In venture capital, tranching refers to investments where portions of the money are released over time when certain pre-negotiated milestones are hit. Usually it will all be part of one Series of investment, so a company might raise, say, $5M in the Series A but actually only receive, say, half up front and half when they’ve hit certain milestones. Sometimes something similar to tranching is simulated, for example when a VC makes a seed investment and pre-negotiates the Series A valuation, along with milestones necessary to trigger it.
In theory, tranching gives the VC’s a way to mitigate risk and the entrepreneur the comfort of not having to do a roadshow for the next round of financing. In practice, I’ve found tranching to be a really bad idea.
First of all, the entrepreneur should realize that the milestones written in the document are merely guidelines and ultimately the VC has complete control over whether to fund the follow on tranches. Imagine a scenario where the entrepreneur hits the milestones but for whatever reason the VC gets cold feet and doesn’t want to fund the follow on tranche. What is the entrepreneur going to do – sue the VC? First of all they have vastly deeper pockets than you, so at best you will get tied up in court for a long time while your startup goes down the tubes. Not to mention that it would effectively blacklist you in the VC community. So just realize that contracts are the right to sue and nothing more. The only money you can depend on is the money sitting in your bank account.
Here are some other reasons both entrepreneurs and investors should dislike tranching:
1) Makes hiring more difficult: Hiring is super critical at an early stage. A very reasonable question prospective employees often (and should) ask is “How many months of cash do you have in the bank?” How do you respond if the money is tranched? In my first startup, our full round gave us 18 months of cash but the first trance only a few months. Should I have said what I had in the bank- just a few months – and scare the prospective hire? Or should I have tried to explain “Oh, we have 18 months, but there is this thing called tranching, blah blah blah, and I’m sure the VCs will pony up.” Not very reassuring either way.
2) Distracts the entrepreneur: The entrepreneur is forced to spend time making sure she gets the follow-on tranches. In many cases, she even has to go present to the VC partnership multiple times (each time requiring lots of prep time). Also, savvy entrepreneurs will prepare multiple options in case the VC decides not to fund, so will spend time talking to other potential investors to keep them warm. So basically tranching adds 10-20% overhead for the founders that could otherwise be spent on the product, marketing etc.
3) Milestones change anyways: At the early stage you often realize that what milestones you originally thought were important actually were the wrong milestones. So you either have to renegotiate the milestones or the entrepreneur ends up targeting the wrong things just to get the money.
4) Hurts VC-entrepreneur relations. Specifically, it encourages the entrepreneur to “manage” the investors. One of the great things about properly financed early stage startups is that everyone involved has the same incentives – to help the company succeed. In good companies, the investors and entrepreneurs really do work as a team and share information completely and honestly. When the deal is tranched, the entrepreneurs has a strong incentive to control the information that goes to the investors and make things appear rosy. The VC in turn usually recognizes this and feels manipulated. I’ve been on both sides of this and have felt its insidious effect.
There are better ways for investors to mitigate risk – e.g. lower the valuation, smaller round size. But don’t tranche.
Related posts:
14 comments ↓
i totally agree chris. this never works well. i did a follow up post on my blog.
http://www.avc.com/a_vc/2009/08/milestone-based-investing.html
great topic for discussion.
agreed! What about tranching as an option, doesn’t it leave chances for the entrepreneur to outperform and this way keep more of her own company?
bunterberg: In most cases, tranching is done as a “if you hit X, you get Y”. So, the best case scenario is that the milestone is hit and you receive the additional funding.
Generally, there’s no clause that says if you hit 3X (i.e. blow out the milestones), you get a better deal or more money or whatever.
So, it’s downside protection for the investor, not an opportunity for upside for the entrepreneur.
@Dharmesh: Everything can be questioned. Given a case where she achieves more with less and she just doesn’t terribly need the next tranche. Shouldn’t she be able to keep more of her company rather than taking in the tranche?
Found an answer in various blog posts (by Peter Davis) via Fred Wilsons hints. Instead of tranching she would plan this case via two rounds while the investor of the first round agrees upon details (and a higher pre) for the eventually upcoming round. She probably needs a strong standing to close such a deal but if it works out she saves time and shares.
Anyways, finally it will still be up to the investor to actually do the second round and if not she might have a serious problem to find alternatives.
I agree with bunterberg. I would never give the VC the upper hand like that without getting anything in return. In my opinion it is clearly possible for the entrepreneur to get upside potential in such a deal. For instance if certain goals are beaten the number of shares for the same amount of VC-money will be lower. It is all about how well you negotiate with the VCs.
[...] The point is with the super high volatility of startups, you can structure the option in almost any way and it’s still like giving someone shares. (I discuss the problems with tranching in more detail here.) [...]
I’ve worked at startups that have been tranched by VCs. I mistakenly did not pose the questions that Chris advises a prospective employee to ask. Instead of driving sales and marketing I ended up supporting BOD presentations and coming up with sales projections to satisfy the tranching needs. And guess what? We didn’t get the funds that the CEO said were there for the asking, when we needed it. Never again. Great post.
Chris,
I’m continually impressed with your posts. I always learn. Keep it up, I’ll be around.
Subscribing to RSS now.
Cheers,
Ryan
[...] From cdixon.org [...]
[...] The point is with the super high volatility of startups, you can structure the option in almost any way and it’s still like giving someone shares. (I discuss the problems with tranching in more detail here.) [...]
[...] First Tweet 15 days ago cdixon chris dixon Highly Influential the problem with tranched venture capital investments http://www.cdixon.org/?p=261 view retweet [...]
[...] The problem with tranched VC investments (cdixon.org) [...]
I am an engineer’s engineer who joined a vc funded startup without knowing much about how vc operated and how much trouble the startup was in. Investors had thrown out some cofounders and had placed a vc partner as ceo. This vc/ceo one day singled me out and laid me off in a very bad way (he’s known for being dismissive and rude) with no explanation to anyone incl mngmt.
I am looking for some advice on whether I can do something related to termination terms (layoff vs others). Does someone know any engineer vs vc forum where i could get some feedback from people more familiar with such stuff?
Leave a Comment