepreneur more beholden to the investor (possibly filtering the news to make things sound more promising) as they want to ensure that the next round of money comes in, and this can distract from growing the business
- Tranches can be more distracting as they usually have a shorter timeframe – say three or six months – between milestones as opposed to the typical 12-24 months between financings
- From a valuation perspective, tranches can be thought of as the average of the current valuation and the projected valuation(s) at the later milestones, such that the investor gets a bonus if the company does better than expected
Entrepreneurs typically want to avoid tranches and focus on negotiating a fixed investment amount upfront, so that they know how much money and runway they have to grow the business before raising another round.
What else? What are some more thoughts on tranche investments in startups?
David Cummings on Startups 
David, thanks for the post. In what cases have you seen this investment mechanism used? Is this something the entrepreneur would want to do with the first institutional money being put in (seed or Series A)? Or is it more of a bridge round strategy between rounds? Just trying to get context as to when the strategy makes sense and if VCs are accustomed to it.
I’ve seen it as part of the initial seed round as a negotiating tactic for investors.
In my first company (Qloud) we raised money from Steve Case and it was in the form of a tranche. It was pretty rough and they initially decided to not do a the last part (part 3 of 3) of the deal.
I think it should be stated that the reason people do this is because it’s the best option they have on the table. Obviously if we had something better, we would have taken it. But my co-founder and i were young and unproven so it was prudent for them to do the investment this way. We had to product or be out on the street. It’s understandable. Ultimately we ended up growing the business and getting acquired but it wasn’t until after we fought through the tranche deal.
details on that deal are here: http://loo.me/2015/02/qloud-fundraising-striking-out-in-silicon-valley-part-2-of-14/
Thank you David.
In my coaching practice I try to emphasize the focus on milestones. So, “milestone investing” creates a collaborative bridge between entrepreneurs and investors. As the business is proven these rounds of investing reduce risk for investors and should reduce the risk of capital for companies that need to wisely manage every penny.
So Tranche funding is just another term for milestone investing?
That is essentially the case, David.
“Milestone Investments” are more apt and descriptive. Most everyone immediately understands what is meant by the term.
Thanks Brian. On some other reading I was doing it sounded like Tranche funding can also refer to a end-to-end financing arrangement covering the same period as say a seed through 3 series rounds, but not necessarily. It seems like Milestone funding is something that facilitates that, but can be something that is applied in some much more minor way to a round of series, yes? One of the weaknesses of traditional Tranche funding I heard is that it assumes too much upfront and is too inflexible. Seems like a hybrid approach is best.
Mind you, a “tranche” is literally a portion of money. Historically, tranche investing is open to many interpretations but generally tied to some measure of performance that is typically agreed to in advance. More often than not investors and companies find themselves at a crossroads and need to evaluate progress and continued investment. For example, goals and objectives can be missed under mitigating circumstances and it’s not in anyone’s best interests to pull-the-plug. In any event, this discussion can get very detailed. But, the best summary I can offer is best results come from great communication with both sides genuinely interested in the others best interests.
I’ve built-and-sold a handful of businesses, raised a fair amount of capital for other companies, realized heady returns, and seen a lot of terrific organizations flounder without capital. While the winds of opportunity are often fickle, flexibility, informed decision-making, and communication more often generate success than terminology that must evolve with changes that include speed-of-technology and economic twists-and-turns.
So, if you are going to write a check or receive a check the best plan is to work very hard together.
Well said, Brian. I like what you said here: “best results come from great communication with both sides genuinely interested in the others best interests.” It seems a rare quality when there is an investor who doesn’t see that it’s in their best interest to make sure the entrepreneur’s best interest is being served.
meant to say: rare quality when there is an investor who sees that it’s in their best interest to make sure the entrepreneur’s best interest is being served.
Fortunately, with my own experience I can happily disagree with that. In my coaching practice, when I help my clients secure funding, a key criteria is synergy. For perspective, there are a fair number of investors in the Atlanta market that share this common sense view.