The problem with tranched VC investments

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.

http://avc.com fred wilson

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.
bunterberg

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?
http://OnStartups.com Dharmesh Shah

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.
bunterberg

@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?
bunterberg

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.
http://www.emerging101.com Johan Söderberg

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.
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Dave Hendricks

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.
http://thedreaminaction.com Ryan Graves

Chris,
I’m continually impressed with your posts. I always learn. Keep it up, I’ll be around.

Subscribing to RSS now.
Cheers,
Ryan
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anonymous

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?
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Hi

your topic interesting and usefully in life.

Olivia
………………………….
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http://www.trancecommunity.com Trance

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?
http://twitter.com/taylorwc taylorwc

have also seen it happen where the VC will commit money they haven’t yet raised for an additional closing of their new fund. Company hit milestones beautifully, but there was no money to invest. Set the company back almost a year.
http://www.seeingbothsides.com bussgang

Funny – we’ve had numerous good experiences with tranching, particularly at medical start-ups where there are “bright line” milestones. It’s in neither the entrepreneur nor the VC’s interests to waste capital and overfund a company. Yet when there is a “bright line” technical milestone that has not yet been achieved, it is nearly impossible to raise outside capital. Tranching allows the existing syndicate to commit to funding at a pre-negotiated price when the milestone is achieved and reduces risk and uncertainty for the entrepreneur as to when it comes to the next round of funding. For many deeply technical start-ups, there are rare cases of big up rounds, so the “cost” to the entrepreneur is pretty minimal as compared to the risk mitigation.
http://informationarbitrage.com/ infoarbitrage

chris, in the scenario you outlined (which represents the lion’s share of tranched deals i’ve seen) i completely agree.

personally, i have used tranching successfully in incubation scenarios, where the dollars are small, the milestones clear and the near-term personnel needs limited. it is designed such that if the first tranche milestones aren’t hit within a reasonable time frame, it’s probably best to take the loss and have the entrepreneur seek more fertile pastures. however, if they are hit the second tranche is sufficient to carry them to the series a, which is done on a fully marketed basis.

i have seen nightmarish scenarios similar to the one you outlined, $5MM, blah, blah, blah. hate them.
DaveJ

Just to be a devil’s advocate (and also because our Series A-2 was tranched and it worked great):
1. Maybe. In the early stages of a company, if you’re hiring people who are worried about whether they will have a job in six months and who somehow think that it’s somehow separate from their performance, you’re hiring the wrong people anyway. Early stage companies should be hiring people who are not only comfortable with the risk but don’t *see* it as a risk because they believe in what they can do.
2. The entrepreneur needs to be nurturing these investor relationships anyway. Eventually there will be a next round anyway, and it’s better to cultivate relationships early and have them follow the company’s progress.
3. Agree with this: the follow-on tranches should be in the investor’s sole discretion so that no one is under any illusions.
4. Is this really different from what the relationship is with respect to the next round? Whether the entrepreneur has 18 months or 6, he or she has to learn how to communicate honestly and openly with the investor while still selling the promise of the company. Is it really better to have open communication for 12 months followed by six months of information manipulation? Also, as an investor you should have a finely tuned BS detector – if you’re getting BS from the entrepreneur you should shut it down after one tranche rather than putting it all in and having the stakes be higher.

I do think tranching makes the most sense early on. It’s try before you buy, keep the pressure on, keep the capital raised low until you figure out the strategy.
Mike Walrath

Missed this one a year ago, but glad to see it re-opened here. I generally agree with your comments Chris. I did however have a pretty positive experience with tranching that may be an option for both investors and entrepreneurs. When we raised the series A for Right Media, we did a deal for 12M of investment, 7M upfront and 5M in a second tranch which our VC’s (Redpoint) had up to 1 year to fund. If they didn’t provide they money within a year, they lost the right to provide it.

Initially I struggled with the concept. It felt like they were getting a free look. However, ultimately I got over it as I thought through the risks or both parties:

- I didn’t need more than the 7M of capital (it was in fact plenty to last more than a year). However, I wanted a valuation that meant that Redpoint would own less of the company than they usually wanted for the 7M.
- Redpoint (naturally) felt the valuation I wanted to was too high, but they really liked the company and wanted to move forward with some downside protection. If we sucked, they were only exposed for 7M, rather than 12.

Think about the scenarios:

If all goes well Redpoint puts in the extra 5M and gets the ownership they wanted (and I was willing to give them). I get the valuation I wanted either way – and I have plenty of capital to get through the term of the 2nd tranche.

If all doesn’t go well they don’t fund the 2nd tranche, I still got 7M (the minimum capital I was willing to raise) and and my price. I am free to go into the market and raise additional capital at the best price I can. The upshot in this case (to the extent there’s an upshot when you don’t execute well) is that we take less dilution than we originally anticipated.

In the end, Redpoint funded the extra 5M before the end of 12 month period and the rest of the story worked out pretty well also.

A few key points:

I would not have accepted a term on the 2nd tranche more than 12 months. Better not to sit longer than that wondering if the money is going to come in or not.

I would not have done a milestone based tranche. Too hard to enforce, and who wants to force someone to put money into your business. This is a board member you’re going to have to live with…milestone based tranching is much stickier than time-based tranching options. I also hate milestone based earnouts in M&A – way to hard to measure and too much control usually sits with the acquiring company when it comes to execution that gets to the milestones…but that’s a different topic.
http://azeemazhar.com/ azeemazhar

Great point chris, from an entrepreneurs perspective you usually want to focus on execution for 18 months

But in your experience, how useful are pre negotiated milestones anyway? What happens if there is a pivot halfway through? Even if there isn’t doesn’t the trajectory of the business normally follow some unforeseen path?
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Anonymous

Can you think of any specific examples where a tranche was employed, the milestones were met, but the VC didn’t follow on as promised?
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