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?